With the downgrade of EU’s emergency funding fund, the UScredit rating agencyStandard & Poor have made the whole rating business a fucking joke. If you think this will make waves in tomorrow’s markets, forget it! Nobody takes this shit serious anymore…
“Triple-A or no triple-A, I couldn’t care less.”
Shakeb Syed
“On Jan. 13, 2012, we lowered to ‘AA+’ the long-term sovereign credit ratings on two of the European Financial Stability Facility‘s (EFSF’s) previously ‘AAA‘ rated guarantor member states, France and Austria,” S&P writes in a press release. Adding: “The EFSF’s obligations are no longer fully supported either by guarantees from EFSF members rated ‘AAA’ by Standard & Poor’s, or by ‘AAA’ rated securities.” Well, we already know that, morons!
And you can’t say A without saying B, also, in this business. So, in light of last weeks mass downgrade of European core nations, this is just a natural consequence.
But it becomes rather ridiculous when we’re talking about an international emergency fund that the EU leaders are able to do whatever they want with. Perhaps they choose to “print” enough euros to ten-fold the size of the fund?
Nobody knows anything for sure, these days.
And that’s why most financial pros just don’t give a damn about the rating actions anymore; it’s no longer possible to take the rating business serious.
And, as Norwegian chief economist Shakeb Syed, rightfully points out – there are far more important things to worry about when it comes to the EU economy than its stupid stability facility.
“Triple-A or no triple-A, I couldn’t care less,” Shakeb Syed at Sparebank 1 Markets says in an interview with Norwegian website www.dn.no.
Syed recon there will be some reactions in the financial markets on Tuesday, but not much,
“In the market, the fund have implied interest costs that is not consistent with a triple-A. So, in practice, the difference is not that great,” Syed points out.
The Norwegian analyst also says what many financial pros are thinking these days;
“The EFST is a dead-end.”
“Triple-A or not, the fund will never be big enough th cover both Spain and Italy,” he notes.
And Shakeb Syed seems too keeping the right focus, stating that investors should be more worried about the ECB than the EFSF.
Anyway – here’s a little more from today’s “shocker” by Standard & Poor’s:
“The developing outlook on the long-term rating reflects the likelihood we currently see that we may either raise or lower the ratings over the next two years.”
“We understand that EFSF member states may currently be exploring credit-enhancement options. If the EFSF adopts credit enhancements that in our view are sufficient to offset its now-reduced creditworthiness, in particular if we see that once again the EFSF’s long-term obligations are fully supported by guarantees from EFSF member-guarantors rated ‘AAA’ or by securities rated ‘AAA’, we would likely raise the EFSF’s long-term ratings to ‘AAA’.”
“Conversely, if we were to conclude that sufficient offsetting credit enhancements are, in our opinion, not likely to be forthcoming, we would likely change the outlook to negative to mirror the negative outlooks of France and Austria. Under those circumstances we would expect to lower the ratings on the EFSF if we lowered the long-term sovereign credit ratings on the EFSF’s ‘AAA’ or ‘AA+’ rated members to below ‘AA+’.”
And here we go again! EconoTwist’s wish you all the very best in 2012, although the economic outlook are bleaker than ever. However, keep in mind that in between all the misery there is actually some great opportunities for the smart investors, and some rare possibilities for all hard-working people. Going forward, econoTwist’s will try to identify these, as well as expose the dangers and manipulative information coming from the establishment. And we’re gonna have some fun…
“Financially futile, economically erroneous, politically puzzling and socially irresponsible, the December 2011 European summit was a failure. Only the attending leaders and their acolytes believe otherwise,” analyst Satyajit Das writes in his first commentary of 2012.
Not that it matters much, but note that Mr. Das wrote and published this article before last weeks mass downgrade of European sovereigns by the US rating agency Standard & Poor’s.
In fact, the downgrades just makes his line of arguments even stronger.
German Chancellor Angela Merkel’s post-summit homilies about the “long run”, “running a marathon” and “more Europe” rang hollow.Europe is now firmly on the road to nowhere, with doubts whether there is enough money or political will to retrieve the position.
