The Nuclear Option [Financial]

The Nuclear Option
by Marshall Auerback

“Let us be blunt about it. The US is now on the comfortable path to ruin. It is being driven along a road of ever rising deficits and debt, both external and fiscal, that risk destroying the country's credit and the global role of its currency. It is also, not coincidentally, likely to generate an unmanageable increase in US protectionism. Worse, the longer the process continues, the bigger the ultimate shock to the dollar and levels of domestic real spending will have to be. Unless trends change, 10 years from now the US will have fiscal debt and external liabilities that are both over 100 per cent of GDP. It will have lost control over its economic fate.” – Martin Wolf, “America on the comfortable path to ruin”.

Martin Wolf succinctly points us to the crucial question preoccupying dollar bulls and bears alike: When will this haemorrhaging debtor nation be compelled to pull back from profligate consumption and resign its role as "buyer of last resort" for the global economy? Indeed, can it do so?

The US is clearly caught between the proverbial rock and a hard place. The expedient of dollar devaluation becomes problematic, given the extent of foreign ownership of US assets, which Bridgewater now estimates at 78 per cent of GDP (versus 33 per cent in 1990). Many of these foreign holders are creditors, who will not all take kindly to the notion of being repaid in substantially devalued dollars (Bridgewater also notes, for example, that foreigners’ purchases of US government securities has brought foreign ownership up to 42 per cent of the total Treasury market; excluding the US Treasuries held by the Fed, and this figure rises to 51 per cent). Against that, the extent of leverage in the domestic economy militates against the sort of rise in rates genuinely need to support and strengthen the dollar and thereby pay back these creditors in “honest dollars”.

This policy conundrum takes on added urgency in light of June’s horrendous trade deficit number of $55.8bn. Of particular note was that at $33 per barrel, the price of crude clearly did not reflect anything near current oil price levels, implying a further monstrous expansion of America’s external imbalances as the figures for July and August emerge.

Against that, international investors stepped up their purchases of US assets. Net purchases by foreigner rose to $71.8 billion from a revised $65.2 billion in May. Of the $71.8 billion that foreigners purchased, $40.5 billion of it was in Treasuries. In June Japan bought a net $21.2 billion of the Treasuries, while China bought a smaller amount. Japan is the largest foreign holder of US Treasuries, accounting for $689 billion, followed by China, which owns $164.8 billion.

The US economy, therefore, continues to be 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 and China--decide to stop the lending or simply reduce it substantially.

It is well known that much of the source for that dollar buying today is the Asian official sector. As we noted last week, such huge purchases have prevented a calamitous fall in the external value of the dollar, which in turn has forestalled a private sector credit revulsion. Private sector creditors effectively view Asia’s central bankers as a bulwark against a precipitous dollar decline, given that their continued purchases of US dollars implicitly sanction the financial practices undertaken for decades by America’s monetary policy authorities and thereby ensure their perpetuation.

It is also true that central banks are not profit maximisers in the manner of a private business and are therefore perhaps happier to maintain the status quo – even if it means being repaid with devalued dollars – because the alternative is the loss of a huge export market and unprecedented financial instability, which central bankers abhor much as nature abhors a vacuum. To stop purchasing US dollars, it is said, risks the economic equivalent of embracing the nuclear option, a reckoning that could arrive as a sudden thunderclap of financial crisis—a precipitous withdrawal of capital a la Asia in 1997, which engenders a backdrop of spiking interest rates, swooning stock market and crashing home prices. Asia’s central banks, like US policy makers, may indeed recognise a self-interest in keeping the game going – avoiding a global meltdown that might ruin everyone.

But a closer examination of today’s capital flows suggests a new and potentially more disruptive class of investor who could easily bring down the whole house of cards on which American “prosperity” and the concomitant stability on which the dollar now rests. It’s not just central bankers who have a become a significant source of those capital inflows now providing offsetting support to a dollar otherwise bludgeoned by America’s growing trade gap. The Bureau of Economic Analysis is now including in its balance of payments figures data on broker/dealers in what used to only be bank data. The figures illustrate how banks and broker dealers have also become a major source for channeling money into the US. In the year ended March 2004, they added $251.7bn to their liabilities to non-residents, which in accounting terms constitutes a capital inflow into the US. These same organizations were channels for substantial inflows from Caribbean tax havens, likely representing foreign based hedge funds and proprietary traders, borrowing heavily in US dollars to fund carry trades in the US.

