Will the U.S. default? Is it really possible?

What happens on the day Uncle Sam runs out of money?

Or equally drastic: What happens when he’s no longer able to borrow from Peter to pay Paul and misses payments to countless creditors around the world?

Treasury Secretary Geithner sent a letter to Congress earlier this month with some of the answers. In it, Geithner describes a scenario in which …

A broad range of government payments are stopped, limited, or delayed, including military salaries, Social Security, and Medicare payments, interest on debt, unemployment benefits, and tax refunds.

Interest rates and borrowing costs move sharply higher, home values decline, and retirement savings for Americans are reduced.

Geithner even warns of “a financial crisis more severe than the crisis from which we are only now starting to recover.” (See my commentary in “Doomsday Scenario” and also Geithner’s actual letter.)

But if the United States truly missed interest and principal payments on its debts, the actual scenario would likely be far worse:

Instead of acting as ultimate protector and benefactor, the government is increasingly perceived as the ultimate deadbeat and even public enemy. Government agents and agencies fail to respond when desperately needed or, worse, overreact to perceived threats to their power, harming innocents financially and even physically.

Local governments shut down libraries, county jails, even courts. Garbage piles up on the streets. Crime rates soar. But police enforcement is so scarce that the wealthy must pay bribes for adequate protection, while middle-class communities are left largely defenseless.

State governments gut budgets, lay off teachers, and close schools. Classrooms are so crowded, children are allowed on campus strictly on a first-come, first-served basis. Truancy is rampant but ignored.

The federal government cuts current Social Security and Medicare payments across the board or, worse, sends recipients greatly devalued checks. Veterans hospitals shut down. Unemployment benefits are slashed.

Fannie Mae’s and Freddie Mac’s lending operations are phased out. Affordable FHA mortgages are scarcer than hen’s teeth. Washington’s many foreclosure prevention programs are themselves closed. Millions of homes are repossessed and dumped on the market.

What Will Actually Happen?

Let’s consider all the facts — coldly, objectively, and without political bias.

Fact #1. Everyone — including Mr. Geithner and the Republican leadership in Congress — knows that the debt ceiling debate is mostly political posturing. Everyone also knows that to overcome this hurdle, all Congress has to do is pass a simple piece of legislation. Therefore, we do not expect the U.S. government to default directly on its debts.

But the U.S. is already defaulting indirectly by devaluing the U.S. dollar … and it will continue to do so!

Fact #2. No government can repeal the law of supply and demand. No army or police can enforce laws that might seek to control global financial markets.

They cannot stop investors all over the world from selling U.S. dollars.

They cannot stop those same investors from dumping U.S. Treasury notes or bonds.

And ultimately, they cannot force foreign creditors to continue lending money to the United States.

Fact #3. The U.S. has already reached its debt limit, and a fundamental shift in global attitudes toward Washington is already under way.

Meanwhile, Mr. Geithner is postponing the ultimate judgment day with a series of money-shifting shell games at the Treasury Department.

The true, drop-dead deadline, he says, is August 2. If Congress doesn’t raise the nation’s legal debt limit by then, that’s when the shift will truly hit the fan.

This gives Congress some more time. But no one knows how much time America’s foreign creditors will give us …

Fact #4. Even as early as the year 2000, the U.S. began to depend massively on borrowing from overseas — a total of $1 trillion.

China, the UK, Germany, and OPEC countries loaned America large sums, with the single largest loans coming from Japan. In fact, at that time, the U.S. borrowed more from Japan than the sum total of the other four.

But it wasn’t enough to sustain the debt-hungry, bubble economy in the United States.

Giant Internet and technology companies crashed. The Nasdaq lost three-quarters of its value. The American economy sank into recession. Unemployment soared.

Fact #5. To save the economy from collapse, then-Fed Chairman Alan Greenspan artificially shoved interest rates down to the lowest levels in a half century … and kept them there for nearly two years.

In addition, the U.S. was forced to borrow massively from overseas AGAIN — this time mostly from China.

But it STILL wasn’t enough!

The housing bubble burst. The economy collapsed. America’s largest banks went broke or needed giant bailouts. All of Wall Street nearly melted down.