Fiscal Bondage…
The centrepiece of the new plan was a commitment to a new legally enforceable “fiscal compact” requiring government budgets to be balanced or in surplus, with the annual structural deficit not to exceed 0.5% of nominal Gross Domestic Product (“GDP”).
The language was Orwellian and incomprehensible in equal measure: “Member States shall converge towards their specific reference level, according to a calendar proposed by the Commission.”
Whatever the long-term merit of greater budget discipline, the compact recycles previous Treaties, which have been honoured in the breach rather than observance.
Since 1999 or from the time of their entry, euro-zone member countries have recorded nearly 70 breaches of the existing Stability and Growth Pact, including nearly 30 occasions when budget deficits exceeding 3% of GDP were allowed because of recessions. Germany and France have been in breach on at least 6 occasions each.
Just as Margaret Thatcher favoured “sado monetarism” (a term coined by Denis Healey), the German plan for Europe is “fiscal B&D” (bondage and discipline).
The plan may result in a further slowdown in growth in Europe, worsening public finances and increasing pressure on credit ratings.
This is precisely the experience of Greece, Ireland, Portugal and Britain as they have tried to reduce budget deficits through austerity programs. This would make the existing debt burden even harder to sustain.
The rigidity of the rules also limits government policy flexibility, risking making economic downturns worse.
Fiscal controls may not prevent future problems.
Until 2008, Ireland, Spain and Italy boasted a better fiscal position and lower debt than Germany and France.
The weak economic fundamentals of these countries were exposed by the global financial crisis, leading to a rapid deterioration in public finances.
Irrespective of the treaty’s provisions, enforcement will be difficult. The Excessive Deficit Procedure call for “automatic consequences unless a qualified majority of euro area Member States is opposed”.
The provision defines how any breach and automatic sanction can be waived rather than the consequences of failure to comply.
It is difficult to see France and Germany voting to levy sanctions on each other.
In 2003, there was an ignominious episode where France and Germany each breached the deficit ceiling but voted against condemning each other.
Recalling John Maynard Keynes’ observation about the Treaty of Versailles, if actually implemented and strictly followed, the compact will skin Europe, especially those in the weaker economies, alive year by year.
The fiscal compact did not countenance any writedowns in existing debt. It also did not commit any new funding to support the beleaguered European periphery.
Germany specifically ruled out the prospect of jointly and severally guaranteed euro-zone bonds.
Instead, there were vague platitudes about working towards further fiscal integration.
Rebranding Bailouts…
Instead of dealing with the financial problems of the central bailout mechanism (the EFSF – European Financial Stability Fund), European leaders chose the re-branding option.
The EFSF will remain active until mid-2013 and then subsumed into the permanent European Stability Mechanism (“ESM”).
The ESM will be implemented by July 2012 once 90% of member countries have ratified it – “rapid deployment” in European terms. Crucially, the overall ceiling of the EFSF/ESM remains at Euro 500 billion, but will be reviewed in March 2012. To increase available funds, the EFSF leveraging rules will be implemented more quickly, using the European Central Bank (“ECB”) as an agent in transactions.
Given the indifference towards various leveraging proposals, especially from emerging nations like China, the ability to reach the target of at least Euro 1 billion in capacity remains in doubt. Long-standing problems of the original EFSF structure remain unaddressed.
The creditworthiness of Italy and Spain (which make up around 30% of the EFSF’s supporting guarantees) remains questionable.
Pressure on the ratings of stronger guarantors (Germany, France, Netherlands, Finland and Luxembourg) complicates the ability of the EFSF to raise funds. Rating agencies have already warned of the risk of a rating downgrade.
Currently, the EFSF is only issuing short-term bills to finance its commitments (under the bailout packages agreed for Greece, Ireland and Portugal).
Its long-term funding costs are nearing the rate it is permitted to charge borrowers.
The EFSF was even forced to deny reports that it would need to include a health warning about the risk of a rating downgrade and also break-up of the Euro in documentation for any new fund-raising. Given the problems of the EFSF especially the ratings threat, the acceleration of the ESM initiative is an attempt to reduce the reliance on the member nation guarantees.
The ESM will have paid-in capital (Euro 80 billion) which member countries can contribute.
