We’ve cribbed the title of a provocative post by Satyajit Das at Eurointelligence. He argues that the US’s days of continuing to borrow abroad with little worry as to the consequences may be nearing an end.
A good companion piece is Menzie Chinn’s Implications of adjustment to riskier dollar assets in a portfolio balance framework, illustrated in three steps . Great minds are working alike.
The key issue with US debt, which not enough analysts have focused on (Brad Setser being a noteworthy exception) is that our creditors are not merely lending to us to fund their exports. They are also lending us the money to pay interest on money they lent us in the past to buy their exports. At some point, the debt service component becomes too high relative to the portion that goes to fund current exports. Or the economies over time develop more robust consumer sectors and the importance of funding exports is less pronounced.
Here is the beginning of the Das post, which I recommend reading in its entirety:
High levels of debt are sustainable provided the borrower can continue to service and finance it. The US has had no trouble attracting investors to date. Warren Buffett (in his 2006 annual letter to shareholders) noted that the US can fund its budget and trade deficits as it is still a wealthy country with lots of stock, bonds, real estate and companies to sell.
In recent years, the United States has absorbed around 85% of total global capital flows (about US$500 billion each year) from Asia, Europe, Russia and the Middle East. Risk adverse foreign investors preferred high quality debt – US Treasury and AAA rated bonds (including asset-backed securities (“ABS”), including mortgage-backed securities (“MBS”)). A significant portion of the money flowing into the US was used to finance government spending and (sometimes speculative) property rather than more productive investments.
The real reason that the US actually has not experienced a sovereign debt crisis is that it finances itself in it own currency. This means that the US can literally print dollars to service and repay it obligations.
The special status of the US derives, in part, from the fact that the dollar is the world’s major reserve and trade currency. The dollar’s status derives, in part, from the gold standard that once pegged the dollar to the value of gold. The peg and full exchangeability is long gone. The aura of stability and a safe store of value based on the strength of US economy and military power has continued to support the dollar. In 2003, Saddam Hussein, when captured, had US$750,000 with him – all in US$100 bills. The dollar’s favoured position in trade and as a reserve currency is based on complex network effects.
Many global currencies are pegged to the dollar. The link is sometimes at an artificially low rate, like the Chinese renminbi, to maintain export competitiveness. This creates an outflow of dollars (via the trade deficit that in turn is driven by excess US demand for imports based on an overvalued dollar). Foreign central bankers are forced to purchase US debt with dollars to mitigate upward pressure on their domestic currency. The recycled dollars flow back to the US to finance the spending. This merry-go-round is the single most significant source of liquidity creation in financial markets. Large, liquid markets in dollars and dollar investments are both a result and facilitator of the process and assist in maintaining the dollar’s status as a reserve currency.
The dominance may be coming to an end. There is increasing discussion of re-denominating trade flows in currencies other than US$. Exporters are beginning to invoice in Euro or Yen. There are proposals to price commodities, such as oil and agricultural goods, in currencies other dollars. Some countries have abandoned or loosened the linkage of their domestic currency to the dollar. Others are considering such a move.
Foreign investors, including central banks, have reduced investment allocations to the dollar. The dollar’s share of reserves has fallen from a high of 72% to around 61%. Foreign investor demand for US Treasury bonds has weakened in recent times. Low nominal (negative real) rates on interest and dollar weakness are key factors.
Foreign investors may not continue to finance the US. At a minimum, the US will at some stage have to pay higher rates to finance its borrowing requirements. Ultimately, the US may be forced to finance itself in foreign currency. This would expose the US to currency risk but most importantly it would not be able to service its debt by printing money. The US, like all borrowers, would become subject to the discipline of creditors.
For the moment, the US$ is hanging on – just.
The post continues here.
17 comments
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Derivatives expert turned monetary economics expert/armageddonista.
He conveniently ignores (if he knows) the fact that US international investment income (which includes interest payments among other things) is virtually in balance. And that’s the implied focus of his concern!
He’s wrong on treasuries. Foreigners are still buying them like crazy.
Setser and Roubini were way off on the timing of this. No reason to think there isn’t additional time for the current account to adjust, which it will do as a result of the housing crisis and lower consumer demand, and which is most of what is required here.
What I see in your comment, Anon of 7:46, is the problem of self-reference. You look at present conditions, they look much like conditions of a month ago, and not seriously unlike conditions of a year ago, and the determination is “All systemes go!” When the present circumstance is compared with other historical instances, the resulting perspectie is sharply divergent.
