ES -- DX/CL -- isee -- cboe put/call -- specialist/public short ratio -- trinq -- trin -- aaii bull ratio -- abx -- cmbx -- cdx -- vxo p&f -- SPX volatility curve -- VIX:VXO skew -- commodity screen -- cot -- conference board

Monday, August 18, 2008


the end of empire?

the new york times lionized nouriel roubini over the weekend.

What economic developments does Roubini see on the horizon? And what does he think we should do about them? The first step, he told me in a recent conversation, is to acknowledge the extent of the problem. “We are in a recession, and denying it is nonsense,” he said. When Jim Nussle, the White House budget director, announced last month that the nation had “avoided a recession,” Roubini was incredulous. For months, he has been predicting that the United States will suffer through an 18-month recession that will eventually rank as the “worst since the Great Depression.” Though he is confident that the economy will enter a technical recovery toward the end of next year, he says that job losses, corporate bankruptcies and other drags on growth will continue to take a toll for years.

Roubini has counseled various policy makers, including Federal Reserve governors and senior Treasury Department officials, to mount an aggressive response to the crisis. He applauded when the Federal Reserve cut interest rates to 2 percent from 5.25 percent beginning last summer. He also supported the Fed’s willingness to engineer a takeover of Bear Stearns. Roubini argues that the Fed’s actions averted catastrophe, though he says he believes that future bailouts should focus on mortgage owners, not investors. Accordingly, he sees the choice facing the United States as stark but simple: either the government backs up a trillion-plus dollars’ worth of high-risk mortgages (in exchange for the lenders’ agreement to reduce monthly mortgage payments), or the banks and other institutions holding those mortgages — or the complex securities derived from them — go under. “You either nationalize the banks or you nationalize the mortgages,” he said. “Otherwise, they’re all toast.”

For months Roubini has been arguing that the true cost of the housing crisis will not be a mere $300 billion — the amount allowed for by the housing legislation sponsored by Representative Barney Frank and Senator Christopher Dodd — but something between a trillion and a trillion and a half dollars. But most important, in Roubini’s opinion, is to realize that the problem is deeper than the housing crisis. “Reckless people have deluded themselves that this was a subprime crisis,” he told me. “But we have problems with credit-card debt, student-loan debt, auto loans, commercial real estate loans, home-equity loans, corporate debt and loans that financed leveraged buyouts.” All of these forms of debt, he argues, suffer from some or all of the same traits that first surfaced in the housing market: shoddy underwriting, securitization, negligence on the part of the credit-rating agencies and lax government oversight. “We have a subprime financial system,” he said, “not a subprime mortgage market.”

Roubini argues that most of the losses from this bad debt have yet to be written off, and the toll from bad commercial real estate loans alone may help send hundreds of local banks into the arms of the Federal Deposit Insurance Corporation. “A good third of the regional banks won’t make it,” he predicted. In turn, these bailouts will add hundreds of billions of dollars to an already gargantuan federal debt, and someone, somewhere, is going to have to finance that debt, along with all the other debt accumulated by consumers and corporations. “Our biggest financiers are China, Russia and the gulf states,” Roubini noted. “These are rivals, not allies.

The United States, Roubini went on, will likely muddle through the crisis but will emerge from it a different nation, with a different place in the world. “Once you run current-account deficits, you depend on the kindness of strangers,” he said, pausing to let out a resigned sigh. “This might be the beginning of the end of the American empire.

roubini expounded at length in his blog.

... [S]ince 2001 the further worsening of the US current account deficit was driven instead by growing fiscal deficits - especially in the 2001-2004 period – caused by unsustainable tax cuts and by the buildup of spending on foreign wars and on domestic security and since 2002 by the collapse of household savings and boom in investment in unproductive stock of housing capital that the housing bubble induced. And while the weak dollar is now inducing a modest improvement of the external deficit the looming sharp increase in fiscal deficits - that the current recession and financial crisis is inducing - will cause a return of twin deficits in the coming years. By now the US is the biggest net borrower in the world – running current account deficits still in the 700 billion dollars range – and the biggest net debtor in the world with its foreign liabilities now over 2.5 trillion dollars.