Like its predecessor – the EFSF – is leveraged – Euro 80 billion supporting euro 500 billion, equivalent to 6 times leverage. Continuing the circularity, nations like Italy and Spain will borrow to contribute capital to the ESM to allow the ESM to buy Italian and Spanish bonds.
The ability of the ESM, like the EFSF, to raise the additional Euro 420 billion is also uncertain.
Calling in the Cavalry …
Euro-Zone nations and other EU members were asked to provide (up to) Euro 200 billion to the International Monetary Fund (“IMF”), to be lent, in turn, back to Euro-Zone countries.
As with the ESM, it is unclear how some countries will finance their contributions and the wisdom of countries de facto lending to themselves.
The curious arrangement was necessary to avoid breaching existing European Treaties. The arrangement, most likely, will be an IMF administered account, with the full risk being taken solely by the providers of funding.
In the unlikely event that the IMF used its general resources, all members would have to bear the risk. Full involvement of the IMF is difficult. A loan on the required scale represents a serious concentration risk for the fund.
In addition, the funding would be released in tranches subject to meeting IMF conditions. IMF loans also have seniority over other obligations.
So IMF involvement may reduce the relevant country’s access to commercial funding.
To date, European countries have only committed Euro 150 billion.
Britain is a notable absentee, having rejected the Treaty changes, refusing the invitation to join the Europeans on the maiden voyage of the Titanic.
The summit communique looked “forward to parallel contributions from the international community”.
The IMF (Influential Monied Friends) have proved reluctant, with the US and others unwilling to get involved. Only Russia has indicated a willingness to contribute (Euro 20 billion).
Bundesbank President Jens Weidmann observed that Germany would only release its contribution (Euro 45 billion) if: “there is a fair distribution of the burden amongst the IMF members. If these conditions are not fulfilled, then we can’t agree to a loan to the IMF.”
He noted that: “If large members, for example the USA, were to say ‘we’re not taking part,’ then from our point of view it is problematic.”
Don’t Bank On It…
Parallel to the Summit, The European Banking Authority (“EBA”) updated its stress tests, increasing the amount of capital that European banks need to raise to Euro 115 billion.
The increase was necessary to cover a fall in the value of sovereign bonds held by the banks.
As the data used was dated, further deterioration of the value of holdings may mean that more capital will ultimately be needed.
Italian, Spanish and Greek banks have the largest capital requirements. Italian banks need to raise Euro 15 billion. UniCredit, which holds around euro 40 billion in Italian government bonds, needs to raise euro 8 billion.
Spanish banks need Euro 26 billion with Santander needing Euro 15 billion.
German banks also need capital with Commerzbank, the country’s second largest bank, needing euro 5.3 billion. With share prices down significantly (40-60% for the year) and the likelihood of weak profits driven by write-offs and lack of balance sheet growth, European banks face difficulties in raising capital.
Unlike US banks in 2008/2009, European banks are reluctant to cut significant dividend payouts.
Spanish bank Santander plans to pay shareholders euro 2 billion in cash and more in stock (over 15% of its stated capital requirements). They argue the need to preserve their brand, compensate investors for poor share price performance and a return to profitability.
Curiously, the EBA or the Bank of Spain has not intervened to force a suspension of dividends to husband capital. The most likely source is national governments providing the capital, adding to their debt problems. Germany has already reactivated its bank bailout fund for this purpose.
Banks can also lift their capital levels by reducing the size of their balance sheets.
European banks could sell (up to) Euro 2 trillion in assets.
In addition to capital concerns, such a move is driven by liquidity factors with European banks having trouble raising dollars at acceptable cost. Credit Agricole, the third largest French bank, is planning to reduce assets by around Euro 15-18 billion by the end of 2011 and by euro 60 billion by end 2013. This will improve the bank’s capital position and also reduce its funding needs by euro 50 billion.
If all banks undertake similar actions, selling foreign assets and shutting (mainly overseas) operations, then the effect on the broader economy will be significant.
The tighter credit conditions and lower economic activity may increase normal credit losses setting off a negative feedback loop.
Asset sales by European banks to improve capital are acceptable to the EU as long as they “do not lead to a reduced flow of lending to the EU’s real economy”. Withdrawal from foreign markets is already having a noticeable impact in Eastern Europe and Asia.
