Great Empire or Grand Illusion?

From the Bird’s Eye:

The US has the largest economy of any country in the world. The US gross domestic product (GDP) is about one third ($10 Trillion) of the global GDP ($31 Trillion). Over the last thirty plus years the US has been the ‘consumer of last resort’ for much of the world’s exports and the US Dollar the de facto world currency. Therefore, unlike any other country, whatever happens in the US economy has a significant impact on the rest of the world. Global capitalism, that is, the present economic and monetary system of this planet is “US centric.”

This US centric world economic model is in jeopardy because, contrary to glitzy appearances, the US economy may be heading for a train wreck.


The Underpinnings:

There are certain basic truths that are self-evident. For instance, it is self-evident that we cannot become prosperous (or remain prosperous for long) if we continuously spend more than we make. We must save and invest because no one can spend and consume their way to prosperity. This is a fundamental reality that applies to individuals, institutions and nations alike. It is possible to feign prosperity for a while by begging, borrowing or stealing from others, but that behavior is unsustainable in the long run. We all know that “rich” relative who lives high on the hog but owes money to everyone. A point ultimately comes when he has sold off all his inheritance and still goes borrowing money to maintain his opulent lifestyle. That is when his family and friends cut him off. Sadly, this is the situation that the United States is heading towards among the family of nations.

Yet amazingly, John Snow, U.S. Treasury secretary made the following comment to assembled finance ministers at the recent G7 conference:

"...the United States is not growing fast enough and neither are you, but we are growing a lot faster than you...We get complaints from our friends around the world who say, ’your current account deficit is so high.’ And our response is: ’Yeah. You know why? Because you don’t buy enough from us. And because we provide the highest risk- adjusted returns on capital in the world, so your capital flows over here. So why don’t you take steps to improve your domestic economy so you’ll be stronger and buy more from us? And you might think as well about steps to improve return on invested capital, and then capital would flow your way as well as to the United States. The fact is the American economy is strong. The underpinnings are good…"

After fretting over the Treasury Secretary’s words, we respectfully disagree.


Phantom Wealth:

The underpinnings of the U.S. economy are not as good as Mr. Snow would have us believe.

Bankruptcies, foreclosures and credit charge-offs are at their highest levels in recent memory.

(In 2002, bankruptcies were over 1.5 million, up 5.7% y/y, a new record. Estimates for 2003 are 1.65 million, up 8% from 2002 record high. Fitch’s card charge-off index rose to 18.61% of receivables, up 25% from 2001.)

Unemployment is steadily rising and shows no signs of abatement (Half a million jobs lost in 2003 YTD, 2 million since George W’s inauguration). Business profits, as a percentage of GDP, are at their lowest level in 40 years. Manufacturing has left the US and gone overseas. Hardly eleven million out of 134 million total wage earning Americans are at all involved with the manufacturing sector. This, in a total population of 280 million, is a very small number in spite of automation and robotics.

We would have asked the Secretary, if we could, whether it was possible for an economy to be ‘strong’ when people were going broke at a record rate...and businesses were not making any profits?

The US has already lost most of its manufacturing jobs and is now exporting its technology jobs as well. After being laid off the manufacturing sector workers did not become prosperous. Why should we believe that the laid off web designers, telephone operators, accountant executives, scientists, and other knowledge workers will fare any better after their jobs are farmed out to India, China and Philippines?


Bait and Switch:

We have searched for the causes of this economic malady and have realized things that sound strange yet are truth. The picture is as surreal as a Dali painting with melting clocks and all.

During the final two decades of the Bretton Woods / Gold Standard era (1949 to 1969) the combined reserves of all the world’s central banks grew by 55%. Then came the Brave New World of the Dollar Standard after March, 1971. That is when President Nixon refused to honor America’s commitment of accepting its paper dollars and redeeming them for gold. That promise was made to the whole world by the United States. It applied to countries, not to individuals. America seemed earnest about keeping its promise and the world believed. The international system of trade worked because the world trusted America’s word. That promise was made with the “full faith and credit of the United States.”