Although fund inflows from Asia (and by extension, the Asian official sector) continue to represent a substantial source of funding for the US, the BEA statistics, although not complete, do give us an alarming picture of a system increasingly dominated at the margin by leveraged financial flows, in an economy already dominated by massive debt accumulation: banks and brokers playing the carry trade, banks writing trillions of dollars worth of derivatives trades, and hedge funds borrowing like crazy in order to maximize returns. If the Greenspan Fed is serious about continuing to raise rates, then the cost of holding these positions becomes correspondingly greater. The margin clerks ultimately seize control, not the central banks. These sorts of leveraged flows are precisely the sort which could cut and run, precipitating the conditions for a violent fall in the dollar despite official sector efforts to the contrary.

Last year the US economy (business and households as well as the federal government) was compelled to borrow $540 billion from overseas creditors. Since the United States first became a debtor nation fifteen years ago, it has accumulated nearly $3 trillion in debt obligations abroad. At the current pace, the foreign debt load will double again in the next six or seven years.

This position severely compromises latitude in policy making. It seems highly improbable to imagine that the fiscal expansion can be continued much longer, taking the budget deficit and government debt into hitherto uncharted territory. Even if the fiscal deficit rises no further the present rate of deficit implies a rise of public debt toward 100 per cent of GDP, notes Wynne Godley of the Cambridge Endowment for Research in Finance. Private expenditure can hardly remain a sustainable long term engine for growth given that personal savings remain non-existent and personal expenditure is being perpetuated by further increases in debt. So American growth in the medium term looks increasingly dependent on rises in net exports which, given the increasing size of the trade deficit, implies a substantial further dollar devaluation (especially since the declines sustained thus far have done nothing to reduce the current account deficit).

Never have the imperatives of American economic policy making been so hamstrung by the realities of external debt build-up. The humbling reality is that across three decades, only one economic event has been guaranteed to produce a more balanced US trade picture: a recession. When the economy is contracting, people naturally buy less of everything, including imports. At the very least, US policy making ought to be geared toward the restriction of domestic demand through repeated interest rate rises.

But the realities of a hugely leveraged economy make this a highly perilous exercise. The markets had a brief taste of it felt like to be at the receiving end of de-leveraging earlier this spring, when the first phase of unwinding the “Great Reflation Trade” took place. Anyone holding gold, commodities, euros, Australian and New Zealand dollars, or China H shares was slaughtered, as the most tenuous portions of this trade came unglued. The base and precious metal drops were particularly dramatic, even though the economic backdrop remained ostensibly supportive of synchronized global growth and hence “reflation plays”.

But as the experience of April demonstrated, it is of the nature of crowded, leveraged trades that when players try to exit, they find massive illiquidity in the exposure they are trying to reduce. Loss control then requires they sell an asset that is more liquid or less compressed in price. Through such channels, behavioral finance tells us to expect contagion effects between seemingly unrelated financial markets. As contagion effects amplify the initial loss control attempts, and liquidity preferences surge en masse, cascading markets can result. This, for example, is what we saw in the LTCM debacle of late 1998. This same kind of de-leveraging effect can ultimately impact on the US dollar and credit system, and given the apparent size of the broker/dealer positions in the market (and the corresponding leverage), a collective rush to the exits by these players could easily overwhelm the best intentions of the Asian official sector.

At this point, even the intentions of the central banking fraternity might change. Seeing the US gradually collapsing at the core, their major export market at risk, Asia’s central bankers might well opt for a strategy of self-preservation, or use the region’s savings surplus at home in order to stave off contagion effects from the US. Under such circumstances, American monetary and fiscal policy makers will have little in the way of negotiating leverage, given the extent to which the country is already at the mercy of its foreign creditors. The consequences will be especially severe for the less affluent--families already stretched by stagnating wages and too much borrowing.

