In February 2010, US Treasury Secretary Timothy Geithner stated that the US was in no danger of losing its AAA debt rating, even though the US government had forecast a $1.6 trillion budget deficit in 2010. Geithner stated that downgrade was not a concern: “Absolutely not. That will never happen to this country.“
In 2011, the unseemly wrangling over the debt ceiling and the downgrade of the US’s credit rating focused attention on the issue of American debt. It has also focused attention on the role of the US dollar in global finance and the problem of large and persistent global imbalances, which remain unresolved.
Non-American observers viewed the debt ceiling debate with morbid fascination and increasing concern. Germany’s largest daily newspaper Bild Zeitung observed: “… America is currently exhibiting is the worst kind of absurd theatrics. And the whole world is being held hostage….Irrespective of what the correct fiscal and economic policy should be for the most powerful country on earth, it’s simply not possible to stop taking on new debt overnight. … the Republicans have turned a dispute over a technicality into a religious war, which no longer has any relation to a reasonable dispute between the elected government and the opposition….The political climate in the US has been poisoned to a degree that is hard for us (Germans) to imagine. But we should all fear the consequences.“
Germany’s conservative daily Die Welt pondered American lack of self awareness about their position: “In the middle of the poker game between the two political parties to prevent a national default on Aug. 2, polls show that 77 percent of Americans believe that they live in the world’s greatest system of government. Just as many are convinced that life is only worth living as an American.“
The inability of many European countries to access markets is an immediate danger that threatens financial markets and the global economy. But the US debt problems remain an equally serious problem.
On 5 August 2011, Standard & Poors (“S&P”) downgraded the US sovereign credit rating by one notch from AAA to AA+. The other two major rating agencies – Moody’s and Fitch – maintained America’s top notch AAA rating.
S&P was not the first rating agency to downgrade the US. China’s Dagong Global Credit Rating Company originally downgraded the US to A+ (4 levels lower than AAA) in late 2010 when the US Federal Reserve decided to continue loosening monetary policy. In August 2011 Dagong subsequently lowered the United States to a single A indicating heightened doubts over Washington’s long-term ability to repay its debts. Dagong has also downgraded Germany, France and the UK.
Outlining the basis for its decision, S&P’s cited “political brinkmanship” in the debate over the debt ceiling as well as concern about the US government’s ability to manage its finances in a stable, effective and predictable way. The planned $2.1 trillion in budget savings “fell short” of what was required, it argued, to reduce the nation’s debt to more manageable levels.
Despite the hyperbole from hyperventilating US government officials, media and pundits, the downgrade is economically insignificant. The psychological effect on markets and on Americans was more profound.
The markets reaction was puzzling. On 18 April 2011, S&P lowered the outlook for the US credit rating to negative, signalling a possible downgrade. The credit default swap (“CDS”) market has been pricing US risk as less than AAA for some time.
The slight downgrade does not pose any imminent danger to the ability of the US to finance its requirements. The US’s cost of debt will not increase significantly as a result of the marginal downgrade. Despite the shrill rhetoric, the Chinese and other foreign investors are likely to continue purchasing US dollars and government bonds.
Japanese government bonds lost their AAA premium quality in 2002 and are now rated AA minus. The loss of the top rating has not affected their ability to finance at the lowest level of interest rates anywhere since pre-history (currently around 1.00% per annum for 10 years).
Rating the Raters
Critics raged about the “unfairness” of the downgrade. Perhaps the most pungent criticism was on the Internet where one blogger compared S&P to Adam: “Oh, I think eating the apple would be fine“.
In the pages of the Financial Times, veteran investment manager Bill Miller railed against “a stunning ignorance and disregard for the potential consequences on a fragile global financial system.” He argued that S&P should have given weight to “the unique role the US plays in the global economy” and the dollar’s role as a global reserve currency. It is not obvious why S&P should take into account these factors in establishing a nation’s ability to meet its obligations.
