Summary: Part three of four part series. Here is part one, part two, and part four.
Forecast #4: bankruptcy
Perhaps only a crisis will catalyze America’s transition to a new form of government. There is no lack of candidates.
The last stone in the foundation of America’s greatness was laid by Alexander Hamilton, who as Secretary of the Treasury published the Report on the Public Credit in January 1790. He argued that America should – unlike most nations – pay its war debts. With the support of Washington, opposed by Jefferson and Madison, it was enacted through one of the great compromises that distinguish early American history.
Now we owe trillions to foreigners and plan to borrow trillions more – scurrilously – as we have neither the ability nor intention of paying back these loans. Worse, childishly, we hope our creditors will never demand repayment.
Look at our domestic balance sheet. Most American households have few savings – many lack even a 60-day emergency fund – and massive debts. The aggregate totals (so loved by economists) conceal this by including both Bill Gates and thousands of unemployed auto workers. It’s not an irrational way to see things, if Gates will donate money to pay off their debts and fund their retraining for well-paying jobs at Microsoft.
Our international balance sheet is equally frightening. Our massive foreign debts, accumulating at over $2 billion per day, spell the likely end of the US Dollar as the world’s reserve currency – and the end of the post-WWII economic regime and America’s role as the world’s hegemon. Without the unlimited ability to borrow in our own currency, America’s current economic condition becomes impossible to sustain.
This is, of course, old news. We’ve heard these warnings for many years.
On September 23 his fleet hove in sight, and all came safely to anchor in Pevensey Bay. There was no opposition to the landing. The local fyrd had been called out this year four times already to watch the coast, and having, in true English style, come to the conclusion that the danger was past because it had not yet arrived had gone back to their homes.
Description of William the Conqueror’s arrival, from History of the English Speaking People by Winston S. Churchill.
The list of agencies, experts and high officials who have warned us could fill many pages. I need not do so, as I believe we all at some level know we are on a course of near-certain self-destruction. A few references will suffice.
Since September 2003 David M. Walker, Comptroller General of the United States, has acted as a modern Paul Revere. He’s crossed the nation giving extraordinarily blunt speeches warning of the fiscal catastrophe looming ahead. Didn’t you see the front-page stories about this?
Here are two of his recent presentations:
Here is another wake-up call – you must have seen the special TV new bulletins when this was published!
Is the United States Bankrupt?. Laurence J. Kotlikoff (Professor of Economics at Boston University), Published by the Federal Reserve Bank of St. Louis Review (July/August 2006)
Perhaps the Fed’s reputation for obfuscation is not deserved. Note the opening of the article’s abstract:
Is the United States bankrupt? Many would scoff at this notion. Others would argue that financial implosion is just around the corner. This paper explores these views from both partial and general equilibrium perspectives. It concludes that countries can go broke, that the United States is going broke, that remaining open to foreign investment can help stave off bankruptcy, but that radical reform of U.S. fiscal institutions is essential to secure the nation’s economic future. …
Have you ever wondered at the total debt of US Government? Treasury Secretary O’Neil did, and asked some experts to compute the answer. Surprisingly, Bush fired him shortly afterwards. Our total liability was $44 trillion. Then. It’s much larger now, of course.
Fiscal and Generational Imbalances, By Jagadeesh Gokhale and Kent Smetters
Not to bore my readers with so many dire warnings, but here are more from former Treasury Secretary Robert Rubin and the International Monetary Fund.
We cannot say that we were not warned.
This precarious load of debt can totter and fall at even a small disturbance.
- Inflation: rising interest rates are lethal to millions of households with adjustable mortgages and floating-rate consumer loans.
- Deflation: a recession that generates unemployment, cutting US consumer spending (an incredible 20% of global GDP) and creating layoffs, which can easily spiral out of control.
The already high deficits of the federal government, during the peak of the up phase – the large number of two-worker, high debt, no savings households – and many other factors make our economy far more vulnerable than at any time since WWII. Anything that destabilizes our economy could spark foreclosures and bankruptcies at levels not seen since the 1930s.
For what will have traded our greatness, our very solvency? We’ll have spent billions on weapons, welfare, and granite countertops. Only the debts will remain.
For more on this see End of the post-WWII geopolitical regime.
