Wednesday, November 10, 2004
letting it slide
start with some background: the united states has been building, over the course of a couple decades, an increasingly profligate culture of debt-based consumerism. government debt has gone off the charts, but less understood among americans is how they have changed personally.
personal savings rates have declined from a 1984 high of 12% (as a share of nominal domestic product) to 3% at the end of 2000 to under 1% in 2004 -- the lowest level since 1933, in the depths of the great depression. it's a problem that has been taken only seriously enough to serve as a cassus bellum for other ideological aims, such as tax reform.
why is it a problem? such small savings mean that america, to float debt -- as it is all too dependent upon doing -- is extremely dependent of foreign capital. buyers of newly-minted treasury bonds and mortgage-backed securities are now largely asian central banks, fighting to keep their currencies cheap relative to the dollar, which helps them export goods to the united states. the measure of this activity -- gross investment less domestic savings -- is the american current-account deficit, also known as the trade deficit.
if that activity slows -- i.e., foreigners decide to invest less of their income in the united states -- the demand for dollars lessens. and the value of the dollar against other currencies then declines.
this helps close the trade deficit -- it makes american exports cheaper, foreign imports more expensive and reduces the relative value of foreign investment holdings (as measured in their home currencies) and thus incentive to invest.
but it has myriad effects that cannot always be foreseen. one of those that can be foreseen -- that is, making it more difficult for america to sell its debt to foreigners, thereby forcing increases in interest rates to make the dollar more attractive -- could squelch economic growth and start recessions. another would be that current holders of american debt might begin to sell, driving up interest rates outside of the control of the treasury.
it should be said that this process is normal, occurring all the time in floating currency markets to balance economies. what is more unsettling is when large imbalances, for whatever reason, build up over time to extremes -- for that is when sudden, unexpected shocks in the direction of rebalancing are most likely to occur.
for example, should a large holder of treasuries or FNMA bonds decide to liquidate some of its holdings in a normal environment, buyers can be found to fill their sell orders. in an imbalanced scenario, however, where everyone who wants any part of such debt already holds it because there's been so much of it around for so long, buyers can be hard to come by -- and, if prices drop precipitously to induce buyers in, a panic can swiftly take hold. this would quickly devalue the dollar and dramatically raise interest rates, with consequences in housing, financial and economic markets that are impossible to foretell but certainly awful for many.
the federal reserve bank has contributed to building our current intimidating imbalance recently by keeping target interest rates very low and printing dollars. this financial engineering (for whatever good it has done to ameliorate recession or avoid deflation) artificially reduces, it is thought, the incentive to save among americans. that, of course, increases american dependency on foreign capital -- generating an imbalance.
it should also be noted that china is one of the largest holders of american debt, and has a currency that does not float against the dollar. this has insulated china's banks -- holders of american bonds as assets on their balance sheets -- from the devaluing of those assets via the dollar's decline. china has been booming in recent years, and many chinese banks have overextended themselves with loans. any fiat devaluation could make many chinese banks de facto insolvent.
china even now is putting the brakes on its economy by raising interest rates, attempting to engineer a slowing that will allow its banks to gently reduce their loans and build safer reserves of capital without sparking a recession or worse. a yuan revaluation is another possible instrument of such an engineered slowdown. but, if it doesn't go according to plan -- and often, government engineerings of economies don't -- disaster could be in the offing.
as today's journal article notes, however, the bush administration -- seeking to reduce the trade deficit imbalance and to please european and japanese debt holders, who also hold great amounts of american debt, and please domestic exporters at home with more favorable terms of trade -- is pressuring china to devalue or even float the yuan, the currency of china.
Indeed, government and Federal Reserve officials and many private economists believe the economic fundamentals point to a lower dollar. But Washington doesn't want to encourage the decline or say anything that might undermine confidence in the dollar and risk a disruptive avalanche of dollar-selling.the potential ramifications of floating the yuan are so complex as to be unpredictable -- but, in a situation with such massive imbalances, they could easily be drastic and possibly catastrophic for the united states and, therefore, the global economy.
The result has been a delicate minuet, in which administration officials speak gingerly if at all about the dollar and instead devote their energy toward another, related issue: China's currency, the yuan. China pegs the yuan to the dollar and the U.S. wants China to let it float, which would almost certainly cause it to rise against the dollar. Without yuan appreciation, U.S. officials fear that currencies in Europe and Japan would bear the brunt of the dollar's depreciation, hurting their exports and restraining their already-weak economies.
the course the united states is currently on -- ever greater deficits and ever more foreign borrowing to finance them -- is unsustainable. the correction in path that must come -- if it isn't dealt with immediately, and possibly even if it is -- may result in the sudden shifts of equilibrium that can spark the kind of fiscal disaster that no living american remembers. many large financial markets, particularly the derivatives markets, are (unbeknownst to most) relatively recent inventions, enabling incredible off-balance-sheet leveraging by qualified borrowers without any significant oversight. counterparty risk in these markets is an unknown, but almost certainly links the global financial system in incredibly complex ways.
so the hard truth is that the imbalances built up in the american current-account deficits, in conjunction with the massive debt/leverage taken on by both public and private interests in the united states, have set the table for a global financial disaster of, frankly, unprecedented proportions. even a slight misstep on the part of the united states or china or japan could end in terrible tears all around. politicians in all directions are unified in their unwillingness to deal with the profound problems involved -- in the united states particularly, there is an amazing state of denial and deceit -- allowing the imbalances to continue to build.
i'm afraid that this scenario has few pleasant endings, and they diminish in probability every day.