Miller found it “unacceptable that privately owned, for-profit companies” that operated secretly and with no accountability should play such an important role in financial markets. S&P and other rating agencies are reasonably transparent about their methodology. Miller did not mention that no one is required to accept or base its decisions on any agencies’ ratings. Investors and regulators choose to use ratings to determine what investments are permitted, how much capital a bank needs to hold and the borrowing costs of an issuer.
In Miller’s view, the ultimate proof of S&P’s error was that the market disregarded it, measured by the fact that the US enjoys among the lowest interest rates in its history. If the S&P decision was as inconsequential as Miller argued, then it is unclear why it was causing him and others so much angst.
Interestingly, critics seemed unconcerned by all these issues when S&P rated the US AAA. However, when the agencies downgraded the debt, the ratings were wrong and the methodology questionable.
The rating decision does raise important questions, just not the ones being asked.
Ratings measure the ability of the borrower to pay interest and principal on a timely basis. The rating does not measure the value of the payments received, only the making of contracted payments. A sovereign, able to print money, should never default on securities issued in its own currency. The real risk is that by printing money it devalues its currency and reduces the value of the payments received, which is what the US has done. The fundamental question is whether ratings of sovereign obligations in its own currency are useful or meaningful at all.
S&P’s overstatement of the increase in debt by around $2 trillion was a significant error, even though the slightly lower debt hardly painted a good picture of US public finances. It was reminiscent of mistakes in methodology or modelling that were discovered in the rating of many structured products during the global financial crisis. Allegations that S&P may have proved selective access to information about the downgrade to some market participants were also troubling.
At Debt’s Door…
The rating, flawed as it is, should not distract from the real issue – the quantum of US government debt and the ongoing ability to finance America. Ralph Waldo Emerson wrote: “The World owes more than the world can pay.” The US certainly owes more than it can repay.
US government debt currently totals over $14 trillion. Commentator David Rosenberg passionately described the problem: “In the past three years…we had the U.S. public debt explode by $5 trillion— the country is 244 years old and over one-third of the national debt has been created in just the past three years. Incredible. The U.S. government now spends $1.60 in goods and services for every dollar it is taking in with respect to revenues which is unheard of — this ratio never got much above $1.20, not even during the previous severe economic setbacks in the early 1980s and early 1990s.” (http://www.zerohedge.com/article/rosenberg-probability-another-qe-round )
The US Treasury estimates that this debt will rise to around $20 trillion by 2015, over 100% of America’s Gross Domestic Product (“GDP”). Even these dire forecasts rely on extremely robust assumption about US growth around 5-5.5% per annum. Lower growth will translate into higher debt levels.
The rapid increase in debt will require Treasury to borrow heavily each year to repay maturing debt and raise new money. Annual interest payments will eventually exceed all domestic discretionary spending and rival the defence budget.
There are other current and contingent commitments not explicitly included in the debt figures reported by the government. Since July 2008, the US government has supported Freddie Mac and Fannie Mae (known as government sponsored enterprises (GSEs)). This totals over $5 trillion in additional on or off-balance sheet obligations.
The debt statistics do not include a number of unfunded obligations – the current value of mandatory payments for programs such as Medicare ($23 trillion), Medicaid ($35 trillion) and Social Security ($8 trillion). Projections show that payouts for these programs will significantly exceed tax revenues over the next 75 years and require funding from other tax sources or borrowing.
In addition to Federal debt, US State governments and municipalities have debt of around $3 trillion.
Apolitical Debt Blues …
US public finances deteriorated significantly over recent years. Pimco’s Bill Gross observed: “What a good country or a good squirrel should be doing is stashing away nuts for the winter. The United States is not only not saving nuts, it’s eating the ones left over from the last winter.“
In 2001, the Congressional Budget Office (“CBO”) forecast average annual surpluses of approximately $850 billion from 2009–2012. With the budget balanced and forecasts of ever-larger annual surpluses indefinitely, the CBO estimated that Washington would have enough money by the end of the decade to pay off everything it owed. The surpluses never emerged.
