Tuesday, April 27, 2004

Auerback - Fed - Economy - Debt

The important element of Marshall's post is the dynamics of national and global debt structures' interest maintainance costs on global demand - what is to be done?

Marshall Auerback

...So what is the underlying paradox at work here? As we have discussed previously, a gently declining dollar has actually provided a far greater cushion to the US bond market than a rapidly strengthening greenback. Asia’s leading central banks, in particular, have in effect acted as a buffer between private speculative capital (which continues to wash its collective hands of the dollar), and the Asian and American industrialists, which are deriving benefits from a slowly declining currency, but who would be the first casualties of a dollar collapse (given the deflationary impact of the latter through the sharply higher long rates it would ultimately produce). Both China and Japan are prodigious financiers of US consumption--the two largest foreign holders of US Treasury bonds--despite the weak returns they get from low US interest rates. China and Japan are willing to do this because they calculate that sustaining their own industrial output and employment is worth more than seeking stronger financial returns elsewhere.

Ironically, should the very recent spate of dollar strength continue, it might begin to unravel this “happy” state of affairs insofar as it removes the incentive for foreign central banks to continue to buy US dollar bonds (as well as overseas speculative capital, which has begun to re-accumulate long term US securities over the past 6 months), as the need for dollar support operations diminish. We use the word “happy” guardedly, since it is clear that even if the dollar resumes its decline, the underlying problem of indebtedness remains, as does the inherent volatility in the bond market. The Fed, and its partners in crime in the Asian official sector, has pushed things so far out of control that they can't ever practically tighten. Consequently, the bond market will be left to swing wildly to accomplish this task for them. This is an environment when volatility protection should be at a premium, yet there is very little evidence this is so in either bonds or stocks.

By accommodating the Fed’s largesse, therefore, the Asian official sector has helped to sustain growing American financial and monetary profligacy, thereby accentuating underlying financial fragility in the US economy. Which brings us back to the Fed’s delicate balancing act: the US central bank must occasionally put grit on the dangerously slippery slope of dollar devaluation and continue to pretend that it can and will tighten to deal with incipient inflationary pressures when the time is right. In so doing, it hopes to retain the status quo of an economy kept afloat by enormous foreign lending so that consumers can keep buying more imports, thus increasing the bloated trade deficits.

This lopsided arrangement will end when those foreign creditors--major trading partners like Japan, China and Europe, or overseas portfolio capital--decide to stop the lending or simply reduce it substantially. To forestall this eventuality, the Federal Reserve has to continue to control inflationary expectations, as Governor Bernanke disarmingly conceded. It is part of an elaborate confidence trick on a country sinking into financial dependency--dangerously indebted to rival nations that are holding its debt, collecting the interest on Treasury bonds and private bank loans, or repatriating the profits from companies that used to be American- owned. A very wealthy nation can tolerate this negative toll for many years, but not forever. Unless the historic meaning of debt has been repealed, no nation – even one with a reserve currency – can borrow endlessly from others without sooner or later forfeiting control of its destiny, and also losing the economic foundations of its general prosperity. Messrs Greenspan and Bernanke can slow the process (to the country’s longer term detriment), but they cannot forestall the ultimate outcome. Gritting icy roads provides but a temporary respite, not a permanent solution against crashes. ...Link

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