A slowdown in these economies will indirectly affect Europe, reducing demand for European exports.
Bad Road Ahead …
The proposed plan is fundamentally flawed. It made no attempt to tackle the real issues – the level of debt, how to reduce it, how to meet funding requirements or how to restore growth.
Most importantly there was no new funds committed to the exercise.
Over the next few months, the Euro-Zone faces a number of challenges including: the implementation of the new arrangements, possible downgrading of a number of nations, refinancing maturing debt and meeting required economic targets.
There will also be complex political and social pressures.
Implementation of the new fiscal compact may not be a fait accompli.
The lack of agreement by Britain makes the change more complex.
A number of treaties and protocols need to be amended. There are also doubts as to whether the “work around” will be legally effective.
At least four governments have indicated that agreement to the changes is contingent on the precise legal text.
One key area of concern is the precise form and extent of powers granted to the EU to police national budgets.
Another relates to the structure of the ESM, where a qualified majority of 85% will have the power to make emergency decisions.
Finland is currently opposed to the ESM act by super majority instead of unanimity. Others are also reluctant to pay in capital, which can be placed at risk without the right to a veto.
Given issues of national sovereignty, it is possible that there will delays in implementation. Changes cannot also be ruled out.
In the background, negotiations on the Greek package of July 2011 have also stalled.
There is a risk that a significant number of banks will refuse to participate in the complex debt restructuring, entailing a write-down of 50% of private debt.
"They're taking away our Triple C?"
The major agencies are reviewing the ratings of 15 euro zone members, including AAA-rated countries like Germany and France.
Retreating from an initial position that any downgrading would be catastrophic, the French President has already sought to reassure voters that it is relatively insignificant, suggesting one is likely.
A downgrade may increase the cost of funds for individual countries.
Depending on the extent, it may restrict the ability of the nations to issue debt, precluding purchases by certain investors.
If France, Germany and the other AAA guarantors lose their highest credit rating, the EFSF rescue fund will also be downgraded.
This would further weaken its already compromised ability to raise funds to meet existing commitments to Greece, Ireland and Portugal and to support the funding of other countries.
Wall of Debt…
A crucial issue is the ability of European sovereigns to meet maturing debt commitments and to keep borrowing costs at a sustainable level.
European sovereigns and banks need to find euro 1.9 trillion to refinance maturing debt in 2012, equivalent to around Euro 7.5 billion each business day.
Italy requires Euro 113 billion in the first quarter and around Euro 300 billion over the full year, equivalent to around Euro 1.5 billion per business day.
Italy, Spain, France, and Germany together will need to issue in excess of Euro 4.5 billion every working day of 2012.
European banks, whose fates are intertwined with the sovereigns, need Euro 500 billion in the first half of 2012 and Euro 275 billion in the second half. They need to raise Euro 230 billion per quarter in 2012 compared to Euro 132 billion per quarter in 2011.
Since June 2011, European banks have been only able to raise Euro 17 billion compared to Euro 120 billion for the same period in 2010.
Given that banks and investors have been steadily reducing their exposures to European countries and banks, the ability to finance this wall of debt is uncertain.
The bailout fund and the IMF with around euro 200-250 billion each cannot absorb this issuance. Europe will be forced to resort to “Sarko-nomics” to finance itself.
The ECB has reduced euro interest rates and lengthened the term of emergency funding of banks to three years with easier collateral rules (a lottery ticket is now acceptable as surety for borrowing).
The French President suggested that banks should buy government bonds, which could then be pledged as collateral to borrow unlimited funds from the ECB or national central banks.
Nicolas Sarkozy was unusually direct: “each state can turn to its banks, which will have liquidity at their disposal.” He pointed out that earning 6% on Italian bonds that could then be financed at 1% from central banks was a “no brainer”.
At the same, ECB President Mario Draghi is urging banks to reduce holdings of government securities and to use the funding provided to meet debt maturities.
Sarko-nomics perpetuates the circular flow of funds with governments supporting banks that are in turn supposed to bail out the government.