All that changed when those unfaithful French weasels called the bluff and had the gall to actually demanded gold for their paper dollars. The President of France, General Charles de Gaulle, refused to accept more paper printed by America in exchange for the balance that the US owed to his country. He wanted gold ingots of equivalent value. Nixon chose to break America’s sacred promise and refused to part with the gold.

(Individual Americans had already suffered from a similar breach of promise. Until 1933, the promise to redeem paper money for gold coins that used to be printed on older currency bills was still being honored, but FDR broke that promise to the American people.)

America had defaulted on its obligation but, amazingly, the world relented and everyone agreed to pretend that nothing bad had happened. The Gold Standard was quietly sent out the back door and the Dollar Standard was ushered in with pomp and pageantry. Now the dollar was to be “as good as gold.”

Dollars, of course, are much easier to produce than are gold ingots. So, in the next three decades those same central banks’ combined reserves have increased by 2000%.

Some people believe, call them old fashioned, that any bank credit which is issued in excess of total savings is basically inflationary because it expands the money supply by that much. But inflation had become the unwritten law of the whole world. Money everywhere could now be issued in any amount by government fiat. The politicians of the world loved that power and thanked Dick Nixon for his dishonorable deed.

The temptation was just too great. It wasn’t necessary to shed sweat and blood digging through deep mine shafts to produce new money. All it took now was a printing press, paper and ink. The forced monetary discipline that used to be imposed by gold had disappeared and an orgy of credit excess began the world over. In theory, the money supply was supposed to expand or shrink in tandem with economic growth, but since there were no enforcement mechanisms in place that could keep the governments honest, money was shamelessly printed in excess of economic growth by practically every country.

Dollars were produced by the Trillions and excess liquidity sloshed around in the international banking system. This excess credit led to many boom and bust cycles in economies around the globe. First it was the Japanese who could sell to America without any limit and Japan got saturated with surplus dollars. Then the Japanese stock market took off like a Roman candle followed by real estate and bonds. Redundant capacity was built everywhere because of misallocation of capital that was the direct result of easy access to unrestricted bank credit. The same happened in the “little tiger” countries of Asia which boomed and then busted. Lastly, it was America’s turn to boom. The stock market began to move in the late 1970s and by the late 1990s it had broken all norms of sanity in its over-reach to the ionosphere. More and more dollars chased stock prices all the way up Mount Everest and even beyond. Yet the government officials insisted that there was no inflation problem. They may just as well have said that black was white and night was day. Real estate and bond market boom followed and although the stock market has stepped back from extreme psychosis to severe neurosis, the astonishing insanity in real estate and bonds continues.

None of this could have happened without easy access to unrestricted credit facilitated by the central banks, foremost among whom is the US Federal Reserve.

America has enjoyed a unique advantage during this credit orgy of the last thirty years because the ultimate fountain of money was owned by the nation’s central bank. The US Fed could create dollars “out of thin air,” regardless of the economic base to back them up. Easy money is like heroin; it is highly addictive. And being the closest to the source of this potent intoxicant Americans indulged the most.

But all good things must come to an end. The US has been on a spending binge and has shunned domestic production. It is a matter of simple common sense that no person or nation can remain wealthy by consuming more than it produces.

America’s number one product and its biggest “export” has been the US Dollar (the second biggest export being jobs). Others produced televisions, vacuum cleaners, cars, crude oil, coffee, sugar – and practically everything else, while America printed dollars and exchanged them for the goods. The architects of this dollar based system have crafted a clear and happy division of labor in the world economy. Foreigners save money and America spends it; foreigners produce things and America consumes; foreigners lend and America borrows and thus it goes on and on forever, or so they think.

Once the greatest producer of capital goods, now America focuses only on services. Today, 80% of the country’s GDP is derived from “services.” Unfortunately, a “service economy” is untenable. You cannot create wealth just by running each other’s errands or doing each other’s laundry. Much of what passes off as “services” does nothing to add or enhance real value. Capital goods have to be produced by someone, somewhere.

