Uncle Sam Against The Wall


The period after World War II has been unusual in that a single nation, namely the United States, has dominated the global economy. The recession that followed the recent global financial system is causing many to question the direction in which the world economic system is heading. And many are worried that the US, with its rolling budget deficits, is going broke. So the question arises, when is too much debt really too much?

Given the high rates of consumer debt in Australia, this is clearly a question with which many of us are grappling on a regular basis. The fear of personal bankruptcy and of the repo guys hauling away our personal effects causes a number of us to think very carefully about buying a house, going to university, applying for a credit card, or purchasing a mobile phone contract.

With these personal financial pressures and the impacts of the global financial crisis still being felt around the world, it is understandable that similar thoughts of bankruptcy have crept into analysis of state economies. If Ireland, Portugal and Greece needed to be bailed out by their neighbours in order to prevent them from going belly up, why should a same fate not befall the US?

In the next few weeks the US will hit its debt ceiling, that is, the legal limit the US government can borrow. Total government debt has reached close to US$15 trillion (yup, that’s 12 zeros), nearly equivalent to the country’s total GDP. The US needs to borrow money not just to keep its government functioning but to pay off the interest on debt it already owes.

Last week, the international credit rating agency Standard and Poors downgraded its outlook for the US to "negative", suggesting that there is a one-in-three chance the US will default on its debt in the next couple of years. China, the US’s single biggest creditor, is worried about the value of their massive US dollar reserves should a US debt crisis occur or the value of the dollar drop due to excessive borrowing. Even Timothy Geithner, the US Treasury Secretary, is describing the country’s continual borrowing as "reckless" and the consequences of a US default on its debt as "catastrophic".

There are two scenarios which could give rise to the US going bankrupt. First, if Congress decides not to raise the somewhat arbitrary US debt ceiling, legally preventing US Treasury from issuing more bonds to meet its interest obligations. Second, if demand for US dollars suddenly dissipates.

However, there is little cause for alarm, at least in the short-term. This is not simply because of the inherent stability of the US economy, but because it is in the interests of US lawmakers and its creditors to ensure the credibility of the US as a debtor and the stability of the US dollar.

To see why this is the case, it is helpful to understand the nature of the budget deficit in the US.

The US government, like all governments, can go into debt by spending more than it raises in taxes. This is possible because governments have the ability to issue treasury bonds, also known as "treasuries". These treasuries are essentially an IOU given by a government to a creditor with a promise to repay that loan at a particular time in the future with interest. Governments can issue these bonds in their own currency or in a foreign currency (called sovereign bonds).

Because the US domestic currency — the US dollar — is the default currency for global trade and finance, the US can continue to borrow money by issuing bonds in its own currency. So long as the US dollar remains a useful currency and creditors believe that the US will be able to honour its debt, then creditors will continue to purchase treasuries, effectively loaning the US money.

In this way, the US is different from countries such as Greece that could not continue issuing bonds in its domestic currency, the Euro, to service its debt. This is because other nations using the Euro refused to underwrite the bonds Greece wanted to issue. Similarly, Greece could not issue treasury bonds in alternative currencies because these would be considered useless in international markets.

There is, in theory, no limit to the number of treasuries that the US government can issue (apart from the Congressionally-imposed debt ceiling). But the ultimate ability of bonds to be a viable means to borrow depends on there being sufficient demand for bonds, such that the costs of borrowing (the bond yield) are reasonable. This demand takes into account the uncertainty inherent in the bond and also the expected future value of the currency that the bond is issued in.

So how can we be sure that demand for US treasuries will not drop suddenly in the short-term?

The US dollar is the de facto world currency. Sixty per cent of global currency reserves are in US dollars. The US dollar remains the currency of choice for global trade, and the US remains the world’s largest economy, with strong institutions that underpin general optimism about its economic future.

There is presently no viable alternative to the US dollar as a global reserve currency. For countries like China, it is still a relatively safer bet to hold US dollars for trading purposes and to insure itself against future balance of payment crisis, especially when compared with its own domestic currency.

Even though the size of the Chinese economy is set to match the US before the middle of the century, the Yuan will not replace the US dollar any time soon. In part this is because the strict capital controls on the Yuan mean that it cannot become a true "global currency". China’s Premier Wen himself admits that the Yuan will not be floated along the path to rivalling the US dollar in the foreseeable future. While the Euro is increasingly used as a reserve currency for trade, uncertainty over the future of that currency, and the fact that it is presently tied to some very weak domestic economies in the Eurozone, makes it less attractive.

It is also not in the interests of large holders of US treasuries, particularly the Chinese, to suddenly sell off their US dollar reserves. China owns about 25 per cent of the US government’s foreign held debt. If the Chinese dump even part of their US treasuries, it is likely to move markets, and cause a devaluation of China’s remaining US dollar reserves as well as abrupt shifts in the global financial system. Such sudden changes in the US dollar’s status are not in China’s interest, nor are they in the interests of other major governments that depend on the US dollar’s relative stability to trade and manage their own growth strategies.

Of course this whole set-up, like so much of the machinations of financial markets, is based on mutual trust and confidence between market actors and is also subject to the vagaries of domestic politicking.

The US government could still default if its creditors suddenly refuse to hold or demand US dollars. Or, the US Congress could decide not to allow the US debt ceiling to be raised, putting a block on the US treasury’s legal ability to issue more bonds. This would eventually result in the US defaulting on interest repayments and seriously impair the presently untarnished reputation of the US government as a debtor.

But at the moment these situations are unlikely to occur because there is little reason to suspect that demand for the US dollar will suddenly drop. Furthermore, collective interest on the part of US lawmakers in stopping a serious collapse of global finance outweighs Republicans making good on their claims to "rescue" America from the spendthrift Obama "regime", by refusing to allow the somewhat arbitrary debt ceiling of the US to be raised.

In the short term, the global reliance on the US dollar and common interests of Congress and foreign governments in the stability of the global financial system means that the US dollar will continue to be propped up as a reserve currency. However, this does not mean that there are not good reasons to believe that the current global currency system is unsustainable in the long-term, or that there needs to be an overhaul of US fiscal policy over the coming years.

There is no doubt that the global economic system is changing. The pre-eminence the US has enjoyed since World War II is being eroded and there are suggestions that a multi-polar global economy is emerging. But these legitimate concerns about the structural challenges confronting the US and future international economic stability will not, at least in the immediate future, be enough to tip the US into bankruptcy.


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