The trouble with these twin deficits is multi-fold. First, superpowers and empires - like the British Empire at its peak - tend to be net lenders – i.e run current account surpluses – and be net creditors, not net debtors; The decline of the British Empire started in World War II when the British fiscal deficits in the war and the current account deficits turned that empire into a net borrower and a net debtor both in its public debt and external debt. That financial switch into an external debtor and borrower position was also the reason for the decline of the British pound as the leading reserve currency. And the British twin deficits were being financed by a rising economic and financial power that was a net lender and a net creditor, the US.

Second, the last time the US was running large twin deficits in the 1980s the main financiers of these deficits were the friends and allies of the US, i.e Japan, Germany and Europe as the US external deficit was against these economies. Today instead the economic powers financing the US twin deficits are the strategic rivals of the US – China and Russia – and unstable petro-states, i.e Saudi Arabia, the Gulf States and other shaky petro-states. This system of vendor financing – with these US creditors providing both the goods being imported and the financing of such deficits – has led to a balance of financial terror: if these creditors were to pull the plug on the financing of the US twin deficits the dollar would collapse and US interest rates would go through the roof.

few americans understand that empire, often undertaken with beneficial economic premises in mind, is an intensely expensive activity for any organization.

the rise of the united states from expanding emerging market circa 1870 to global power circa 1918 to superpower in 1945 was fueled by real economic growth -- a blessed combination of inexpensive territorial expansion, massive population growth and rampant industrialization underpinned that line of development -- in conjunction with the near-complete lack of a standing armed forces or need of the other standard expenses of imperial maintenance. but 1945 brought empire -- specifically the inheritance of the rump of the british commercial empire -- and with it a permanent and voracious military-industrial complex. the diversion thereafter of a significant share of national income to the unproductive constructs of the imperial security state we euphemized as 'the cold war' eroded the dynamism of the america economy, which has since the late 1940s gradually fallen back to the field as a share of global production. as economic output refused to keep pace with the growth of the imperial siphon, a spiral of degradation set in, the symptoms of which were visible by the late 1970s -- a devalued currency, chronic indebtedness, economic stagnation.

the solution, so called, arrived in 1981 with the election of the reagan administration -- which did nothing so well as to begin the deregulation of finance private and public and spark the birth of the financial services industry. against an inflationary background which penalized domestic savings, social mood changed and the concept of american indebtedness caught fire. debt as a percentage of GDP began its harrowing ascent, the result being a somewhat illusory prosperity as current consumers, corporations and governments began to borrow eagerly against future income with ever greater ease. the emergent facilitators of that borrowing -- stepping into the role that the united states itself had played for the desiccating european empires of the 19th and early 20th centuries -- were east asian industrial powers, first japan and europe, thereafter 1997 china, russia, korea and a host of others, as well as petrostates both inside and outside the mideast.

roubini is here countenancing the end of this dynamic of vendor finance that has nourished and indeed made possible american empire, hubris and contentedness for nearly three decades.

roubini validly cites the decline of the british empire -- one that had been underway since the bleeding of 1914 -- but i would forward another for further context. the soviet union, which had been experiencing a perhaps even more rapid decline in its share of world production in the aftermath of the second world war, finally found itself unable to reconcile a massive growth in its imperial military/security spending with the halving of global oil prices in the 1980s. the soviets were compelled to move away from autarky and became progressively more reliant on western financing as their energy export revenues declined without concomitant declines in spending -- even as they financed a bloody and corrupting long war in central asia. indeed american engineering of a global oil glut with the obedience of its saudi client state sought to manufacture this outcome and achieved it. the rate of increase of soviet foreign indebtedness rapidly grew on the accession of mikhail gorbachev in 1985, as he borrowed from the west to finance his attempts to improve the society's manufactured goods export competitiveness, hoping to pay back the debt by returning the soviet union to a trade surplus. this never happened, as western banks cut moscow off as its debt-to-GDP ratio rose to uncomfortable levels with the soviet government budget deficit running at about 15%, effectively precipitating the abandonment of imperial possessions beginning in 1989. phyllis schlafley was irate about it then, as was the wall street journal -- i wonder if they eventually understood what a critical lever western banks proved to be in destroying the soviet union.