All over the country’s harbors we see that the American ports have huge stacks of empty containers. They are loaded with goods when they arrive but many do not leave. America has little to sell abroad. Those containers stay stateside because the country’s biggest export, the US dollar, can now be sent anywhere electronically. Virtually mountains of surplus dollars have accumulated overseas. The foreign central bankers call them “reserves.” These reserves provide them the ‘backing’ to create even more credit in their local economies and print their own currencies and on it goes, round and round.

What else can the foreigners do with all those extra dollars? They can only be spent in America, so the foreigners “invest” them in US dollar denominated assets like Treasuries. It’s a neat arrangement. America takes the paper dollars back from these foreign investors and exchanges them for other pieces of paper. These other pieces of paper (called Bonds) are nothing more than written promises to the effect that after a certain number of years the US Treasury will pay the holder of that piece of paper even more paper dollars than he had returned to America in the first place. No real asset backs up these promises, they are only based on the “full faith and credit of the United States.”

Yeah right!! We know all about those promises. General de Gaulle told us.

Perversely, according to the dogma taught in business schools and economics departments, and put into practice by bankers and finance ministry bureaucrats around the world, these pieces of paper (a.k.a. US T-Bonds) are considered “assets.” These assets are, of course, the “liabilities” of the United States. The comedy doesn’t end here. The interest income of these assets is considered “risk-free return on investment.” However, we prefer to agree with those few visionaries who observe that at today’s miniscule yields, these bonds instead seem like “return-free risk to investment.”

The foreigners, particularly Asians, are caught in a monkey trap of their own that has worked wonderfully for America, until now. But the scales could tip the other way at some point.

In order to keep their own exports going they have become addicted to shipping their goods to America and are therefore willing to accept more Federal Reserve issued paper (a.k.a. ‘dollars’) in exchange. For three decades now they have been willing to trade their materials, their sweat equity, and their living standards in exchange for paper that America prints at essentially no cost. How long will they keep playing this game is anybody’s guess? Establishment professionals tell us that this gravy train will never leave the American station. They claim that the foreigners, chiefly Asians, cannot afford to lose the American market and therefore the dollar will never lose its lure. However, as the exporting countries’ dollar savings get cheaper and cheaper because of excessive printing by the US mint, at some point the pain of owning those ever-growing mountains of dollars, whose value is ever-shrinking, will become greater than the pain of losing their exports to America. When that happens, the party shall be over.


Going Broke Big Time:

Just before losing his job, towards the end of 2002, Paul O’Neil who was then Treasury Secretary received a report that he had ordered some time earlier. This report was prepared by the cooperative efforts of the Treasury Department, The Congressional Budget Office, The Office of Budget and Management, and the Federal Reserve. O’Neil had ordered his team, led by Jagadeesh Gokhale, Federal Reserve senior economist, and Professor Kent Smetters of Wharton Business School, then deputy assistant secretary for economic policy at the Treasury, to answer the following: (question paraphrased)

Suppose the government could, today, get its hands on all the revenue it can expect to collect in the future, but had to use it, today, to pay off all its future expenditure commitments, including debt service net of any asset income. Would the present value (the value today) of the future revenues cover the present value of the future expenditures?

In other words, can the US government’s future net income meet its future net obligations? And if not, how much is the shortfall in terms of today’s value of the dollar and how can it be covered?

The results clearly showed that the federal government of America is going broke. The answer to O’Neil’s question is a flat “NO, the government cannot meet its future obligations.” As usual, the United States government has made long term promises it cannot keep. The fiscal gap today is over $45 Trillion.

It is important to understand that the $45 Trillion is not the accumulative amount of yearly sums that will be short in the future. This is the present value of what would, in the future, turn out to be a much larger number due to the effects of inflation and amortization.

$45 Trillion today is a very huge sum by anyone’s count. It is more than four years of America’s current GDP and ten times the officially declared amount of federal government debt. The US fiscal shortfall is 35% greater than the GDP of the whole planet.

To visualize this amount in concrete terms, let us suppose that we take dollar bills and pile them up such that a hundred bills make a stack half an inch thick. Then forty five trillion dollars will make a stack so high that from the sea level it would rise to touch the surface of the moon and still there will be enough left over to wrap around the earth’s equator almost four times.

