You were concerned about the US government debt ceiling and the current game of chicken being played by Congress. I am sanguine regarding this; I see it as mostly posturing for the base.
But you perhaps have missed the real risk, the Fed. Two major problems. First, it is leverage at over 50:1, giving new meaning to the term "fractional reserve system." An exogenous shock, and they become insolvent.
The second is with regard to QE2, the massive expansion in the monetary base, which has put things in a historically extreme situation. The key figure is the ratio of cash holdings to GDP. Give me a few paragraphs to spell it out.
The ratio can be modeled by a non-linear function of short-term interest rates. When interest rates are low, people are more willing to hold cash, when interest rates are high, the money moves into interest-paying investments.
This also means that when interest rates go up, the ratio will change, which means either the money supply shrinks or GDP increases. The fastest way for GDP to increase is for prices to go up, i.e. inflation.
Currently the ratio stands at 17 cents, which is a historical extreme. Worse, this is the extreme (of the non-linear function) when small changes in interest rates have huge impact on the ratio. Increasing the short-term treasury yield to even 0.25% would require either QE2 to be completely undone (reducing the numerator) OR the denominator to increase by 40%.
So there really is no easy way out under the current "rules".
I am not as worried as I perhaps should be. My thought is that civilization is always at the edge of a cliff-- a cliff created by the rules. The usual solution is to cheat, or change the rules. Money and the monetary system are really nothing more than convenient fictions. When the fiction is no longer convenient, the usual solution is to re-define it. Change the story, change the outcome. So I also have a strong curiosity as to what is going to emerge.
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