In October 2008, the Western world was close to a financial meltdown. Today, as the Eurozone stands at a cliff, Capitol Hill is pushing the U.S. economy to the edge.
Reportedly, leaders of a bipartisan “Gang of Six” senators have reached agreement on a major plan to cut the deficit by more than $4 trillion over the coming decade. The plan has already been touted as a bold entry into the bitter bipartisan debate on the deficit.
In the short term, the news is positive and may calm the U.S. markets. But the devil is in the details.
Last week, I visited Washington, D.C. During my stay, I met several representatives of U.S. political, security, and industrial elites. In one way or another, each asked a similar question: Why hasn’t the United States already been penalized by the markets?
Well, due to the postwar history, international markets have a high regard for the United States – perhaps too high.
Markets are not efficient. But nor are they dumb.
Short-Term Impact of Liquidations
Today, only a third of Americans believe that the United States is heading in the right direction. This figure is now the same as in September 2008, right before the onset of the financial crisis in the U.S., which triggered the Dow’s fall of over 50% in 17 months.
At the time, members of the Congress saw the Dow plunge and could not believe their eyes, even as they contributed to the market panic. As one listens to a wide variety of views in the Capitol Hill today, it is déjà vu, all over again.
During the financial crisis, informed international observers thought that the lessons had been learned in the United States. There would be no return to business as usual. America’s growth trajectory would change. America would save more and consume less. And yet, the U.S. national debt already exceeds $14.5 trillion.
Today, foreign nations fund a third of the U.S. budget deficit, by holding Treasury Securities. Last May, the grand total of foreign holders amounted to more than $4.5 trillion. China accounted for more than 26%, followed by Japan (20%), UK (8%), oil exporters (5%), Brazil (5%) and Russia (3%).
According to U.S. media, China, along with other major foreign holders, has “no alternative but to continue buying U.S. debt.” Yet, as history demonstrates, there are always alternatives. To think otherwise is naïve.
So what if, for whatever reason, these foreign holders would disinvest their treasuries?
After all, non-Chinese interests account for 74% of the foreign holders’ total. Moreover, advanced economies – including Japan, UK, Ireland, Italy, and France – that account for a major portion of the Treasuries have substantial debt problems of their own.
In Japan, gross debt exceeds 210% of GDP. In UK, growth is stagnating and economic problems keep mounting. Ireland has already been bailed out once. In the Eurozone, uncertainty is rising rapidly because, with €1.6 trillion of debt ($2.2 trillion), Italy is dependent on investors’ confidence to keep its interest payments low.
Conversely, in the United States, concerns over the potential impact of disinvestment have grown as national governments have become more active investors and as uncertainty over the risks associated the post-crisis challenges has increased volatility in financial markets.
Also, since the current U.S. economy is not experiencing robust rate of growth and credit markets are already under substantial pressures, withdrawal prospects could have a stronger effect on the economy.
Unfortunately, the international environment magnifies such prospects.
Taken into consideration the rapidly-escalating debt crisis in the Eurozone, Japan’s lost decades, rising inflation in the large emerging economies, the continued turmoil in the Middle East and the rising food and energy prices, not to speak of the feedback effects within and among these forces, any adverse development in the U.S. Treasury markets risks a storm in the global markets.
In a typical withdrawal scenario, a single large foreign investor or a group of such foreign investors would rapidly liquidate U.S. Treasuries, diversify dollar-denominated assets, or shift away from such assets.
In the “sudden withdrawal” scenario, the price of U.S. Treasuries would plunge in U.S. securities markets. Conversely, the market rate of interest would climb. As the shift away from dollar-denominated assets would increase demand for and the prices of other currencies relative to the dollar, the dollar would fall in value relative to other currencies. In turn, the subsequent uncertainty associated with the U.S. marketplace would dramatically reduce the postwar trust in Pax Americana, while boosting demands to replace the dollar as a world currency with a basket of major currencies.
In the “diversification” scenario, foreign investors would seek to diversify disruptively the composition of their portfolios by replacing a significant share of their holdings of U.S. Treasuries with other dollar-denominated assets. As foreign investors would struggle to get rid of Treasuries for other assets, the price of the former would decline and the prices of other assets would rise. Investors would run away from Treasuries and toward other dollar-denominated assets.
In the “shift away from dollar-denominated assets” scenario, foreign investors would try to pare down their holdings of dollar-denominated assets through a liquidation of part or all of their holdings of dollar-denominated assets, possibly even direct investments (in U.S. businesses and real estate), either slowly or rapidly. In the former case, the investors could avoid the large short-run shifts in the prices of financial assets and in the exchange value of the dollar. In the latter case, the prices of those assets would plunge, given the pervasive role of foreign investors in most U.S. markets.
The Inevitable Has Begun
In absolute terms, China’s purchases of U.S. debt have continued. In relative terms, these purchases may have peaked in fall 2010. In other words, the slow shift away from dollar-denominated assets and effort at diversification has been increasing. Currently, other major foreign holders are either engaging in or considering similar strategic moves.
Based on gradual evolution, this strategy purposefully seeks to avoid abrupt disruption. And that is very much in the interest of China, other major foreign holders, and the United States.
In the past few weeks, however, the stalemate on Capitol Hill has effectively reduced incentives for this strategy. Instead, the stalemate is eroding international trust in the United States.
On May 16, 2011, the U.S. debt exceeded $14.3 billion, the legal debt limit. As difficult as it has been for the two dominant parties to agree on a new debt limit, that objective is no longer enough.
Recently, the ratings agency Standard & Poor’s warned there is a one-in-two chance it could cut the United States’ prized triple-A rating if a deal on raising the government’s debt ceiling is not agreed soon. Putting the U.S. on negative watch, S&P, along with investors, expects more.
In order to sustain its triple-A rating, Washington should opt for a credible long-term fiscal adjustment. If the bipartisan plan will materialize, it could provide an appropriate medium-term benchmark. But in the absence of long-term adjustment and adequate containment of health care costs, the faith in the U.S. markets that has characterized the world economy since the postwar era will decline
Washington’s Worst Threat
During the two Bush terms, America’s international prestige suffered significant setbacks. In the future, America’s relative economic power will continue to decrease, due to the secular shift of global growth drivers from the advanced economies to the emerging economies. In the next two decades, the U.S. share in the world economy is expected to be halved from 24% to 12%.
Faced with such powerful cyclical and secular forces, one would expect America’s grand strategy to build on the existing strengths while preparing for the future challenges. In the past few weeks, however, Washington has contributed to the erosion of the current U.S. strengths, while leaving the nation increasingly vulnerable to global forces that it can no longer manage.
If, in the coming days, the decline of the U.S. prestige will accelerate, it can no longer be attributed to some exogenous force. Today Washington’s worst threat is not Wall Street or offshoring, Al Qaeda or Taliban – but Washington itself.
If this relative decline will not accelerate, the past weeks have demonstrated how political polarization and lack of leadership on Capitol Hill can push U.S. economy to the edge.