1. The US debt becomes a problem because it is no longer risk free. This is a theoretical possibility but requires a lot of systemic change. The devastating nature of a US default makes US debt risk free both because no other asset would be immune to such a failure and because it is unlikely that the US political structure would allow such an event. Both of these factors could change but I tend to think we would see that coming.
2. Somehow the economy adjust to produce rapid expected GDP growth. Now, the easiest way to do that is through a massive consumer driven recession. This seems the likeliest possibility to me. Rapidly rising government interest rates begin to crush consumer spending which leads to a massive recession and skyrocketing savings. Something similar to what we just experienced but likely much larger. The rapid increase in savings would push down government yields and the decrease in output would push up expected growth.
I can agree with those scenarios, so I just want to take some time to elaborate. The first scenario is actually covered in Bernard Lieater’s excellent book The Future of Money, in a chapter entitled “Hell on Earth”. In that chapter, Lietaer outlines an equilibrium where governments around the world are unable (or unwilling) to make systemic changes to the financial economy, and simply muddle along from crisis to crisis providing stop-gap “solutions”. During this period, the monetary instability becomes an institutional feature of advanced economies (much like it is an institutional feature of developing economies today). Crises continue to become more intense until eventual (and inevitable) monetary collapse. I tend to think that Smith overestimates either foresight, or the probability that (as will be needed) international coordination of such magnitude is (currently) possible. This is a very scary scenario indeed, but far from being some wild fringe, it is the logical conclusion of such an ecosystem.
On the second, I think his paragraph kind of glosses over the magnitude of the grinding deflation consumers would need to endure in order for businesses to “lose” enough productive capacity to facilitate extremely high growth — and even then, economists to this day argue what pulled us out of the Great Depression, but for those who advocate the “WWII view”, that is a very unhappy conclusion to a very difficult time. Not only that, but depressions of such magnitude produce very unhappy policy conclusions. I think it is much more likely that, if an extreme solution such as this is to come, it will probably be on the inflation side…see scenario one.