A cri$i$ looms large

The US' mounting multi-trillion-dollar debt to the rest of the world will probably have disastrous consequences, and it might take much of the global economy along with it

S Siddharth Washington

There exists a great disequilibrium in  that all-weather ship called the global economy, and if certain things come to pass, it might even capsize — a financial Armageddon of unimaginable proportions. Since the collapse of the Breton Woods international monetary system — an agreement that came out of World War II to stabilise the world economy and gave rise to the General Agreement on Tariffs and Trade (GATT), the International Monetary Fund (IMF) and the World Bank (WB) — there has been a surge in international reserve assets, which have increased by a factor of almost 20 since 1969. At the heart of the matter is the latest US trade deficit, which is increasing by almost US$ 50 million an hour.

The crisis took off when gold ceased to be the foundation stone of the global house of usury. Trade imbalances under the gold standard were unsustainable due to recessionary pressures and were self-correcting through changes in relative prices in any two countries. A possible "crowding out" effect (an increase in interest rates due to rising government borrowing in the money market) deterred governments from incurring a large deficit as it would make it harder for the private sector to borrow and invest. These undesirable effects of deficits also forced governments to prepare balanced budgets.

The Breton Woods system was a close substitute to the gold standard and was established for the smooth functioning of the post-World War II international financial system, in which the US dollar was pegged to gold at US$ 35 an ounce and all other currencies were pegged to the dollar at fixed rates. The value of the dollar was backed by the US government's gold reserves. This system prevented gratuitous devaluation, whereby countries could gain unfair advantage in trade by devaluing their currencies.

This system worked well until the mid-1960s, when the US dollar began to come under pressure. This happened due to various factors such as heavy overseas investments by US corporations and the rising military expenditure in Vietnam. These factors led to the deterioration of the balance of payment and other countries found themselves holding, and exchanging for gold, the dollars that were flooding their reserves. This, in turn, caused a huge outflow of gold and forced the US government to take drastic measures. By August 1971, then US president Richard Nixon suspended dollar convertibility into gold as a short term measure.

The Breton Woods system came to an end in 1973, when major trading countries allowed their currencies to float freely. By 1982, the US had accumulated a budget deficit of US$ 100 billion. By 1986, the US also had a whopping current account deficit of 3.5 per cent.

Under the present arrangement, the US imports goods from the rest of the world and pays in dollars, essentially dollars printed in the US mint. These dollars are then used by foreign central banks to buy debt instruments, bonds, stocks, private sector enterprises and real estate. Americans are, thus, freed from the burden of saving and the onerous requirement of having to produce first in order to consume later. Their unfaltering consumption leads to the growing indebtedness to non-Americans of the private sector and the Federal Reserve Bank. This state of affairs is obviously unsustainable and will crash after a plummet in the dollar exchange rate relative to other currencies.

Unlike gold, which is excavated with great difficulty, a US treasury debt instrument can be easily created, since nothing has to be actually produced to add value to the instrument. The overdependence of the global economy on the wellbeing of the American economy is the first flaw in the post-Breton Woods system. This transnational over-reliance also leads to the creation of asset price bubbles in countries, bubbles that, when they burst, can wreck entire national economies.

Between 1991 and 2003, the US' cumulative global borrowing has risen to US$ 2.4 trillion, or roughly 22 per cent of the US Gross Domestic Product (GDP). In the absence of significant policy changes, federal budget deficits are expected to total around US$ 5 trillion over the next decade. Such deficits will cause the US government debt-to-GDP to rocket. As the so-called baby boomers age, their claims on social security, healthcare and medicare benefits are going to increase, ratcheting up government deficits and debt.

According to Sustained Budget Deficits: Longer-run US Economic Performance and the Risk of Financial and Fiscal Disarray by Robert E Rubin, Peter R Orzag and Allen Sinai, "The scale of the nation's projected budgetary imbalances is now so large that the risk of severe adverse consequences must be taken very seriously, although it is impossible to predict when such consequences may occur." However, the adverse consequence of sustained large-scale budget deficits may well be far larger and may occur more suddenly than traditional analysis suggests.

Such enormous budget deficits under the gold standard and the Breton Woods system would have been impossible because of their inherent self-adjusting mechanism. Last year alone, the US ran up a current account deficit of US$ 500 billion. The markets continue to furnish America with the money it needs without demanding higher yields. This would never be possible for any other country. Richard Duncan wrote in The Dollar Crisis: "How much longer will the rest of the world be willing to accept debt instruments from the United States in exchange for real goods and services? It is only matter of time before the United States will not be credit worthy." In fact, there is already speculation that traders might soon openly start trading in European Union and other non-US securities and debt instruments.

The massive purchase of dollars by China, the second-largest purchaser of American debt after Japan, may well be one of the main reasons why the crisis hasn't struck sooner. The yuan, the Chinese currency which is pegged to the dollar, is forced to import American debt, because the ongoing China boom could be the result of a lax Federal Reserve Bank policy. China is a large importer of goods and has played a crucial role in Japan's economic recovery. China's GDP today accounts for 13 per cent of the world's output (at purchasing power parity).

China is set to become the world's third-largest exporter after the US and Germany. China, which has become the engine of growth for East Asia, accounts for a third of global imports. Notwith-standing some ups and downs, China's gains over the past two decades can be attributed to wealth-creation, in the real sense, through employment.

This is in stark contrast to the American economy. A senior Chinese official acknowledged that the country was planning to introduce flexibility into its exchange rate system by allowing the yuan to fluctuate in a wider range against a basket of foreign currencies. Apart from revaluing the Chinese currency, it will relieve pressure on the dollar. But, given the Chinese track-record of playing hooky, it is anybody's guess when it will start to move towards the free-float system. The yuan's revaluation is probably the best thing that can happen to the dollar.

As traders and investors become increasingly wary that the US government might resort to high inflation to bring down the real value of its debt, or that an unpredictable fiscal deadlock might occur, investor confidence could be seriously undermined. The deficit might also trigger a big loss of confidence among participants in the foreign exchange markets and in the international credit markets, as the participants become alarmed not only by the ongoing budget deficits but also by related large account deficits. This loss of confidence might cause investors and creditors to invest funds in non-dollar-based investments —causing a depreciation of the exchange rate — and demand very high interest rates on US government debt. As interest rates spiral and exchange rates plummet, stock prices will tumble, increasing cost of financing and reducing domestic spending.

Such a financial market disruption might impede intermediation between lenders and borrowers, crucial participants in the complex international financial markets, and might cause a substantial increase in interest rates in the long-maturity credit market. This would make them illiquid, and the consequent reduction in asset prices would adversely affect the balance sheet of banks and other financial intermediaries.

As the inability of the US government to reduce the fiscal balance permeates the general society, a consequent reduction in investment and real economic activity will be automatic. These various effects can feed on each other to create a vicious cycle of higher interest rates and diminished economic activity, further worsening the fiscal imbalance and creating a boomerang of negative feedback.

The US treasury is in for a rough time.