Brad Setser at the Council for Foreign Relations has deemed the crisis the biggest since the depression. Here’s why that statement could possibly be true.
For one, the US has finally admitted it is engaging in the process of ‘quantitative easing’. Any notion this path was one freely opted upon by the US, however, should be quickly dismissed. It’s clear there was never any other choice. Writing in 2006, Richard Duncan, author of the Dollar Crisis, predicted it wouldn’t take policy makers long before they figured this out. The chronic US current account deficits are what created the problem in the first place, he says, by destabilising the global economy. As a result, it is essential for total debt to GDP to be maintained or else the system will implode. If the ratio of total debt to GDP actually fell, the economic slump facing the world would make all post- World War II recessions look mild in comparison he says. In September 2007 he wrote:
To prevent that from happening as private sector credit contracts, the US government is going to be forced to increase its level of debt very sharply.
The US government is going to have to spend hundreds of billions (and perhaps trillions) of dollars to prevent a global recession. The money will be spent. Unfortunately, there really is no alternative. The only question is will it be spent wisely or foolishly.
More to the point, it will be imperative for the US to successfully sell its Treasuries to avoid disaster.
This takes us back to Milton Friedman. He was the one who most significantly argued a US deficit was sustainable. Currency would always come back to the country of origin in some form or another, he said. If not, the joke was on the country which had exchanged perfectly useful goods for cheaply-made paper, the same effect as burning the dollars it had earned. This is largely why net financial inflows have systematically matched the US current account deficit over the years (Note Duncan chart below).
Yet, as Setser points out, demand for corporate and agency paper has dived, meaning Treasuries are increasingly the sole attraction for foreign dollars. This, he says, is a symptomatic of a currency crisis, a big danger if the US is to continue to be able to issue debt (see chart below). He writes:
A country cannot finance a trade and current account deficit without financing, and two big sources of financing for the US deficit — foreign purchases of Agencies and foreign purchases of US corporate bonds — have disappeared.
So could Friedman’s theory be up for testing? Certainly, neither a sharp devaluation of the dollar or the increased cost of protecting against a US default is attractive to the dollar-surplus nations. The question is what other choice do they have?
One theory is the redirection of dollars on a mass scale into the financing of emerging market economies. Both EM corporate and sovereign dollar-denominated debt issuance will increasingly be able to compete with the issuance of the US and UK treasures. While it might not absorb all the surpluses, it would certainly be enough to knock the balance.
In that scenario, what could the US do? One theory doing the rounds in Japan is US foreign-currency denominated debt issuance of its own. According to the Asia Times this would incentivise flows by protecting against possible dollar devaluation. Plus, the practice is not new. It was done before by the Carter administration in the 1970s. Known as “Carter bonds”, the debt was denominated in German marks and Swiss francs to attract foreign investors.
Faced with the unprecedented growth of the US budget deficit and the prospect of an increasingly weaker dollar compared with the yen reducing the value of Treasury debt held by Japan, economists in Tokyo are calling for the administration of president-elect Barack Obama to issue US Treasuries denominated in yen and other currencies. The issuance of foreign currency-denominated US Treasures would reduce the perceived risk of holding the debt.
Behold the dawn of the ‘Obama bond’.
Related links:
The doomed dollar - FT Alphaville
Fed capitulates redux: quantitative easing in the USA - FT Alphaville
The Great Currency of China - FT Alphaville
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