Instead, the US government has run large budget deficits of approximately $1 trillion per annum in recent years. The major drivers of this turnaround include: tax revenue declines due to recessions (28%); tax cuts (21%); increased defence spending (15%); non-defence spending (12%) higher interest costs (11%); and the 2009 stimulus package (6%). German finance minister Wolfgang Schäuble told the Wall Street Journal on 8 November 2010 that: “The USA lived off credit for too long, inflated its financial sector massively and neglected its industrial base.”
The US budget deficits and debt problems are apolitical, with bipartisan contribution to the accumulated mess in public finances.
Prior to the election of Ronald Reagan, deficit spending largely from military conflicts such as Vietnam and economic downturns created a national debt of around $1 trillion. President Reagan held firm views on government and the welfare state: “Government is like a baby. An alimentary canal with a big appetite at one end and no responsibility at the other.” He quipped that: “Welfare’s purpose should be to eliminate, as far as possible, the need for its own existence.” But between 1981 and 1989, tax cuts and peacetime defence spending contributed to an increase in the debt of $1.9 trillion. The President was disappointed at the growing national debt, joking that: “[The deficit] is big enough to take care of itself.“
Under President George Bush Senior, the national debt increased a further $1.5 trillion, driven by the costs of the first Gulf War and fall in tax revenues from a recession.
Under President Bill Clinton, national debt increased $1.4 trillion. There were large budget surpluses in some years, but increased spending added to the debt. The surpluses were driven by increased tax revenues from corporate and personal tax revenue gains due largely to the Internet bubble. In addition, Treasury Secretary Robert Rubin’s “carry trade“, shortening the maturity of US debt to take advantage of lower short term rates, resulted in interest costs savings.
Between 2001 and 2009, President George Bush Junior added $6.1 trillion in debt, driven by the wars in Afghanistan and Iraq, tax cuts and revenue losses of the economic downturn that started in 2007.
President Barrack Obama added a further $2.4 trillion in debt. The major contribution came from stimulus spending to counter the effects of recession, tax revenue losses due to the downturn, extension of the Bush tax cuts and the continued cost of two military actions.
The US debt problems resemble Agatha Christie’s Murder on the Orient Express – everybody did it but no one is responsible.
Drowning by Debt…
No borrower can incur debt on this scale without the complicity of its lenders.
The US government holds around 40% of the debt through the Federal Reserve ($1.6 trillion), Social Security Trust Fund ($2.7 trillion) and other government trust funds ($1.9 trillion). Individuals, corporations, banks, insurance companies, pension funds, mutual funds, state or local governments, hold $3.6 trillion. Foreigner investors hold the remainder including China ($1.2 trillion), Japan ($0.9 trillion) and “other”, principally oil exporting nations, Asian central banks or sovereign wealth funds ($2.4 trillion).
Until the global financial crisis, foreign lenders, especially central banks with large foreign exchange reserves, led by the Chinese, increased their purchases of US government debt as part of a giant global liquidity scheme.
These reserves arose from dollars received from exports and foreign investment that had to be exchanged into local currency. In order to avoid increases in the value of the currency that would affect the competitive position of their exporters, the exporting nations invested the reserves in dollar denominated investment, primarily US Treasury bonds and other high quality securities. By the middle 2000s, foreign buyers were purchasing around 50% of US government bonds.
During this period, emerging countries, such as China fuelled American growth, both supplying cheap goods and providing cheap funding to finance the purchase of these goods. It was a mutually convenient addiction – China financed customers creating demand for exports and America received the money to buy cheap Chinese goods. Asked whether America hanged itself with an Asian rope, a Chinese official told a reporter: “No. It drowned itself in Asian liquidity.“
Following the global financial crisis, foreign purchases have decreased to around 30% of new issuance. Around 70% of US government bonds (US$ 0.9 trillion) have been purchased by the Federal Reserve, as part of successive rounds of quantitative easing.