The moral hazard dialectic of remedying successive crises in an ever more fragile financial structure with bailout measures is coming home to roost. Against a backdrop of historically unprecedented current account deficits, the ability of American policy makers to deal with the economic fall-out were the “nuclear option” of massive capital withdrawal to be activated is minimal. Ultimately, the global economy will have to deal with the “nuclear fallout”. The transition will undoubtedly be unsettling, even dangerous, particularly as the declining economic power also happens to be the pre-eminent military power. An American reckoning is going to have consequences for the entire world, but harshest consequences will likely be experienced by US consumers. The vast majority in the country will experience a major decline in their living standards to a degree unprecedented since the Great Depression. This will be remembered as the true legacy of the Greenspan Federal Reserve. The Nuclear Option

Twin Deficits at the Flashpoint

Twin Deficits at the Flashpoint
by Stephen Roach

June’s enormous US trade deficit should be a wake-up call to America and the rest of the world. It is a direct manifestation of a lopsided global economy that remains biased toward unprecedented external imbalances. As long as the US continues to live well beyond its means and as long as the rest of the world fails to live up to its means, this seemingly chronic condition will only get worse. The imperatives of global rebalancing are reaching a flashpoint.

America’s record $55.8 billion trade deficit in June was a shocker. Annualized, it is equivalent to a $670 billion shortfall, or 5.75% of nominal GDP. Nor can this deterioration be explained away by surging oil prices. Excluding petroleum products, the trade deficit for goods still widened by $2.7 billion in June -- an enormous swing by any standards. The plain fact of the matter is that America has never come close to running such an outsize external deficit before. By way of comparison, the last time the US had a “foreign trade problem” was in the latter half of the 1980s; back then, the trade deficit (as measured on a national income accounts basis) peaked out at 3.2% of GDP in the second quarter of 1987. Needless to say, that was not the most tranquil of times in financial markets. As America’s external imbalance widened in mid-1987, the dollar came under sharp downward pressure and US interest rates were pushed higher. Those were the classic manifestations of a current account adjustment that many (myself included) believe were at the heart of the stock market crash of October 1987. Today’s external imbalances dwarf those of 17 years ago.

It’s easy to point the finger at others in diagnosing the problem. In the political season, the blame game always intensifies. US Treasury Secretary John Snow blames it on new weakness in the global economy. The Democrats tie America’s trade and jobs problems to the pressures of outsourcing and unfair foreign competition. As usual, there are some elements of truth in both explanations. The global economy does, in fact, appear to be sputtering. Goods exports plunged by 5.9% in June (in real terms), the largest monthly decline on record. While month-to-month fluctuations can never be taken too seriously, I don’t think it’s a coincidence that such a sharp decline in overseas shipments of American made goods occurred as slowdowns became increasingly evident in China and Japan and sluggishness persisted in Europe. On the other side of the trade ledger, renewed sluggishness on the US job front and a 1.8% surge in non-petroleum imports in June (sequential monthly rate) certainly speak to the unrelenting pressures of foreign penetration into US markets.

Yet this finger pointing misses the basic problem -- that of a saving-short US economy that is locked into the destructive spiral of ever-widening twin deficits. Lost in all the shuffle was the latest monthly update on that “other deficit” -- a $69.2 billion shortfall in the July federal budget deficit reported last week by the US Treasury. Not only was that about $7 billion worse than expected, but it puts America easily on track to break the $400 billion threshold on the budget deficit for the first time ever. While America’s budget deficit has been larger as a share of GDP -- the estimated 3.6% gap in the current fiscal year falls well short of the 6% peak hit in 1983 -- the sheer volume of financing is obviously of critical importance for the capital markets. Nor has the US ever experienced such a massive turnaround in its budget position -- with the deficit for the current fiscal year representing a swing of 7% of GDP relative to the 2.4% budget surplus recorded in 2000.
Moreover, there’s another key aspect of this problem: Unlike the deficits of the 1980s, America is lacking in any backstop in private saving. Net of depreciation, the private saving rate of households and businesses, combined, stood at just 4.5% of national income in 2003; that’s only a little more than half the 8.3% average recorded in the latter half of the 1980s -- the last time the US had a deficit problem. In addition, the personal saving rate fell back to just 1.2% in June 2004 -- underscoring the asset-dependent US consumer’s seemingly chronic aversion to income-based saving. This deficiency of private saving means that outsize government budget deficits are now putting a greater strain on the US economy and financial markets than was the case during the latter half of the 1980s.

