U.S. Failing to Defend Dollar’s Fall
On Oct. 30, 1938, the weekly radio program Mercury Theatre aired “The War of the Worlds.” As adapted from H.G. Welles’ novel and directed by Orson Welles, the effect was stunning. The broadcast’s first half was presented as a series of dramatic news bulletins about a Martian invasion. Many listeners who had missed, or ignored, the opening credits assumed that the invasion was real. Local police were swamped by phone calls from panicky listeners. Some people fled their homes.
The financial equivalent of this broadcast today would be: “We interrupt regular programming to announce that the United States of America has defaulted on its debt!” But, unfortunately, this would be no fantasy news event.
Default means that the borrower has failed to honor his contractual obligations by not paying interest and principal owed to the lender. The most immediate financial effect of default is the loss suffered by the lender.
Yet lenders to the U.S. government have suffered significant financial losses. Not from nonpayment of interest or principal, but because the currency in which the debt is serviced and paid back — the dollar — has lost substantial value relative to other currencies.
Consider a Japanese investor who bought 30-year U.S. Treasury bonds in 1985, when the exchange rate was $1 = 250 yen. Based on the current exchange rate of $1 = 105 yen, the value of the investment has dropped 58 percent. European investors who bought U.S. government bonds in recent years suffered similar financial losses. If they bought U.S. bonds when the exchange rate was 1 euro = $ 0.85, their investment would have lost 46 percent of its value with today’s exchange rate of 1 euro = $1.56.
Such losses to foreign buyers because of the dollar’s declining value are not that unusual. What’s scary for these investors is that these kinds of losses are tantamount to default. Is Washington effectively defaulting on its debt obligations by refusing to defend the dollar? Even today, when the dollar fell around the globe as news of the proposed $700-billion Wall Street bailout spread through the world markets, Washington did nothing.
The U.S. national debt has been rising at a rapid clip. In March, it stood at $9.4 trillion, up 50 percent since 2000. In 2007, it grew by $500 billion, from $8.7 to $9.2 trillion. In 2005, the U.S. national debt amounted to 67 percent of that year’s gross domestic product; in 1988, it had been just 51 percent of GDP. The Office of Management and Budget projects the debt to rise to $12.3 trillion in 2013.
Who owns U.S. debt? Some $2.4 trillion of the $4.7 trillion held privately is owned by foreign investors. Japan holds about $600 billion, or 24 percent; while China’s share is $500 billion, or about 20 percent. Britain, Brazil and the oil-exporting countries own about 6 percent.
Middle East and Russian holdings of U.S. debt may, in fact, be higher. Because these nations might seek to avoid disclosure, Belgium, Caribbean banking centers and Luxembourg — which represent 8 percent — may actually be vehicles for their investments.
What’s troubling is that the $9.4 trillion figure does not take into account the U.S. government’s unfunded liabilities. For example, it does not factor in the huge costs of buttressing Medicare and Social Security as baby boomers retire.
In June, Peter Orszag, director of the Congressional Budget Office, testified before the Senate Finance Committee that, “The U.S. economy faces the long-term threat of ‘collapse’ unless major reforms on health-care spending are instituted in the coming years.” The federal budget, he added, is on an “unsustainable path” because health-care costs are growing faster than the overall economy.
A month later, Richard W. Fisher, head of the Dallas Federal Reserve Bank, said, “The unfunded liabilities from Medicare and Social Security…comes to $99.2 trillion over the infinite horizon.” That works out to $1.3 million per family of four — more than 25 times average household income.
While the national debt is soaring, its maturity is shortening. In December 2000, the average maturity of U.S. government debt held by private investors was 70 months. As of March, it was 53 months. Even more troubling is that, of this debt, 71 percent is due in less than 5 years, 39 percent in less than 1 year.