Here is the money paragraph to me from elsewhere in Das’ piece: “Sovereign debt crisis, especially in emerging markets, are characterised by high levels of debt, especially foreign borrowings, poor fiscal policies, persistent trade deficits, a fragile financial system, over-investment in unproductive assets and a sclerotic political system. Arturo Porzecanski (in Sovereign Debt at the Crossroads (2006)) noted that: “Governments tend to default specifically when they must increase spending quickly (for instance, to prosecute a war), experience a sudden shortfall in revenues (because of a severe economic contraction), or face an abrupt curtailment of access to bond and loan financing (e.g. because of political instability). He further observed that: “governments with large exposures to currency mismatches and interest rate or maturity risks are, of course, particularly vulnerable.” ” _That_ picture by and summary well describes the US of A as of 2008. Other comparable contexts ended in major social and political whackage. Well, my fellow citizens, if the ass fits, wear it.
It is not ‘different this time’ even if the same good times are what those in the midst of them mostly, selectively see. The best inference is that for the US and it’s currency, it is exactly the same this time as for others other times, only moreso. Das makes another very relevant point also elsewhere in his article, that debt service may be managed initially, but eventually reaches a level where it is politically unsustainable even before it becomes economically unsustainable. This is perhaps the most likely scenario for the US, we spin the hampster wheels of debt service on our $10T, $12T, $15T owed, while foreign currency holding shares for the $ drop to 50% and then below . . . and then we skip on a bond, and the world is made new and strange. This all may change not with a bang but a simper. What’ll we do when our creditors fail to applaud?
Richard Kline:
A few differences:
a) Relative to the problem at hand, the US faces a favorable currency mismatch – US dollar liabilities, foreign currency assets – in its NIIP (net international investment position). This is a different relative configuration than Thailand or Argentina.
b) The size of the NIIP is very small (net liability to the rest of the world of $ 1.5 trillion or so) relative to more popularized armageddon quantifications of the problem at hand.
c) The US current account will adjust due to problems already mentioned. Indeed, it must adjust to some degree. This will happen as it needs to happen because the US economy still has the flexibility to adjust – even in the wake of admittedly outrageous transgressions in mortgage lending. But the adjustment capacity makes the situation different than for some tin-pot foreign nation that has borrowed too many US dollars.
“Many global currencies are pegged to the dollar. The link is sometimes at an artificially low rate. At a minimum, the US will at some stage have to pay higher rates to finance its borrowing requirements.”
The inverse of the first statement is that the dollar is valued at an artificially high rate. International demand for dollar reserves holds the dollar’s external value higher, and U.S. interest rates lower, than they would be if the dollar were only a minor component of forex reserves.
In Richard Kline’s insightful comments, I would differ with the “bang but a simper” formulation. It’s more likely to be a ‘chaos theory’ scenario, such as determining when one last grain of sand on a sandpile will cause an avalanche.
Political arrangements can have tremendous inertia. The Ottoman empire was widely considered to be decadent on the eve of World War I, but it had soldiered on for decades in that condition. Similarly, the U.S. dollar was made the central reserve currency in Bretton Woods I because the U.S. constituted 50% of global GDP in the war-torn world of 1946. Six decades later, U.S. troops remain in Europe and the dollar remains the principal reserve currency, despite a transformation of Europe’s security situation for the better, and of the U.S. dollar’s fundamentals (both the closing of the gold window in 1971, and the chronic current account deficit now) for the worse.
Predicting when the dollar’s “unclothed emperor” plight will suddenly attract unfavorable comment is as tough as forecasting the top tick for crude oil. It could go on for decades, or end at 3 a.m. tomorrow. Both presidential candidates are saying that they will escalate the war in Afghanistan. This surely implies continued inflation (in the 5 to 10% range) and continued dollar weakness for the foreseeable future. It also implies rising current account deficits which will need to be financed.
Dollar crisis is a wild card. But the dollar’s postwar crises have occurred in wartime — the demolition of Bretton Woods I (1968-1973) during the Vietnam War; the recent bout of weakness during the Iraq War. Continuing the foreign imperial wars is like playing Russian roulette with several bullets in the chamber. One day, something goes bang, and it’s “Goodbye, Uncle Buck.” The wheels of economic justice grind slowly, but the result is certain.
The US is well pn it’s way to an Argentina moment, it may be delayed but it will happen so timing is the only question best guess withing the next 3-4 years.