the result, even ten years after the collapse of the soviet union, was a humiliated post-soviet russia reduced to barter and unrestricted asset sales for hard currency, following the default on soviet-era rouble debt that famously precipitated the august 1998 long-term capital management crisis on wall street -- saddled with such metrics as 80% total external debt to GDP, 200% total external debt to exports, and 550% total external debt to revenues.

thinking about the collapse gap gives me the shakes. however, while the worst outcome is certainly on the spectrum of the possible, does anyone really expect the united states to follow the soviet union's comprehensive dissolution?

yet, in spite of the seemingly ludicrous comparison, while the economic cases may be quantitatively different it must be said that they are qualitatively of a kind. joseph stiglitz can call the american economy "war-torn" with credibility. the united states being crippled by high-price energy imports is the inverse analog to the soviets being crippled by low-price energy exports. as a result, the pace of foreign borrowing has accelerated monstrously, per stiglitz:

Moreover, this war has been funded differently from any other war in America’s history... Normally, countries ask for shared sacrifice... Taxes are raised. ... When America went to war, there was a deficit. Yet remarkably, Bush asked for, and got, a reckless tax cut for the rich. That means that every dollar of war spending has in effect been borrowed.

For the first time since the Revolutionary War, ... America has had to turn to foreigners for financing, because US households have been saving nothing. The numbers are hard to believe. The national debt has increased 50% in eight years, with almost $1-trillion of this increase due to the war — an amount likely to more than double within 10 years. Who would have believed that one administration could do so much damage so quickly?

as a result of that damage, the united states indeed may be facing a foreign financing crisis of great importance in the near future. that possibility seemed some several steps closer today as foreign buyers of fannie mae and freddie mac securitized debt appeared to be not only backing away from further purchases but selling.

it is also quite important, i think, to note that no one envisioned the collapse of the soviet union even in 1988. western bankers prattled about the USSR's excellent payment history, never envisioning sovereign default as they made tens of billions in non-recourse loans. correspondingly, that few would publicly expound on the possibility of an imperial collapse for the united states is little comfort. the fact of the matter is that -- while roubini and others think it unlikely -- china has more to gain than to lose by increasing the pace of withdrawal from the vendor finance scheme and accelerating the depegging of the yuan. on the strength of external research i've read, this is a process that -- if central bank policy in the united states remains rampantly easy in light of the insolvency of the banking system, thereby transmitting inflation into china through the exchange rate support -- could be compressed into as little as 36 months as chinese government seeks to rein in the expansion of money supply. in that case, the collapse of both american economy and empire could be shockingly sudden.

Labels: , , , , ,

"...a balance of financial terror: if these creditors were to pull the plug on the financing of the US twin deficits the dollar would collapse ...."

If the dollare collapses, China et al. take a huge hit on their dollare holding. Sounds a little like mutual assured destruction. Maybe, like nuclear war, it won't happen.

------ ------- ------
it has to end simply because it isn't sustainable, ae. but i do agree there's reason to hope that the transition could be gradual.

that would be rare, however, in the historical record compared to crisis transitions.

moreover, china has much to gain from letting the yuan go to free-float.

this would have the great intermediate-term benefit of moderating chinese inflation and cutting speculative inflows to the country, even though the transition could be disruptive. it is also the long term policy goal of the chinese government as they move to a free floating currency from a dollar peg, which will likely allow the yuan to become the de facto reserve currency of the far east (with all the implied benefits). as demonstrated by private research i've had the pleasure of reading, many highlight the potential cost to china -- particularly forex losses on its massive dollar-debt holdings -- but ignore the manifold benefits. a stronger yuan would reduce the cost of oil for china in local terms, and this benefit alone given the rate of oil consumption in china would all but offset all the forex losses. its export sector would be hampered on the lowest end, but china is already in the process of moving its manufacturing capacity up the scale of finished goods into more complicated products (such as cars and semiconductors) where there are simply no viable competitors in the world on quantity and price. the net cost to china of revaluation is widely overestimated in the united states -- largely out of wishful thinking, i suspect.

the end of boom-tail commodity inflation and the onset of deflation has put china in a similar position to what the united states found itself in 1930. inflation control won't be a problem there again soon, so the pressure is off there.

but the intermediate term realization should be, i think, that the american current account deficit will close as china transitions away from vendor finance.

------ ------- ------

Post a Comment

Hide comments

This page is powered by Blogger. Isn't yours?