End Game?

By Satyajit Das, derivatives expert and the author of Extreme Money: The Masters of the Universe and the Cult of Risk Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives – Revised Edition (2006 and 2010)

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 $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. 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 may now beinevitable.

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.

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