I don’t think anyone really has any idea how exactly this will play out, but the first poster’s sanguine attitude echoes those predicting as recently as 18 months ago “a leveling off to sustainable levels” of the housing market in the US, or those making the same prediction about the UK just a month or two ago.
I think Soros had it right when he characterized the last 20 years or so as a giant credit bubble. And there are a lot of silly truisms that have seemed to be repeatedly confirmed over that period. One of my favorites is, “never underestimate the American consumer’s willingness to spend.” As if income and access to credit had nothing at all to do with it, it was simply a matter of attitude.
The sanctity of the dollar and US debt is a sure thing–up until the point when it isn’t any longer…
I tend to agree with the view that this will end chaotically. Looking at history, it’s clear that the conditions that lead to crises can fester for a long time without provoking a crisis. This is typical of dynamic systems: they can be perturbed up to a point and then all of sudden they reconfigure themselves into a new equilibrium state that looks very different from the old one.
The current unwinding of leveraged debt positions will continue unabated as our monetary system of fractional reserve banking will shrink by the multiples by which the money was created.
Today the rules are being bent backwards to float these insolvent financial institutions.
But, at some point when new debt can no longer be created the system crashes rendering almost all debt uncollectable.
The only hope is a Public Central Bank that is the arbiter and guarantor of all credit and that creates such credit from future revenue streams of taxation so as to create money without debt.
The bankers will crash the financial system or cry for war before they allow this to happen.
Relative to the problem at hand, the US faces a favorable currency mismatch – US dollar liabilities, foreign currency assets – in its NIIP (net international investment position). This is a different relative configuration than Thailand or Argentina.
But that is the point – the favorable conditions tend to change to unfavorable. Argentina, Chile, Russia (1998) – all had one thing in common – very favorable currency exchage conditions, due to the “hot” money, prior to the collapse.
The other thing, that the Anon is probably not aware of, is that the current account includes the investment income from abroad, so it is unclear what exactly is meant by being “in balance”. It’s common knowledge that the current account balance of the USA is minus $0.7 trillion for the 2007:
http://en.wikipedia.org/wiki/List_of_countries_by_current_account_balance
If foreigners dump their dollars, the effect will be to devalue the dollar and push up inflation accordingly. Inflation is good for borrowers and bad for lenders. Most of the US debt is not inflation-indexed, so the value debt will decline in real terms. If the fed does not stem the inflation, the effect will be to bail out the US govt on the backs of its debt holders. It’s happened before. Meanwhile US goods will become cheaper on the world market and imports will become more expensive, leading to a significant shift in the trade deficit.
On the other hand, as Buffett points out, foreigners may choose to buy Rockefeller Center and land in Hawaii and US companies at ridiculous prices. That’s happened before, too. Purchases of US companies are particularly good news for the US since often the assets are intangible. Let China buy Nike and Disney, say. They can have ’em, we’ll make more.
I think this was the “money” parahraph:
“The dry measured economic prose of the Washington Consensus does not capture its human elements. It will require reductions in US real wages and living standards on a scale that those who have not experienced it first hand cannot understand. Just ask the average citizen of many Asian countries (post the 1997/ 1998 monetary crisis), Argentina and any other country that has taken the IMF’s “cure”. “
Max –
Good grief. The point is that the US is short its own currency. It’s international position improves if the dollar weakens. And the balance on investment income is a subset of the current account. It is the net servicing requirement for the US external position. It is roughly in balance. That is a good thing. It is because the US earns more on foreign investment than foreigner investors earn in the US. You won’t find that in Wikipedia.
Anon @ 8:23
(could you please use a handle, it’s very simple, and easier for participants to refer to you)
The point is that the US is short its own currency. It’s international position improves if the dollar weakens.
Actually, even though this has been correct up to now, the rules have changed – the surge in input commoditties. See, you can’t just print your way out of your debt – the market punishes you at the input. So the international position, overall, hardly improves as the USD weakens. What else you won’t find at Forbes is that the Chinese USD reserves grew at a very elevated pace during the 2008 – this can’t go on for much longer, because political risks of having very high domestic inflation will prevent the reserves from further accumulation.
That is a good thing. It is because the US earns more on foreign investment than foreigner investors earn in the US.
By the same logic, people in Argentina should have rejoiced when their peso collapsed, because “the Argentine earned more on foreign investment than foreigner investors earned in Argentine”. Or another argument – you borrowed $20 from Jack and didn’t pay it back – you just earned more on Jack than he earned on you. You do it repeatedly, until Jack doesn’t let you borrow.
