FYI | Jun 12 2007
By Greg Peel
Economists of the ilk of Nouriel Roubini and Morgan Stanley’s Stephen Roach have been pushing the line for at least a couple of years now that the US current account deficit, which has been creeping up consistently in the twenty-first century, is unsustainable. The world cannot continue to finance the US’ insatiable appetite for consumer exports, and eventually something has to give. What is likely to give is the value of the US dollar.
“The US dollar is akin to the promissory note of a defunct finance company”, says M.R. Venkatesh, a charted accountant from Chennai, India.
Is M.R. an authority on such matters? Not, indeed, a globally recognised one, but M.R. does have the capacity to encapsulate the problem in pretty simple terms – an achievement that often eludes macroeconomists. And it is simply the factual evidence that is damning.
“Put modestly, Americans have been living way beyond their means, consuming much more than what they could possibly afford and, in the process, borrowing far beyond their capacity for too long.”
The reason the US has found itself in this position is, to a great extent, a result of the rise of China and other Asian emerging economies and their decision to keep their exchange rates pegged at low levels against the US dollar as a result of the region-wide currency collapse that occurred in 1997. However it must be remembered that China still represents only the third largest surplus on the other side of the US current account ledger. Germany is number one and Japan number two.
When the Chinese economy began to accelerate the balance of currencies actually suited both parties. China was able to fuel a manufacturing surge that employed vast numbers of its peasant population, and the US was keen to voraciously consume whatever cheap exports came its way. But like any drug, it is often foolish to think that a little bit will do and the habit will never get worse. The trade imbalance with China has become much worse.
If you buy a car from a dealer financed by the a loan from that same dealer – a transaction that occurs every day of the week in Australia – the amount you owe is fixed and as long as you can make the interest payments everything is sweet. What is unlikely to happen is that you would buy another car the next, year, and then another, without having disposed of or paid off the first. This would probably lead you into bankruptcy eventually were the car dealer not diligent with its credit assessment.
The US is buying affordable export goods from China on credit. China lends the US the money to do so by buying US Treasuries. The money it lends represents the receipts from the sale of the goods. This seems like a fair arrangement, except that the amount of goods bought on credit never falls – it just rises year on year. And China is not the only country exporting goods to the US. The spark for the whole transaction lies in undervalued foreign currencies – those which make the exports appear cheap in the first place. And the US is hooked on a consumption drug.
In mid May the US national debt stood at about US$8.85 trillion, or US$28,000 for every man, woman and child. The current account deficit – that which is financed by foreign rather than domestic reserves – stood at $850 billion or 7% of GDP at the end of 2006. The US is, on the other hand, having trouble with its own export economy. Traditional leviathans like General Motors are struggling to stay afloat in the face of global competition from countries with much cheaper labour. In order for the US dollar not to collapse as the country continues to move to what appears, from a corporate point of view, to be ultimate bankruptcy, the Fed has continued to raise interest rates.
The US has been bankrupt once before – in 1971. It had reached bankruptcy by financing the long and painful Vietnam War (any analogies here?). But in order to avoid the collapse of the global economy at this point the world capitulated to the US decision to abandon the gold standard. The US dollar has not been backed by gold since 1971. It is simply a promissory note from the US government. All other currencies are measured against this global reserve currency.
As inflation begins to creep back into the global equation – rather ironically as a result of rising commodity prices driven by China’s all-consuming need for resources to make the products that it then exports to the world – the Fed is again looking at raising rates. The decision to do becomes far more onerous the larger the actual amount of debt involved. Were the US to cut rates to stimulate the economy and attempt to trade its way out of insolvency this would mean risking no longer attracting the lenders – foreign Treasury buyers – in the first place.
On March 28, 2006, the Asian Development Bank is reported to have issued a memo, advising members to be ready for a collapse of the US dollar. The US dollar has been falling steadily, although a recent pick up in economic data suggests the end is not yet quite nigh. But the reason the Asian Development Bank issued its warning is because the Fed stopped publishing the quantum of M3 – the aggregate of all US dollars circulating in the world.
If your car dealer asked you to outline your existing debts and you refused, would he lend you the money for the car? What have you got to hide? he would ask. The US dollar is merely a promissory note, an IOU. How many of them are out there? We don’t know anymore. But we do know that the Treasury’s printing presses do not sleep.
M.R. Venkatesh has an interesting twist on Weapons of Mass Destruction. Did Saddam ever have any? We may never know, but the devastation would have been similar if he’d managed, as intended, to switch the trading of Iraqi oil away from US dollars and into euros. “Never in the history of mankind,” says M.R., “has a national army protected the national currency so vigorously as the US Army has done in the past decade or so.” Apparently Venezuela and Iran have similar ideas.
Since the fall of the gold standard, the US has ensured that its currency is implicitly backed by crude. The US dollar is the global currency of oil exchange. To date OPEC has gone along with it. It’s not hard to see why the US has strategic interests in the Middle East. But despite US efforts, the oil price has soared. All commodity prices, again traded in US dollars whether in New York or London or Kirkusk, have also soared. This is not supportive of the US dollar. And consider that a barrel of oil that costs about US$10 to produce is trading for over US$60.
The world has found itself in a fight against inflation as a result of rising commodity prices. There has to date been commensurate deflation exported out of China along with the diminishing value of consumer goods. But labour costs in China will not get cheaper, so soon commodity price increases will be passed through to the world, if that isn’t the case already. Central banks across the globe have been raising rates, providing good reason for global diversification away from the US dollar as the most sensible interest bearing deposit.
The US has very little room to move.
The only thing stopping the US dollar from collapsing is indeed the fact that so much of the world’s reserves are invested in that very dollar. To allow its value to fall would be to cut one’s own throat. Says M.R.:
“While every central banker is conscious of this fact and thereby seeks to postpone the inevitable while nervously looking for his counterpart in any other country to break ranks and thereby trigger the collapse.”
However, the risks are building. Already many countries, enemies and allies of the US alike, are quietly reducing their risk against the US dollar by shifting into euros or other financial assets. There is no longer strident support for US bonds, and for the first time in a while US bond yields are creeping up, signalling perceived inflation. If there was a major shift toward trading oil in euros, the US dollar would surely collapse. In is unlikely that America’s allies would precipitate such a move, but what of its enemies?
There are only two possibilities from here on. Either the US dollar collapses or a controlled devaluation is allowed. A controlled devaluation means the revaluation of those currencies that are undervalued. Read: Asia. India has untethered its currency. When will China?
To relieve this doom and gloom scenario somewhat, consider that there are those who believe that the US current account deficit is not a problem at all. The lateral thinkers at GaveKal have dismissed current account fears as old economics, having no place in a globalised world. A lot of the manufactured goods coming out of China are manufactured under licence from US companies. China may take collect the revenues, but US companies keep the profit. If the US continues to make strong profits, as the last few years’ earnings reports would suggest, how can it be insolvent?
The argument will continue, but suffice to say, even GaveKal is getting a bit nervous about the increasing yield on US bonds.