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