The large stock of US debt and seemingly uncontrollable US budget deficits now pose several problems. Is the level of debt sustainable? How is it going to be funded? How can the deficits and debt be brought under control? What happens if the US finds itself unable to finances its requirements? The answer to these questions will shape the global financial economic landscape for a long time to come.
In their book “This Time Is Different“, Carmen Reinhart and Kenneth Rogoff suggest that a sovereign debt level above 60-90% of a country’s Gross Domestic Product (“GDP”) is not sustainable. But the level of tolerable sovereign debt depends on a multitude of factors.
One factor is the currency of the debt. The US borrows in its own currency, meaning that its debt capacity is only constrained by the willingness of investors to purchase its securities and the cost of that borrowing. As the US dollar is also a major reserve currency, used in global trade or favoured as an investment by central banks, the scope for borrowing to finance America’s budget and trade deficits is commensurately higher.
Where a country has a large domestic saving pool, like Japan, the ability of the government to finance its expenditure is significantly increased. A country reliant on foreign investors for its funding is far more restricted, limiting its debt levels. Unfortunately, the US saving rate declined in recent years making the country increasingly reliant on foreign investors.
The level of interest rates and the proportion of public revenues needed to service the borrowing affect the level of debt. Low interest rates have allowed the US to maintain higher levels of borrowing.
Assuming a debt-to-GDP ratio of 100%, an average interest rate of 3% and federal revenue of 15% of GDP (the current level), the interest bill consumes around 20% of the budget. At an interest rate of 6%, it would be an unsustainable 40%.
Given that current interest rates are artificially low, critics have argued that: “The government is on ‘teaser’ rates. We’re taking out a huge mortgage right now, but we won’t feel the pain until later.“
The maturity structure of the debt is important. Short term debt increases vulnerability to market disruptions, limiting the level of borrowing. Conversely, longer maturity and low concentration of maturing debt in an individual period can increase debt capacity. The US’s average maturity of debt at one stage fell to under 4 years. Issue of longer dated bonds has increased it to just over 5 years. However, the US must still issue a substantial amount of securities each year making them financially vulnerable.
The most important factor is current and expected economic growth rates as well as the size and economic structure of the country. A dynamic economy capable of high levels of growth, with the attendant ability to generate additional tax revenues, can maintain higher levels of debt than one with lower growth prospects.
Unfortunately, the structure of the US economy has changed in a deleterious way in recent years. The economy has become more narrowly based. In addition, the majority of borrowings were not used to improve the productivity or economic base of the economy. The debt was not used to finance a 21st-century equivalent of the 19th century railroads. The debt financed costly wars and consumer spending, including over investment in housing.
But the real issue is that the economic growth of recent years was debt fuelled. Since 2001, borrowing contributed to around half the recorded economic growth in the U.S. By 2008, $4 to $5 of debt was required to create $1 of growth. Reduction in debt will reduce growth, which in turn makes the level of borrowing more difficult to sustain.
Historically, America has been able to run large budget and balance of payments deficits because it had no problems in finding investors in US treasury securities. The unquestioned credit quality of the US, the unparalleled size and liquidity of its government bond market ensured investor support. Given its reserve currency and safe haven status, US dollars and US government bonds remained a cornerstone of investment portfolios.
The US dollar’s share of world trade and investment is extraordinary and out of proportion to its economic role. The dollar remains the principal currency for invoicing and settling trade. 85% of foreign exchange transactions involve the dollar. 50% of stock of international securities is denominated in US dollars. Central banks hold 60% of their foreign exchange reserves in dollars. All this is despite the fact that the US’s share of global exports is only 13% and foreign direct investment is 20%.
At one stage, around 85% of global capital flows was flowing into the US, including a significant portion (around $400 billion per year) into US government bonds.
The sheer quantum of US debt and credit concerns now means that foreign investors may be less willing to finance America. Investors may baulk at continuing to roll over debt or increase their exposure. Foreign investors in Japan and Europe, struggling to finance their own government obligations, may simply not have the funds to invest.