It does not address the unsustainable high cost of funds for countries like Italy. If its cost of debt stays around current market rates, then Italy’s interest costs will rise by about euro 30 billion over the next two years, from 4.2% of GDP currently to 5.1% next year and 5.6% in 2013.
In many countries, Sarko-nomics will be supplemented by “financial oppression” as government increasing coerce their citizens and institutions to purchase sovereign bonds.
Regulatory changes will require a proportion of individual retirement savings to be invested in government securities.
Banks and financial institutions will be required to hold increased amounts of government bonds to meet liquidity and other requirements.
There may be restrictions on foreign investments and capital transfers out of the country.
Financial oppression will complement traditional public finance strategies such as direct reduction in government spending, indirect reductions in the form of changing eligibility such as delaying retirement age, and higher taxes, including re-introduction of wealth and property taxes as well as estate or gift duties.
Debt reduction through restructuring remains off the agenda.
The adverse market reaction to the announcement of the 50% Greek write-down forced the EU to assure investors that it was a one-off and did not constitute a precedent.
Despite this, investors remain sceptical, limiting purchases of European sovereign debt.
Weaker euro-zone countries may meet their debt requirements through these measures but it will merely prolong the adjustment period.
It will also increase the size of the problem, locking Europe into a period of low growth and increasing debt levels.
Reality Check…
The prospects for the real economy in Europe are uncertain. European debt problems and slowing growth in emerging markets such as China, India and Brazil may lead to low or no growth.
For the nations that have received bailouts, the austerity measures imposed have not worked.
Growth, budget deficit and debt level targets have been missed.
Greece has an euro 14.4 billion bond maturing in March 2012.
Prime Minister Lucas Papademos must meet existing targets and agree the second Greek bailout worth euro 130 billion by end-January 2012 before scheduled elections to allow official funding to be available to re-finance this debt.
Even Ireland, the much-lauded poster child of bailout austerity, has experienced problems.
The country’s third quarter GDP fell 1.9% and its Gross National Product fell 2.2% (the later is a better measure of economic performance due to the country’s large export/ transhipment activity). Ireland must reduce its budget deficit from 32% of GDP in 2010 to 3% by 2015.
Despite spending cuts and tax increases, Ireland is spending Euro 57 billion euros including Euro 10 billion to support its five nationalised banks, against euro 34 billion in tax revenue.
Spain, which has voluntarily taken the austerity cure, is missing economic targets. Spain’s budget deficit is above forecast and the need for support of the Spanish banking system may strain public finances further. Spain’s economic outlook is poor and deteriorating.
Under Prime Minister Maria Monti, Italy has passed legislation and budget measures to stabilise debt. The actions focus on increasing taxes, especially the regressive value-added tax, rather than cutting expenditures.
Structural reforms to promote growth are still under consideration and the content and timing is unknown. It is also not clear whether the plans will be fully implemented or work.
If the pattern elsewhere in Europe continues, it is unlikely that Italy will be able to stabilise its public finances.
The sharp drop in demand from cuts in government spending and higher taxes will result in an economic slowdown, which will result in continuing deficits and increased debt.
In the third quarter of 2011, Italy’s economy contracted by 0.2%. The government forecast is for a further contraction of 0.4% in 2012. The government forecasts may be too optimistic.
Confindustria, the Italian business federation forecasts the economy will contract by 1.6% in 2012.
Consumption is especially weak in many of the problem economies, with Greece experiencing falls of around 30% and Italy also experiencing large falls.
Stronger countries within the euro-zone are also affected. Lack of demand for exports within Europe and from emerging markets combined with tighter credit conditions may slow growth.
German industrial production and export orders are slowing, reflecting the fact that the EU remains its largest export market, larger than demand from emerging countries. Germany exports to Italy and
Spain total around 9-10 per cent in 2010), higher than to either the US (6-7%) or China (4-5%).
As what happens in Europe will not stay in Europe, being transmitted via trade and investment channels, negative feedback loops will complicate the economic outlook.
One complication will be the Euro itself.
Following his American counterparts who insist that they favour a strong dollar inconsistent with the evidence, German Finance Minister Wolfgang Schaeuble stated that: “The Euro is a stable currency.”