Nonsense. Money is neither patriotic or sentimental. We attract such vast amounts of capital for the simple reason after every euro,dinar,franc,pound,yen,won,rupee,ruble,renminbi,riyal and so on that can be invested in the home country or anywhere else besides the US is invested what do you do with the surplus? Do you invest the funds in Africa? Too risky. Latin America? Again too risky. India? China? Indonesia? Pakistan? Again all too risky. Where does leave you? Europe and Japan. Population too old and not growing, economies that are no longer capable of growing at a rate that merits that kind of investment and is incapable of absorbing it. The entire Muslim world cannot absorb the pools of surplus funds the Gulf Arab states have to invest aside from the fact they are also too risky. When you narrow down all the possibilities where do you invest? There is only one place left and that is the USA. Not for love or sentiment but for the balance of safety and returns.
However crazy our national politics are with respects to debt,taxes and spending in comparison to all of the world’s largest nations and economies we are on the whole the sanest and safest of the lot. That is why we attract the capital and will continue to do so. Investors don’t think in hundred year horizons, they think in ten,twenty and thirty year horizons and there is nothing to indicate that any other major player or blocks of players will be saner,safer and an overall better investment in those time horizons than the US for the huge pools of foreign investment. This is in large part why we have stock market booms,real estate and credit booms and now commodity booms. The money has to go somewhere and new ways of investing have to be invented however dubious in retrospect. For more than a hundred and ninety years the American rube has been fleecing the foreign sophisticates and will continue to do so as long as the eye can see. Hamilton and Washington were clairvoyant. They knew that by honoring the revolutionary war debt America will establish a credit worthiness no other nation can claim. Always make the payments and always on time and never dishonor a debt or a currency and the world will always lend and invest in the US. No other nation can make that claim and that is the reason above all the money pools get invested here. Dollar up or dollar down is really nothing more than interest rate spreads and the stupidity of Congress. Cut taxes further, cut the political welfare spending even more and get the Fed to raise interest rates slightly higher than the Euro and the Dollar will regain its strength and commodities including oil will drop. That is the real point to be decided in this coming election.
What we really have overspent on is not on war and weapons, but welfare of all types ranging from farm subsidies,union subsidies, university subsidies in addition to the subsidy of the parasite class. However in comparison to our major competitors and peers all of that welfare is still small scale in proportion compared to theirs. The irony is as long as we are a bit less stupid than the rest, the world will be throwing money our way enabling us to continue the spending, debt and deficits. Someday a better investment country will arise and God help us then, unless we remake ourselves in to the better investment. We have the time, we have the means but only time will tell if we have the wisdom and sense to to do so.
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Fabius Maximus replies: The US current account deficit is funded almost totally by loans by foreign central banks. For more on this see the work of Brad Setser (Council on Foreign Relations), such as “Central banks — not sovereign funds — are doing the heavy lifting these days; they financed much of the US deficit in the first quarter.” These loans result from political calcuations, largely the decision to peg their currencies to the US dollar.
These flows will continue until they decide it is no longer in their interest. The timimg may bot be conventient for the US, but debtors by definition have little control over their fate.
Please remember that the comment policy requests that comments be brief. At 605 words this is long for a comment. 250 words is the max practical — or that most people will read.
When you narrow down all the possibilities where do you invest? There is only one place left and that is the USA. Not for love or sentiment but for the balance of safety and returns.
Another way of putting this is that – since about 1980 – financial services actually have constituted a “product” which we have “exported.” The inflows of foreign investment actually have reflected the value of this “export.”
Unfortunately, this is where the mortgage crisis comes in. For it portends the end of the era when the United States’ financial service industry constitutes an attractive “product” which can be “exported.”
Accordingly, we should not presume that capital inflows into the United States will continue as they have in the past 25 years or so.
FM China proves my point. They invest here because they cannot invest more there. To do so would risk loss of control by the party. Private investors there don’t trust the party not to steal their wealth so they to invest abroad above what they need to maintain their business in China. Central banks in Europe keeps shoveling more money here to prop up their exports. The rest of the world can’t absorb the exports to the US. European pension funds remember Argentina very well. Hence the flows of capital here. DK it is that foreign capital that fueled the sub prime mess to begin with. They are facing their own mortgage crises, what was sent here was the surplus they could not absorb.
Yes financial services is a product that we have been ‘exporting’. In the eighties we did that to bail out the banks and clear that era’s real estate excess. The weak dollar is sign that we are employing the tactic of the foreign bailout again to be followed by the buyback when the dollar regains its strength. Its a beautiful hustle since both sides win. We clear the excess inventory, they buy the markdowns with over valued currency. A tremendous discount for the European. We buy back later when they cash out when the dollar regains its strength. Remember DK when you owe the bank $100 the banks owns you. When you owe the bank $100 million you own the bank. Just ask Donald Trump. We may be sick but the Europeans are older and sicker. They will continue lending for the next 20 years. They have no other choice.