Total debts to foreigners as of the latest reckoning: $4.47 trillion, or more than QUADRUPLE the level of 2000 — by far the largest of all time.

Fact #6. If you think borrowing trillions from overseas is a warning sign of big trouble, wait till you see what happened next.

When the lowest interest rates in a half century and the biggest-ever borrowing from overseas were STILL not enough to rescue failing banks and finance ballooning federal deficits, Fed Chairman Ben Bernanke resorted to the greatest money printing in U.S. history (as measured by aggregate reserves of banks and the monetary base).

Heck, even in the most extreme circumstances of recent history, the Federal Reserve had never pumped in anything close to the amounts Bernanke created.

For example, before the turn of the millennium, the Fed scrambled to provide liquidity to U.S. banks to ward off a feared Y2K catastrophe, bumping up the monetary base from $557 billion on October 6, 1999 to $630 billion by January 12, 2000. At the time, that sudden increase was considered extreme — $73 billion in just three months.

Similarly, in the days following the 9/11 terrorist attacks, the Fed rushed to flood the banks with liquid funds, adding $40 billion through 9/19/01.

But Mr. Bernanke’s money printing since September 2008 has been a whopping 22 times larger than during in the Y2K episode and 41 times larger than 9/11!

Moreover, in the Y2K and 9/11 episodes, soon after the immediate crises had passed, the Federal Reserve promptly reversed its money infusions and took the excess amounts back OUT of the economy, restoring a semblance of normalcy.

But now, Mr. Bernanke has done precisely the opposite! He has continued his money-printing binge virtually nonstop — first under the rubric of “quantitative easing round one” (QE1) and now under “quantitative easing round two” (QE2).

Total amount printed by Bernanke so far? $1.634 trillion! (From 9/10/2008 through 5/4/2011.)

And that’s on top of Bush and Obama economic stimulus packages — not to mention countless government bailouts and guarantees!

But It’s STILL Not Enough!

As Mike Larson explains in “The Forgotten Crisis,”

“The massive economic stimulus package from a few quarters back, plus the Federal Reserve’s unprecedented wave of money printing, didn’t buy us much. We printed, borrowed, and spent more than $2 trillion. And all it bought us was a few quarters of tepid GDP growth.

“Now the end of QE2 is looming in just six weeks. The federal government is tapped out, what with the debt ceiling pressure. So we’re left with an economy that has to stand on its own two feet … and it appears it just can’t!

“GDP growth already slowed from 3.1 percent in the fourth quarter of 2010 to 1.8 percent in the first quarter of this year. Now it looks like things could be even worse in the current quarter.”

Meanwhile, Mike points out that …

1. Housing starts have just plunged 10.6 percent, leaving the market stuck at a dismal level of about 500,000 to 600,000 starts for two-and-a-half years — DESPITE hundreds of billions of dollars in aid being thrown at the market by Washington.
2. Home prices are down again. They fell apart in the housing bust. Then they recovered a bit. Now, they’ve fallen back down and are dangerously near their lowest levels reached during the depth of the housing bust in early 2009!
3. Industrial production flatlined in April, confounding economists who were looking for a gain of 0.4 percent.
4. The Empire Manufacturing Index, which measures activity in the greater New York area, plunged to 11.9 in May from 21.7 a month earlier.

“Bottom line,” concludes Mike, “the American economic engine is starting to sputter again!”

Time Is Running Out!

The U.S. dollar has already been plunging against nearly all major currencies of the world.

The cost of food, energy, and imports are already going through the roof.

Mr. Bernanke’s second big round of money printing is already about to end. Even if he embarks on a third round, he will have to step up the pace dramatically, risking even bigger price surges … or cut back the pace, risking an economic tailspin.

Which will it be? Right now, Bernanke’s on track to ramp up the printing presses even further.

Our advice:

• Stay away from medium-term notes or long-term bonds of any kind, whether issued by local governments, the U.S. Treasury, or corporations. Remember: Even a moderate acceleration of inflation can significantly erode their value.
• To protect yourself against inflation, buy, hold, and accumulate gold and other hedges.
• The best defense is to go on the offense. And the best way to go for substantial profits is with ETFs that are most likely to rise as the dollar falls.

Good luck and God bless!

Martin