In recent history, foreign investment in US government bonds reduced the interest rate by between 0.50% and 1.00% per annum (equivalent to $73-145 billion per year). If foreign governments ceased to continue purchasing Treasuries, US bond interest rates could increase, potentially sharply. If foreign governments actively reduced their investment by selling existing Treasury positions, then the rise in rates would be even greater. This would, over time, increase the borrowing cost of the US, reducing its ability to sustain the high level of debt.
In a more extreme case, if foreign investors cease to start to sell-off holding of US Treasuries and cease to purchase new bond, it is conceivable that the US would be unable to finances its requirements entirely. This would register as failed government bond auctions.
The Balance of Financial Terror…
US financing strategy is based on the “balance of financial terror“.
China, the major investor in US government bond investors, finds itself in the position that John Maynard Keynes identified: “Owe your banker £1000 and you are at his mercy; owe him £1 million and the position is reversed.” Over recent years, Chinese concerns about the US debt position has become increasingly shrill.
In 2010, Yu Yongding, a former adviser to China’s central bank, mused: “I do not think U.S. Treasuries are safe in the medium-and long-run…Only God knows how much value that China has stored in the U.S. government securities will be left in the future when China needs to run down its reserves.” In 2011, a Chinese government spokesperson could only “hope the US government will earnestly adopt responsible policies to strengthen international market confidence, and to respect and protect the interests of investors.” In 2010, US Treasury Secretary told a gathering of Chinese students that US government bonds were “safe” investments, eliciting derisive laughter.
But China has America right where America wants China!
Existing investors, like China, must continue to purchase US dollars and government bonds to avoid a precipitous drop in the value of existing investments. This allows America time to correct its deteriorating public finances and reduce its borrowing requirements. It also allows increases in domestic savings to reduce reliance on foreign investors. The US Federal Reserve remains a buyer of last resort, although the long term consequences of this “printing money” strategy remains uncertain.
For the moment, this tenuous strategy appears to be holding. Demand for Treasury securities from investors and other governments has continued. Domestic investment, primarily from banks who are not lending but parking cash in government securities, has been strong. US government rates remain low. The government’s average interest rate on new borrowing is around 1%, with one-month Treasury bills paying less than 0.10% per annum. This has allowed the US to keep its interest bill manageable despite increases in debt levels.
In effect, the US requires artificially low interest rates to able to service its debt. Federal Reserve Chairman Ben Bernanke told the House Financial Services Committee that the US faces a debt crisis: “It’s not something that is 10 years away. It affects the markets currently…It is possible that the bond market will become worried about the sustainability [of deficits over $1 trillion] and we may find ourselves facing higher interest rates even today.“
The current position is not sustainable in the longer term. Unless the underlying debt levels and budget deficits are dealt with the ability of the US to finance itself will deteriorate. The US treasury must issue large amounts of debt almost continuously – weekly auctions regularly clock in at $50-70 billion unimaginable a few years ago. America’a ability to finances its need may not continue. As English writer Aldous Huxley observed: “Facts do not cease to exist because they are ignored.“
The solution lies in bringing budget deficits down, through spending cuts, tax increases or a mixture of both.
According to the CBO, spending increases have averaged 21% of GDP from 1980 to 2007 and are likely to increase to 25% by 2019.
In 2011, the major categories of government spending were defence (24%), social services (44%), non-defence discretionary (25%) and interest (7%). Interest costs, currently around 7% of total spending, are expected to increase by as much as three times driven mainly by the increase in the level of debt. The major increase in spending will come from social service entitlement programs. If current policies are maintained, pensions and health care for the retired (Social Security and Medicare) and health care for the poor (Medicaid) will increase from 10% of GDP in 2011 to 18% by 2050.
Winding back military overseas commitments and also reduced stimulus spending, assuming the economy and employment improve, will help reduce the deficit. But any significant reduction in government spending requires decreased spending on defence and entitlement programs.