This situation is so ridiculous that continuing on the present course is a mathematical impossibility. Demographics dictate that fundamental structural reforms are a dire necessity, starting today.

The Baby Boom generation shall begin to retire and become entitled to Social Security benefits in five years. In eight years they will also start collecting Medicare benefits. By the time all 76 million Baby Boomers retire, the US retiree population will have doubled but the additional tax payers who carry the financial burden will have increased by a mere 15%.

Gokhale and Smetters concluded that in order to avoid insolvency either the benefits will have to be cut by 56%, or income taxes (personal and corporate) increased by 66%, or payroll taxes must go up by 95%. These changes need to begin effective immediately. If we wait until 2008, then the income taxes will need to be raised by 73% to balance out this shortfall which, at the time, will have risen to $54 Trillion (present value).

The findings of this report were to be included in the US Budget document for fiscal year 2004. However, they did not make the final cut and the outspoken O’Neil was sent home. Somebody high up, obviously, did not want these facts advertised out loud during a presidential election year. This clearly demonstrates that the political mafia in Washington has no interest in addressing real economic issues and they are far more interested in the next election than they are in the next generation.

The US is not alone in this dilemma. Similar Social Security crisis are also staring Western Europe and Japan in the eye. The big difference is that Eurozone and Japan are net creditors, the US is a net debtor.

In the US as a whole, 19% of the population will be above 65 by 2023 (i.e., the percentage of seniors in Florida today). For France and the UK, that date is: 2016. Japan reaches 19% in 2005. Italy is already there. The whole developed world is vulnerable to this fast approaching senior citizens’ tsunami.


Arrival and Departure:

After the Second World War America was, by far, the world leader in industrial production, investment capital, energy production and exports. The GDP was more than 40% of the entire world’s GDP. America had the financial power to dwarf anyone else’s in the rest of the world. Everyone was in awe of the United States of America. In less than two hundred years this young nation had become the greatest of Great Powers. America had finally arrived.

By contrast, today the economic reality is changing very fast even if perceptions around the world remain the same.

The military might of the US is still supreme, but it is fast becoming a giant with feet of clay. For America to take on the role of the world’s policeman is about as absurd as imagining a near bankrupt corporation taking over a whole industry.

Princeton economist Paul Krugman says in the New York Times that it is critical for America’s economic stability that “investors remain in denial, unable to believe that the world’s only superpower is turning into a banana republic.”

Like other Great Powers in history the US has finally over-reached itself and has become the victim of it’s own success. In Paul Kennedy’s words, the US is going through the phase of “imperial overstretch,” the final stage in the life cycle of a Great Power, where it’s economic resources cannot keep pace with it’s political ambitions and military adventurism.

America’s great might ultimately depends on its paper. The dollar has been America’s sword and armor and it could also turn out to be its Achilles’ heel.

The world may not think so yet, but America may be getting ready to depart.


Borrow and Consume:

Today the US economy is beholden to the rest of the world and the country can only maintain it’s living standards through the kindness of strangers. What we mean by the “kindness of strangers” is that the US economy is utterly dependent on foreign capital (over $500 Billion a year) for its stability, while the US government owes additional vast sums of money it has borrowed. From being the world’s largest creditor, United States has become the world’s largest debtor and that debt is growing geometrically (80% of the world’s current account deficit in 2002 belongs to the US).

We often hear the retort that the US debt burden is not so bad when considered as a percentage of its GDP. Japan, we are told, has a debt burden that is even larger than that of the US as a percentage of GDP, therefore, anyone who sounds an alarm at the explosive growth of the US debt bomb is a mad Cassandra.

But the US is not Japan. Almost all of the Japanese debt is internal, meaning that Japan only owes money to the Japanese. The US debt, by contrast, has a huge foreign component (40% of government debt, 23% of corporate bonds, 20% of mortgage debt). This foreign component is growing faster, as a proportion of the total debt, than the domestic share. Not only that, Japan is also the world’s biggest net creditor nation, which means that (regardless of its domestic budget debt) the rest of the world owes more to Japan than is owed to any other country. The US is the world’s biggest debtor by far.

