In his January 23rd newsletter John Mauldin used the McKinsey report, Working out of debt, to examine the probable plan that countries like the United States will use to reduce their debt level. If you follow John Mauldin and the McKinsey report’s reasoning then government deleveraging is inevitable and economic success depends on how well these countries will manage the process. The McKinsey report draws insight from history and the deleveraging examples of Finland, Sweden, and South Korea. The report goes on to describe how one the primary methods used by these countries was to grow their economies and lower their debt level was by increasing exports. For the sake of argument let us assume that using these historical examples are appropriate for the United States, then we must also assume that a 30% to 50% currency devaluation is a necessary sacrifice to stimulate exports. So here is where I am stuck. Who is going to buy our stuff and why? At the top of the list has to be China and Japan. So let’s follow this logic to its logical conclusion. We devalue the dollar by 30% and China and Japan will start buying our products! As Carmen M. Reinhart & Kenneth S. Rogoff pointed out in This Time Is Different: Eight Centuries of Financial Folly, high inflation and interest rates occur frequently with currency devaluation. It is far more likely that China and Japan will decide to dramatically reduce their dollar position in response to a deteriorating financial situation in the United States. This would likely trigger a financial panic. If China and Japan starts purchasing goods they do not normally purchase and ship them out of the United States for resale would a financial panic. In both situations currency devaluations will likely lead to a financial panic. Regardless of the reason if Chinese and Japanese treasury bond holdings go down by 30%, the Chinese and Japanese will assuredly demand changes. A likely demand will be to replace the dollar as the world’s reserve currency with a basket of currencies. This is not a new demand but it is the beginning of the end of United States deficit spending. Without the Chinese and Japanese supporting the United States treasury market and by extension the United States policy of deficit spending, legislators in the United States will be forced to deal with higher interest rates and a declining financial situation. As an advanced economy the United States is unwilling to default on its debt, allow massive currency deflation, or allow high inflation rates. This leaves only one solution. The United States must start reducing its debt level and addressing its entitlement spending. Unlike a conventional war where there is a “war dividend” when it ends, entitlement spending is a never ending war. This will require the United States to unwind its final financial bubble, the government spending bubble. Unwinding the government spending bubble will force our legislators to support an “almost” balanced budget solution involving some small tax increases, many budget cuts, and the ability to run a temporary, short term budget deficit. This is balanced budget will probably be similar to the balanced budget used by Switzerland. Unfortunately a disproportionate share of balancing our budget will fall on budget cuts including some painful and unpopular cuts to entitlement programs. In this case it is the invisible hand of the financial market enforcing same financial responsibility on the United States that it is enforcing on the rest of the world. The impaired financial stature of the United States implies that China will assume the world leadership position for world economic health sooner rather than later.