Anon 8:23p –
“the US is short its own currency…that is a good thing”
From the perspective of freezing the economy at some point in time, and screwing our creditors, yes, it’s a good thing for the USA. We tell China and OPEC to pound dirt and devalue/print.
Now what?
Read about life in Russia in the early 80s, when citizens were burning their currency in the winter because it was cheaper than wood. That should give you a pretty good idea of what comes next.
To Anon of 8:40 AM and (I suspect) 8:23 PM, I fully agree with you that the situations of Thailand and Argentina of the last dozen years _by themselves_ are not good comparables for the present US situation. These countries had huge current account imbalances as you are aware, were small with few foreign investments of their own, and had spongy, unreliable currencies and a prior history of economic weakness. Shawn H.’s comp of Russia in the early 90s is better, but really I’m thinking of far more instances over much greater time. Yves has frequently, and rightly, made mention of a paper this Spring by Rogoff and Reinhardt regarding sovereign defaults goinb back _hundreds of years_: That is the timescale and sample base relevant. And the US macroeconomy as of today fits those ‘on defaulters’ much better than it does a healthy but for the moment wobbly economy.
Re: NIIP, this is not the point. Nor is the issue of US investments overseas? If those investments were in the hands of the Federal government, and their proceeds were turned right around to pay off our _external sovereign and quasi-public debt_, then those ‘balances’ might matter. But those profits go into private hands whereas the payouts for our public and quasi-public debt must be financed from public revenues. Said revenues are manifestly inadequate for the still increasing external public debt. If what you are proposing, then, is that the US nationalize all offshore investment profits if and as they are repatriated, and use that revenue to pay off our sovereign debt, than we may get closer to ‘being in balance.’ It is much not my impression that you suggest anything of the sort. Ergo income and outgo are NOT in balance—because they are billed to quite different parties. Abstarct total quantities obscure more than they reveal; peel them back, and you’ll find different answers.
The Ottoman Empire was thought to be decadent on the eve of _the Napoleonic Wars_, and rightly so. States may go bankrupt, and many times, but they do not go away quickly. A bad patch for the US won’t eliminate us as a major power for any length of time, but we will be more nearly _a_ major power than _the_ structually ensconced presumptive power. To me, this is a good thing, not only for the rest of the world but for us, too: USonians need to take care of business at home, and live right.
Previous changes in the reserve currency have much to do with war-induced financial collapses. Britain was insolvent in 1940 and bankrupt in 1944, but the US simply refused to let if go under and funded WW II _and_ Britain. Take a look at Britain in 1946. This is not a great comparable for the US but something to consider. Life didn’t end, but it changed, and empire ‘went west.’ . . . Which might mean over the International Date Line in this metaphor, but I think back to Europe is more likely. Hard to say.
For a guy who has pushed dynamical issues much in my comments, I am not strongly in the campt that a change in the dollar will be sharply nonlinear, even chaotic, in movement. Dynamical comparisons assume NO OUTSIDE INTERVENTION IN SYSTEM VARIABLES, but as we see there have been massive outside interventions in the US financial system over the last year. Yves comments on this closely, and Brad Setser just put up a good, tight summary Thursday, 24 July for anyone who needs it. I strongly suspect that the dollar would have collapsed last Fall or Winter if left to ‘the markets,’ but the world’s central bankers most explicitly did NOT leave this outcome to the markets but bought dollar denominated public and quasi-public debt massively to support the dollar. But eventually that debt, and all the debt they will be buying once things _really_ go sour for the US economy over the next 12-14 months will have to be paid back: That is the Six Point Four Trillion Dollar Question. Personally, I think the answer will be, “Oops.”
Richard Kline:
A very interesting point re NIIP and nationalization.
First, let me be clearer on the two points I should have made about NIIP:
a) The NIIP as you know is the international component of the US balance sheet. TO THE DEGREE that the external position of the US represents an exposure, there is some correlation with the degree to which this international component represents a net liability position. It is a net liability position. But it is a smaller net liability position than one would infer by simply adding up the cumulative current account deficits of the US. Essentially, the long term investment performance of assets is better than that of liabilities. There are a number of reasons. E.g. the foreign investment performance of US multinationals; the fact that assets are weighted more toward US risk taking abroad whereas liabilities are weighted to “risk-free” (note quotes) treasuries and agencies; the fact that assets tend to be denominated in appreciating currencies such as the Euro and that liabilities tend to be denominated in dollars.
b) The income associated with NIIP (receipts and payments) is a component of the current account. TO THE DEGREE that this component is well behaved compared to the core current account exposure (the trade deficit), it is very important in determining the sustainability economics of the current account deficit. This component is well behaved. Even though the NIIP is a net liability, the net investment income is close to being in balance and in fact for a number of years was actually in surplus. The main reason is that the US earns more on its foreign assets than foreigners earn on their US assets, and this difference dominates the disadvantage of servicing a net liability position.