Tax increases will be required. US Federal revenue is around 15% of GDP (down from 18-19%). Comparative levels of government tax revenues are Germany (37%) UK (34%) and Japan (28%).
Rating agency Fitch in maintaining America’s AAA status assumed that revenue raising measures totalling an extra $1 trillion would be found and government revenues would stabilise at 21% of GDP, a 40% increase and above historical average levels.
Increasing revenue will require a combination of increased taxes, fewer deductions, new taxes and changes in the tax system. Tax reform ideally requires reducing complexity and broadening the tax base, generally by increasing taxing on consumption.
The US tax system relies heavily on income tax (both individuals and corporations) and payroll taxes. The system discourages work and investment while encouraging borrowing and spending. The tax code is riddled with tax credits and exemptions, worth as much as $1 trillion per annum.
The system distorts behaviour. The mortgage interest deduction encourages borrowing, leverage and over-investment in housing. Deduction of employer provided health insurance encourages more expensive programs and higher health care costs.
The system is regressive, favouring individuals with higher income. The tax system is complex (several million words long with changes, on average, more than once a day) increases compliance costs (estimated at $200 billion per year) and creates opportunities for avoidance.
Tax reform would require broadening the tax base, by eliminating loopholes and exemptions while lowering rates. Most exemption and deductions would need to be eliminated, with the possible exemption of incentives for retirement saving. Around $500 billion per annum could be generated from eliminating deductions for employer-provided health care, mortgage interest, capital gains on homes and state and local taxes.
Other options including a broad tax on consumption. A 5% value added tax, exempting education, housing, religious and charitable services, would raise $300-400 billion a year. Some of the proceeds would probably need to be directed to reduce the impact on the poor, to offset the tax’s regressive nature. Another alternative would be a tax on carbon emissions or a higher fuel tax, which would raise revenue, penalise consumption and encourage energy efficiency.
The task is Herculean. Government revenues would need to be increased 20-30% or spending cut by a similar amount. In a nation where 45% of households do not pay tax (because they don’t earn enough or through credits and deductions) and 3% of taxpayers contribute around 52% of total tax revenues, it is difficult to see the necessary changes being made.
Reducing the budget deficit and reducing debt may also mire the US economy in a prolonged recession. In 2009, students at National Defence University in Washington, DC, “war gamed” possible scenarios for bringing the US debt under control. Using a model of the economy, participants tried to get the federal debt down by increasing taxes and reducing spending. The economy promptly fell into a deep recession, increasing the budget deficit and driving government debt to higher levels. This is precisely the experience of heavily indebted peripheral European nations, such as Greece, Ireland, Portugal, Spain and Italy.
America’s ability to control its budget deficits and debt is a function of its politics. Major categories of spending (defence and entitlements) are politically sensitive and regarded as sacrosanct by both major political parties.
Tax reform may also be politically impossible. Some political factions within the Republican Party will not countenance any tax increase at all. Even removing an exemption or credit, in their view, qualifies as a tax increase. Given that tax code loopholes have fierce defenders and new federal taxes are politically toxic, it is difficult to see how any progress is possible.
As one participant in the National Defence University economic war game observed about the process of bringing US public finances under control: “You’ll never get re-elected and you may do more harm than good.”
Given the magnitude of the US debt problem and the lack of political will, the most likely policy is FMD – “fudging“, “monetisation” and “devaluation“.
US states and municipalities demonstrate “fudging“. In the boom years, local government revenues increased from rising property values and taxes allowing additional services and larger payrolls. When the housing bubble burst and property values dropped an average of 35% reducing tax revenues, these entities found it difficult to cut expenses or increase taxes. Instead, some cities and states relied on fiscal “magic tricks” to close budget gaps each year but at great future cost.