In part, the shortening maturity of U.S. debt is because the Treasury stopped issuing 30-year bonds during the Clinton administration. This has since been reversed by the Bush administration. But the ostensible rationale was that projected U.S. budget surpluses would allow some government debt to be retired. In reality, low, short-term interest rates during the 1990s reduced the borrowing costs of issuing short-term bonds — which had the effect of boosting annual government surpluses. Today, interest rates are higher, and Washington must now “roll over” significant amounts of debt at those rates in the coming years.
The seriousness of the country’s rising national debt is compounded by the projected 2008 budget deficit of $380 billion — more than 2 percent of GDP; and the current account deficit that is is expected to exceed $700 billion this year — more than 4 percent of GDP.
Combine that with an extremely low U.S. savings rate — which is probably even lower today. Until recently, U.S. consumers counted asset appreciation — primarily their homes and stocks– as savings. The problem was that they borrowed against these assets, now depreciating, to fund consumption.
One mainstay of the U.S. economy had been its vaunted financial system. In 2001, Lawrence Summers, former deputy Treasury secretary in the Clinton administration, extolled the merits of the system at the London Stock Exchange. “The United States is the only country in which you can raise your first $100 million before you buy your first suit.”
Summers dismissed critics who felt that the U.S. financial system’s sophistication in creating new trading instruments was synonymous with financial instability: “[That belief] is observed in inverse proportion to knowledge of these matters.”
In a 1998 speech during the Asian financial crisis, Summers also preached the merits of American-style “transparency and disclosure.” But it is the U.S. that now needs “transparency and disclosure.”
The U.S. financial system has been badly affected by losses on subprime mortgages and the credit crunch. Losses are already in excess of $300 billion. The banking system needs additional capital, despite having raised more than $200 billion so far. The U.S. government has engineered the sale of Bear Stearns to JPMorgan Chase, nationalized Fannie Mae and Freddie Mac, bailed out the insurance giant American International Group and announced a plan to buy bad loans tied to the housing market made by banks. The Federal Reserve has provided almost $500 billion to support the financial system, and the cost of the plan to buy back banks’ bad loans is pegged at $700 billion.
The result of all this is that glabal confidence in U.S. financial markets has greatly suffered. The largely unregulated growth of securitisation and off-balance-sheet vehicles -– the “shadow banking” system -– now threatens the financial system and perplexes many foreign observers. Byzantine U.S. accounting practices — off-balance sheet debt, mark-to-market requirements and derivative accounting — and the failures of the rating agencies, basically a U.S. phenomenon, have also undercut investor confidence here and abroad.
Even the veracity of the economic data released by the government has been questioned. Bill Gross of PIMCO, one of the world’s largest bond investors, and other commentators contend that Washington’s official measure of “inflation” significantly understates actual levels because of statistical adjustments made over the past 25 years. Mohamed El-Erian, co-chief executive of PIMCO, summed it up on June 25: “What has suffered most is the credibility of the most sophisticated financial systems in the world.”
High levels of debt are sustainable, provided the borrower can service and finance it. Washington has had no trouble attracting investors, domestic and foreign, to date.
In recent years, the United States has absorbed roughly 85 percent of total global capital flows — about $500 billion each year — from Asia, Europe, Russia and the Middle East. And risk-adverse foreign investors prefer high-quality debt –- U.S. Treasuries, AAA rated bonds, including asset-backed securities.
Warren Buffett, in his 2006 annual letter to shareholders, noted that Washington can fund its budget and trade deficits because it is still a wealthy country with a relatively strong economy. The problem is that a significant portion of the money flowing in from overseas is not used to finance productive investments. Rather, it funds government spending.
The mass hysteria and panic that followed the broadcast of Orson Welles’ “The War of the Worlds” played on fears about an attack by Germans. It is interesting to speculate whether a broadcast on a U.S. default on its sovereign debt would play on the secret fears of global markets and trigger a similar panic. “We interrupt regular programming to announce that the United States has defaulted on its debt!”
- Satyajit Das is a risk consultant and author of “Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives.” *
At the time of publication the author or his firm did not own any direct investments in securities mentioned in this article though he may be an owner indirectly as an investor in a fund.