All of this represents a marginal advantage, other things equal, in the ability of the US to have sustained its current account deficit so far. For example, in response to an earlier anonymous comment, I never said that the depreciation of the US dollar was a good thing for the US dollar. What I did say was that, for a given or assumed depreciation in the US dollar, it is a good thing rather than a bad thing that one result is a favourable valuation effect on NIIP.
(Brad Setser wrote extensively about these technical aspects about a year ago.)
Now, you make a very interesting point re nationalization. You correctly assume I did not mean to infer this. But I must admit I’d need to think more about the point you’ve made. In the interim:
I posted this yesterday on Setser’s very interesting post (to which you referred and where you’ve made a comment as well):
1. anon Says:
July 24th, 2008 at 8:46 pm
Central banks finance the deficit at the exact point they buy the dollars that the US exports via the deficit. They buy treasuries and agencies because, essentially, they have nothing better to do with the money, and they must do something with it. The exchange rate policy is the preeminent one. It is the critical risk, more so than the funding pattern corresponding to the assets that are purchased with the dollars.
Brad responded:
bsetser Says:
July 25th, 2008 at 2:23 am
anon — technically, you are right. central banks buys dollars ( a us asset) when they intervene. after that they just shuffle between dollar assets. I don’t want to discount that reshuffling — a world where the official sector buys $1 trillion of us equity is different than a world where the official sector buys $1 trillion of us debt. and, of course, just ’cause you buy a dollar doesn’t mean that you hold a dollar — dollars can be sold for euros, if there is a buyer. but I agree that the key decision is the decision to step into the market to begin with and to purchase dollars.
Anon here: Unfortunately, this only brings me to the point of reiteration and technical convergence with your comment, which is more fundamentally geared. Sorry I have no more time to respond here. But I think the balance sheet dimensions in totality are very important to the issue of the likely path of resolution of all of this. It is important to know for example that the NIIP liability is about $ 1.5 trillion, that Gross’s latest estimate of mortgage losses is $ 1 trillion, that US household wealth is about $ 55 trillion (and declining), etc. etc. etc. The US is not a small country, and the foreign account is arguably the one with the greatest degrees of freedom as to how it will get resolved. This is not a small country that will suddenly fall off a cliff, although pricing action in FX and bonds may at points become abrupt (not the same thing as falling off a cliff). Finally, it is very important to know that foreign central banks have also brought this on themselves, to a very great degree.
So Serial Anon:
Re a): You were actually clear, and I understood you. Seeing all flows in and out of the US on a single balanace sheet is not, however, a helpful perspective in isolation. Viewing investment and profits without seeing the public and quasi-public debts involved in maintaining the currency will yield a skewed assessment of exposures. It matters, and greatly, _whose_ accounts are in balance or not. As things stand, corporations take the profits and the public takes the debt in aggregate on our external flows. If through the last generation we had had an appropriate corporate tax rate, especially on overseas profits, we would be in a very different position today as a country, but the last seven Administrations did not see it that way.
Re b): Yes definitely, if trade and investment flows are ‘well-behaved,’ most current account numbers, including the present ones for the US, are managable. In the short term. In the long term, the absolute total outstanding obligations do really matter. Our public and quasi-public exposure is far more than the _public_ revenues available to meet them or any rational relation to our GDP. True, chunks of those overseas earnings don’t make it into GDP; not for caluclation, but also not for revenue-generating taxation. Other countries with the kind of public inablity to come into balance that we have now have seen this structural situation end very badly. I do not see corporations and plutocrats stepping up to pledge an appropriately higher share of their assets and revenue to pay off the imbalance. Just for the record, they didn’t do so either in Argentina, Thailand, Russia, or any other sovereign default I can think of off the top of my head. In absence of that, I default to historical comps which say our problems exceed our solutions as things stand. That’s not socialism: it’s realism. And no, we haven’t had any too much of that in the US of A over the last generation, either.