Illinois, which has not made the required annual payments to its pension funds for years, borrowed $10 billion in 2003 and used the money to invest in its pension funds. When the recession sent investment returns below their target, Illinois sold an additional $3.5 billion worth of pension bonds and is planning to borrow $3.7 billion more for its pension funds. US state and local government have unfunded pension liabilities nearing $3.5 trillion. Others are selling off assets to temporarily plug budget holes, without viable plans to permanently fix finances.
There is no shortage of creative ideas of financing government debts. Bankers suggested the US issue perpetual debt, that is, the government would not be obligated to pay back the amount borrowed at all. Peter Orzag, former director of the US Office of Management and Budget under President Obama and now a vice-chairman at Citigroup, suggested another creative way to correct the problem – lotteries. To encourage savings, banks should offer lottery-linked accounts offering a lower rate of interest, but also a one-in-a-million chance of winning $1million for each $100 deposited.
As governments printed money to service their debts, US Post issued 44-cent first class “forever stamps” that had no face value but were guaranteed to cover the cost of mailing a first class letter, regardless of how high that cost might be in the future. Between 2007 and 2010 the public bought 28 billion forever stamps. The scheme summed up government approaches to public finance – US Post was cleverly hiding its financial problems, receiving cash up-front against the uncertain promise to pay back the money somewhere in the never, never future.
Debt monetisation – printing money – is the second option. The US Federal Reserve is already the in-house pawnbroker to the US government, purchasing government bonds in return for supplying reserves to the banking system. Expedient in the short term, its risks debasing the currency and setting off inflation. The absence of demand in the economy, industrial over capacity and the unwillingness of banks to lend have meant that successive rounds of “quantitative easing” – the fashionable moniker for printing money – have not resulted in higher inflation to date. But the longer term risks remain.
Monetisation is inexorably linked to devaluation of the US dollar. The now officially confirmed zero interest rates policy (“ZIRP”) and debt monetisation is designed to weaken the dollar.
On 19 October 2010, US Treasury Secretary Timothy Geithner told the Financial Times: “It is very important for people to understand that the United States of America and no country around the world can devalue its way to prosperity and Competitiveness. It is not a viable, feasible strategy and we will not engage in it.” The facts show otherwise.
Despite bouts of dollar buying on its safe haven status, the US dollar has significantly weakened over the last 2 years in a culmination of a long term trend which with minor retracements. In 2007 alone, the US dollar weakened by about 8% improving America’s external position by $450 billion, as US foreign investments gained in value but its debt denominated in dollars were unaffected.
On a trade weighted basis, the US dollar has lost around 18% against major currencies since 2009. The US dollar has lost around 30% against the Swiss Franc, 25% against the Canadian dollar, 37% against the Australian dollar and 16% against the Singapore dollar over the same period.
US dollar devaluation makes it easier for the US to service its debt. In the balance of financial terror, it forces existing investors to keep rolling over debt to avoid realising currency losses on their investments. It also encourages existing investors to increase investment, to “double down” to lower their average cost of US dollars and US government debt. The weaker US dollar also allows the US to enhance its competitive position for exports – in effect, the devaluation is a de facto cut in costs. This is designed to drive economic growth.
Valery Giscard d’Estaing, French Finance Minister under President Charles de Gaulle, famously used the term “exorbitant privilege” to describe the advantages to America of the role of the US dollar as a reserve currency and its central role in global trade. That privilege now is not only “exorbitant” but “extortionate“. How long the rest of world will allow the US to exercise this “extortionate privilege” is uncertain.
A World Without the US Dollar…
Winston Churchill famously observed that Americans can be counted on to do the right things but only after all other possibilities have been exhausted. Unfortunately, it is doubtful that the US debt problem will be resolved by resolute American actions. The deployments of FMDs seem more likely.
America remains the world’s only military super power and constitutes a quarter of the global economy. This means that what happens in America is unlikely to stay in America. The world must prepare for the denouement of the US debt crisis. At best, actions by America will usher in a prolonged period of stagnation for the US economy reducing global economy growth. At worst, continuation of a strategy of FMD and maintaining the balance of financial terror will create a volatile and dystopian economic environment.