In fact, the Euro has fallen around 12 % against the dollar.
Should the European debt crisis cause currency volatility, as seems likely, the effects will be widespread.
One unstated element of the calls for the ECB to engage in quantitative easing is to weaken the Euro, increasing the export competitiveness of weaker European nations boosting growth.
Such action risks setting off currency wars as both developed nations (US, Japan, Britain, Switzerland) and emerging countries retaliate.
The risk of capital controls, trade restrictions and currency intervention is high.
Voting Intentions…
The risks of political and social instability remain elevated.
Greece faces elections in April 2011. The polls indicate a fractious outcome, with the major parties unlikely to gain majorities with significant representation of minor parties.
An unstable government combined with a broad coalition against austerity may result in attempts to renegotiate the bailout package.
Failure could result in a disorderly default and Greece leaving the euro.
The French presidential elections, scheduled for May 2012, also create uncertain.
The principal opponents to incumbent Nicolas Sarkozy either oppose the Euro and the bailout (the National Front led by Marine Le Pen) or want to renegotiate the plan with the introduction of jointly guaranteed Euro-Zone bonds (the Socialists led by Francios Holland).
The European debt crisis is also creating political problems in Germany, Netherlands and Finland, especially among governing coalitions.
The risk of unexpected political instability is not insignificant.
In the weaker countries, austerity means high unemployment, reductions in social services, higher taxes and reduced living standards.
Social benefits increasingly below subsistence are widening income inequality and creating a “new poor”.
Protest movements are gaining ground, with growing social unrest.
In the stronger nations, increasing resentment at the burden of supporting weaker euro-zone members is evident.
Despite the tabloid headline, Germans have been relatively sanguine about the commitment of funds to the bailout, aided by limited disclosure of the extent of the commitment and a relatively strong economy.
A downgrade of Germany’s cherished AAA rating or any steps to undermine the sanctity of a hard currency (by printing money or other monetary techniques) will force increasing focus on the costs to Germans of the bailouts.
Germany’s commitment to date is Euro 211 billion in guarantees, euro 45 billion in advances to the IMF and Euro 500 billion owed to the Bundesbank by other national central banks – around 25% of GDP.
The increasing risk of losses may even divert attention away from the 2012 European Soccer Championship where Germany is drawn in the “Group of Death” with Netherlands, Portugal and Denmark.
Road to Nowhere…
In the short-term, Europe needs to restructure the debt of number of countries, recapitalize its banks and re-finance maturing debt at acceptable financing costs.
In the long-term, it needs to bring public finances and debt under control.
It also needs to work out a way to improve growth, probably by restructuring the Euro to increase the competitiveness of weaker nations other through internal deflation.
Such a program is difficult and not assured of success, but would provide some confidence. At the moment,
Europe does not have any credible policy or workable solution in place.
One persistent meme is that Europe has enough money to solve its problems.
This is based on the euro-zone members’ aggregate debt to GDP ratio of around 75%. There are several problems with this analysis.
The debt is concentrated in countries where growth, productivity and cost competitiveness is low, which is what caused the problems in the first place.
The relevant wealth is in the hands of a few countries like Germany that appear unwilling to bail out spendthrift and irresponsible neighbours.
A substantial portion of the savings is also invested in European government debt directly or in vulnerable banks, which have invested in the same securities.
The total debt of the PIIGS (Portugal, Ireland, Italy, Greece and Spain) plus Belgium is more than Euro 4 trillion.
A write-down of around euro 1 trillion in this debt is required to bring the debt levels down to sustainable levels (say 90% of GDP).
In the absence of structural reforms and a return to growth, the write-downs required are significantly larger.
This compares to the GDP of Germany and France respectively of euro 3 trillion and euro 2.2 trillion.
In addition, the stronger nations may have to bear the ongoing cost of financing the weaker countries budget and trade deficits.
Satyajit Das
This does not appear economically or politically feasible.
Europe now resembles a chronically ill patient, receiving sufficient treatment to keep it alive.
A full and complete recovery is unlikely on the present medical plan.
Europe resembles a zombie economy, which functions in an impaired manner with periodic severe economic health crises.
The risk of a sudden failure of vital organs is uncomfortably high.