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Fabius Maximus replies: This is beyond my ability to explain, nor do I have the data. I recommend reading Brad Setser’s articles. He is one of the world’s leading experts on global capital flows, and clearly and briefly explains these things. He also links to a wide range of other experts, most of whom draw similar conclusions.
You might be correct that “Private investors there don’t trust the party not to steal their wealth so they to invest abroad above what they need to maintain their business in China.” The available data makes this difficult to prove. However, it is clear that most of the capital flowing from China to the US is government money — stabilizing the RMB vs. the US dollar at a lower level than the market price.
Credit is drying up worldwide as we enter an asset deflation (= bank and investor losses) period in several countries (US, UK, Spain, Ireland, and soon to be Australia). Investors, including sovereign wealth funds, have limits on the losses they can take and investing in US bonds is a mugs game at the moment. Many would like to buy US assets, but the US is blocking some countries (ie Arab countries, China, etc, which is a bit rich since they have allowed the UK and EU countries to buy so much). Economically this is silly as this is just about the one way the US could start (albeit slowely) to dig itself out of this morass, sell the family silver, quickly, before the price drops even more.
The continuing devaluation of the US$ is causing many of the ‘cash rich’ countries a lot of problems, basically because they are awash with increasingly worthless $ and this is impacting them through inflation and investment losses. So there will be an end to the ‘easy money’ for the US, the investors simply cannot take the losses forever and the associated inflationary effects of a weak US$. When? like all these things from tomorrow to a few years. The process has already started. The ‘smart’ money is increasingly moving to Europe, China and physical assets (like gold, oil, etc) to hedge against dollar devaluation. It is the foreign Govt money from countries that are holding things up at the moment (reserve banks, SW funds, etc). The private investors have already gone.
Just as an aside, I had the ‘joy’ of a private briefing by a Bank’s top economist a year ago, where he stated sagely “Australians’ have too little debt”, which given, that in consumer debt, we are not far off the US position I thought was bit ‘self interested’. Must ring him up sometime to find out what he thinks now ;).
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Fabius Maximus replies: I will discuss many of these things in the next chapter. However, the US dollar devaluation — that is, the upwards revaluation of their currencies — is not usefully seen as causing problems in the sense you describe for the emerging nations using the Bretton Woods II system. They have large holdings of US dollar debts. These bonds are falling in value in terms of their own currencies.
As oil rose in price (Middle East), or as their countries moved through the development cycle (e.g., China) their currencies should have increased vs. the US dollar. They bought these bonds in order to maintain their currencies at a value below market rates. Domestic inflation (theirs) and valuation losses are inevitable results of this policy. These things just took a while to appears.
Dear Maximus
There are a lot of things I don’t understand about modern economics. I admit that. But I do know that there are laws in nature and if you throw a stone up in the air it will come down eventually. Stones don’t fly. Regarding the American economy (the stone) there are, however, several reasons why other countries at least would try to keep in the air by trying to catch it and throw it in the air again. Please remember: A lot of countries – however resentful they are towards the United States – are dependent on Pax Americana. It keeps our military budgets down in Europe, so we can spend it on social security and the welfare state. A country like China needs the United States for its export and thus for keeping stability in China. I could continue.
How long can this go on? In theory for decades, but the whole system is very unstable. Just for one thing: The American military has become increasingly expensive with “wunderwaffen” like the F22. In the meantime the American military has great trouble defeating even a small insurgency in Iraq (never numbering more than 20-30.000 active insurgents as far as I know with perhaps 100-200.000 supporters). Also the dollar keeps eroding and I would like to add nothing is more powerful than seeing the once omnipotent dollar become less valuable than the Euro. Please bear in mind that symbols matter. Perhaps the true weakness of the United States is its dependence on foreign oil. If things get really tough with oil spikes (Gazprom predicts 250 dollars pr. barrel in 18 months time) the USA would truly be in trouble, because 95 percent of its transportation is dependent on fuel. An oil crisis could truly bring the whole lot down. At that point even for China and Europe the American stone would be too heavy to catch.
However, let me add: The American people is generally sound. They work hard and they are ambitious. The national character could in the end save America and start a painful rebuilding that could lead to a better country.
I have heard it said that countries like China have not stopped buying US treasuries, but are somehow lowering their total holdings of them. If this were so, I would expect to see interest rates rising, in order to compensate foreign investors for the perceived risk. Of course, I dont understand the connection between rates set by the Fed and those arrived at by auction of US Treasuries. Any comments welcome.
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Fabius Maximus replies: There is little hard data on these things, but in aggregate it does not appear to be true. See Brad Setser’s articles at the Council on Foreign Relations for some of the best and clearest analysis of this.