Additionally, Japan had the world’s biggest hoard of domestic savings when the Japanese markets crashed in December, 1989. Even today Japan’s total private savings in individual hands in over $10 Trillion. In the US, by comparison, the domestic savings were near the lowest point in history when the bubble started deflating in March, 2000. The average Japanese had been saving up for a rainy day, while the average American was going deeper in debt.

The consequences of this debt bubble for America are far more serious than anything the Japanese face.


Print and Spend:

It is said that the ultimate outcome of having a so-called ‘social democracy’ is the destruction of the currency.

Leaving the foreign debt aside for a moment, let’s look at the untenable domestic obligations of the US retirees mentioned earlier. (The same may apply to some other ‘developed’ countries but not on this scale.)

Drastically raising taxes or cutting entitlements is politically suicidal so no politician will do either. The only action to bridge the $45 Trillion fiscal gap that we can imagine which the politicians would take is the one that is the most dishonest, sneaky and underhanded. They will simply print even more dollars with total abandon and further debase the currency.

By tinkering with the math of the COLA (cost of living adjustment) of beneficiaries to a slower adjusting “diet-COLA” the Social Security and Medicare pay-outs could be manipulated to lag further and further behind the wage inflation. Thus more and more nominal tax dollars will become available to meet the nominal benefits. The recipients of the benefits would see a corresponding erosion of their purchasing power but the politicians could still tell them, with a straight face, that their “benefits have not been cut.” It is thus necessary for those in power to print infinitely more dollars and inflate their way out of their fiscal obligations.

It should be realized that with respect to its debt obligations, America has an ace-in-the-hole that it can pull out to the chagrin of all its creditors, foreign and domestic. Because of its unique position all of America’s debt is denominated in its own currency even if much of it is owed to foreigners.

All the recent talk about deflation may only turn out to be a smoke screen to justify printing more money.
As the world’s biggest debtor it would be impossible to resist the temptation of printing money to pay off the creditors. Sadly for the creditors, the dollars they get back will be worth a lot less than the ones they had loaned out. But there is no free lunch. In order to meet debt obligations this way the US, like Germany facing war reparations after Versailles, has to destroy its own currency.

The exporting countries, in an attempt to stay affordable and preserve their market shares, could also follow the US and begin a race of “competitive devaluation” of their respective currencies. The world could drown in an ocean of paper. The dollar’s status as the world’s reserve currency would surely become history and all of us could find ourselves in a Global Weimar Republic. Only, unlike the Republic of the 1920s, there would be no safe haven to escape to in Switzerland next door.


The Day of Reckoning:

The present set up in the US is such that it penalizes saving and investing for the future while it rewards spending and frivolous consumption. This thrust towards forced consumption is exemplified by a recent Fed policy paper titled: Monetary Policy in a Zero-Interest Rate Economy, in which the authors, vice president Evan Koenig (Dallas Fed) and senior economist Jim Dolmas, have proposed a “carry tax” on currency deposits on all savings accounts.

The constant banter we hear from everywhere basically says, spend, spend and spend, then borrow and spend some more. The tax structure encourages borrowing instead of saving and rewards expenses instead of income. Those who may have the power to initiate change are instead committed to preserve the status quo and their personal interests with it. Federal Reserve governors and highest ranking government officials have the temerity to stand up in public and say that it is a “patriotic duty” to go out and spend more.

This voracious consumerism is touted by the peddlers and soothsayers as a strength of the US economic model and the “good underpinning” that Secretary Snow talks about. We laugh at these claims and compare this pure consumption model to the Perpetual Motion Machine. It is simply unsustainable. Something has to give.

Americans have become the spoilt children of modern history and have lived in prosperous isolation from the world. But for the last half a century they have been dwelling on the fertile slopes of a sleepy volcano that is beginning to yawn and wake up. The Day of Reckoning is bound to arrive sooner or later.

Yours truly,

…SR

(Sohail Rabbani, –June 2003)