In their song “Road to Nowhere”, David Byrne and the Talking Heads were on “a ride to nowhere”. Byrne sang about “where time is on our side”.
Europe’s time has just about run out.
A failure to properly diagnose the problems and act decisively has put Europe firmly on the road to nowhere.
It is journey that the global economy will be forced to share, at least in part.
By Satyajit Das
Satyajit Das is the author of Extreme Money: The Masters of the Universe and the Cult of Risk (2011).
The total US debt have now passed 15 trillion dollar. It’s an unimaginable amount of money. If you think the European debt crisis is serious, just wait untill this baby blows – and, believe me, it will. From a historical point of view, the US nation is a baby. Just 244 years old. It has, however, managed to increase its debt by USD 5 trillion over the past three years. Experts suggest that a sovereign debt level above 60-90% of a country’s Gross Domestic Product (GDP) is not sustainable. According to the US Treasury, America’s national debt will reach 20 trillion by 2015 – more than 100% of the nations GDP.
“A major organ failure within the global economy is now inevitable.”
Satyajit Das
So, what do you think will happen when USA eventually finds themself in the same situation as Greece does now? I don’t think anyone can imagine the full impact of this financial Armageddon. But the worlds only economic superpower will fall from grace, fall hard, and the world’s number one reserve currency – the mighty dollar – may seize to exist. And from the ashes a brand new world will rise, for better or for worse…
Satyajit Das with eurointelligence.com – whom I’ve introduced you to before – has proven himself to be an outstanding analyst with extended knowledge, completly in touch with reality and crystal clear conclusions.
In this extremly good timed commentary he sums up the situation and tries to pinpoint exactly what may happen.
His main point, however, is: Be prepared!
Please take the time to read this – it’s really important stuff,
In February 2010, US Treasury SecretaryTimothy 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.
“America is currently exhibiting is the worst kind of absurd theatrics. And the whole world is being held hostage.”
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.
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 market’s 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”.
“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.”
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 $15 trillion.
Commentator David Rosenberg passionately described the problem in a guest post at Zero Hedge:
“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 US 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.”
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 ($2.4 trillion).
Until the global financial crisis, foreign lenders, especially central banks with large foreign exchange reserves, led by the Chinese, increased their purchases of US government debt as part of a giant global liquidity scheme.
These reserves arose from dollars received from exports and foreign investment that had to be exchanged into local currency.
In order to avoid increases in the value of the currency that would affect the competitive position of their exporters, the exporting nations invested the reserves in dollar denominated investment, primarily US Treasury bonds and other high quality securities.
By the middle 2000’s, foreign buyers were purchasing around 50% of US government bonds.
During this period, emerging countries, such as China fuelled American growth, both supplying cheap goods and providing cheap funding to finance the purchase of these goods. It was a mutually convenient addiction – China financed customers creating demand for exports and America received the money to buy cheap Chinese goods.
Asked whether America hanged itself with an Asian rope, a Chinese official told a reporter: “No. It drowned itself in Asian liquidity.”
Following the global financial crisis, foreign purchases have decreased to around 30% of new issuance.
Around 70% of US government bonds (US$ 0.9 trillion) have been purchased by the Federal Reserve, as part of successive rounds of quantitative easing.
Debt Reckoning…
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 US.
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.
Foreign Alms…
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 are 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 have 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 have 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’s ability to finances its need may not continue.
As English writer Aldous Huxley observed: “Facts do not cease to exist because they are ignored.”
Debt Calm…
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 was 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, penalize 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.”
Extortionate Privilege…
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 $1 million 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 monetization – 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.
Monetization is inexorably linked to devaluation of the US dollar. The now officially confirmed zero interest rates policy (“ZIRP”) and debt monetization 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.
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 FMD’s 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 1930’s 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 has 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, belligerently observed: “Our dollar, but your problem.”
Minor symptoms, often increasing in frequency and severity, can provide a 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.
The 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.
Satyajit Das is the author of Extreme Money: The masters of the Universe and the Cult of Risk (2011) and Traders, Guns & Money: Known’s and Unknowns in the Dazzling World of Derivatives – Revised Edition (2010)
EconoTwist's 