As a significant amount of US government debt is held outside the country, foreign investors will suffer significant losses, through depreciation of the US dollar. These investment losses will limit the financial flexibility of these countries, limiting their future growth.
The damage may lead to political instability. In China, the blog-o-sphere has seen fierce criticism of the central government and its management of its reserves.
Foreign lenders may simply give up on the US, write off their existing investments (either explicitly or implicitly) and withhold further investment. This would trigger a major collapse of the US dollar and US government bond prices, triggering a different kind of financial crisis.
A policy of devaluation of the US dollar may trigger trade and currency wars. Many emerging markets have already implemented capital controls. These will be strengthened and supplemented by other measures such as trade sanctions. There are already accusations of protectionism, currency manipulation and unfair competition. This is reminiscent of the trade wars of the 1930s and will retard global growth.
US dollar devaluation is also destabilising for emerging markets and commodity prices. Low interest rates and the falling US dollar have encouraged investors to increase investments in emerging markets, offering better returns and higher growth prospects. These flows have pushed up asset prices and currency values distorting economic activity in these countries.
As most commodities are priced and traded in US dollars, the lower value of the currency causes price rises. Low interest rates have encouraged speculation in and stockpiling of commodities.
Higher commodity prices and strong capital flows are fuelling inflation in emerging markets. Central banks in these emerging countries have been forced to increase interest rates and restrict bank lending to reduce price pressures. Given that emerging markets have been a key driver of economic growth globally, this risks truncating the recovery.
Any problems with the US dollar and unequivocal acceptance of America’s creditworthiness are amplified by its pre-eminent role in economic activity and financial markets. There are limited alternatives to the dollar in global trade, especially given the problems of Japan and the Euro-Zone.
US government bonds are traditionally seen as a safe-haven as well as the preferred form of collateral used widely to secure borrowing and other obligations. If the quality of US government bonds were to fall significantly, then this would affect the solvency of the banking system which have substantial holdings.
US government bonds are used as collateral to raise funding (in the “repo” market) and secure trading in financial instruments. Falls in the value of US government bonds or a loss of confidence in their value as surety would lead initially to a global “margin call“, as the value of the collateral is marked down setting off a “dash for cash“. In an extreme case, where US governments bonds are not accepted as collateral, it would lead to a contraction of liquidity and financial activity generally.
Many of these problems are not new. Politicians and policy makers have persistently refused to deal with the role of the US dollar as a reserve currency and large global financial imbalances for many years. Recent proposals, such the use of Special Deposit Rights (“SDRs”) or introduction of Keynes’ Bancor, are impractical.
No Exit …
The US is in serious, perhaps irretrievable, financial trouble. Peter Schiff president of Euro Pacific Capital, identified the state of the Union with characteristic bluntness: “Our government doesn’t have enough spare cash to bail out a lemonade stand. Our standard of living must decline to reflect years of reckless consumption and the disintegration of our industrial base. Only by swallowing this tough medicine now will our sick economy ever recover.“
There is a lack of political or popular will to take the action necessary to even stabilise the position. The role of US dollars and US government bonds in the financial system mean that the problems are likely to spread rapidly to engulf other nations. As John Connally, US Treasury Secretary under President Nixon, beligerently observed: “Our dollar, but your problem.“
Minor symptoms, often increasing in frequency and severity, can provide warning of a life threatening problem in a key organ, such as the heart. Since 2007, the global financial markets have been providing warnings of an impending serious crisis. Private sector credit problems have spread to sovereign nations. Debt problems of smaller nations have flowed on to larger nations. The problems are gradually working their way to the issue of US debt. Without rapid and decisive action, which seems to be unlikely, a major organ failure within the global economy is now inevitable.
Th magnitude of the problem and its effects are so large, market participants would do well to heed Douglas Adams famous advice in The Hitchhikers Guide to the Galaxy. Find dark glasses that go black in the case of a crisis and a towel to suck on.