This lack of saving, in my view, is America’s most vexing problem. Adding in government deficits, the net national saving rate -- the combined saving of households, businesses, and the government sector adjusted for deprecation -- has averaged only about 3% since 2000. By way of comparison, the net national saving rate averaged nearly 10% in the 1960s and 1970s before falling to 5.9% in the 1980s and 4.8% in the 1990s. Lacking in domestic saving, the United States has no other choice than to import foreign saving from abroad -- and run massive current-account and trade deficits to attract that capital. To the extent that the extraordinary deterioration in the federal budget has been the main culprit in pushing down America’s domestic saving rate in recent years, the two deficits are joined at the hip. Without a cushion of private saving, a long-term structural budget deficit problem -- precisely the outcome the US now faces, according to the non-partisan Congressional Budget Office -- spells unrelenting pressures from America’s twin deficits for as far as the eye can see.

This is not a message that plays well in Washington. Believe me, I know that -- having testified many times in front of the US Congress on one of these deficits or another. Politicians, in their never-ending search for both the scapegoat and the quick fix, are hardly predisposed to looking in the mirror and accept any blame for the recent deterioration in national saving and the current-account and trade deficits it spawns. Pete Peterson makes that same point eloquently in his latest book, Running on Empty (Farrar, Straus and Giroux, 2004). The subtitle of this tome says it all: Both the “Democratic and Republican Parties are Bankrupting Our Future.” I couldn’t agree more -- especially with the ever-ticking demographic clock calling out for an increase in national saving at precisely the time when America is going the other way. Yet deficit reduction never sells on the campaign circuit, regardless of the mounting perils of a saving-short economy. Campaign 2004 is no different in that respect. Senator Kerry and President Bush are arguing more over the types of additional tax cuts America needs rather than debating the imperatives and tactics of deficit reduction.

Maybe June’s trade deficit is a wake-up call. If so, it will be up to financial markets to send that message. That was the verdict in October 1987 and it may well be the case again. Financial markets have long served the painful but useful purpose of venting imbalances in the real economy. No two such episodes are alike, however. Just because the tensions of America’s twin deficits in 1987 were vented in equity markets doesn’t mean the same such phenomenon will necessarily occur in 2004. Other asset markets could just as easily give way -- the dollar, the bond market, credit markets, or even property. Nor is the recent slide in the US equity market inconsistent with the outcome that might be expected in a more full-blown current account adjustment.

The point is that a chronic twin-deficit problem in a saving-short US economy requires ever greater volumes of capital inflows into dollar-denominated assets in order to finance ongoing growth in the domestic economy. As the current-account gap -- the broadest measure of international transactions -- rises toward 6% of GDP, America will need to import in excess of $2 billion in foreign capital each and every business day of the year. Up until now, that financing has occurred on terms that are very favorable to the United States -- there has been only a limited decline in the broad dollar index and virtually no increase in real long-term interest rates. In the end, however, a chronic shortfall of national saving cannot be financed indefinitely without consequences. Barring a sudden improvement in the national saving outlook, underlying asset values in the United States must be written down to match the ensuing reduction in this saving-short economy’s intrinsic growth potential. That’s where pressures on asset prices come into play.

Never before has the world’s dominant economic power lived this far beyond its means. Most believe that America is special -- that it deserves special dispensation from current account, debt, and saving adjustments. Just as history is littered with the remnants of other such new paradigms, I continue to believe that the United States will have to pay a steep price for its imbalances. As America’s twin deficits move inexorably toward the flashpoint, there is a growing risk that its external financing terms could take a sudden turn for the worse. The dollar, US equities, and credit markets strike me as most vulnerable to such a development. Twin Deficits at the Flashpoint