Tavakoli Structured Finance LLC

Clear and Present Danger

October 31, 2011 (Revised November 17, 2013)

Foreign Borrowing Poses An Imminent Threat to the U.S. Dollar and the U.S. Financial System.

The United States is the largest debtor nation in the history of the world, and our borrowing is increasing. In 1950 spending for social programs was only six percent of the total Federal Budget, and pensions were 4% of the budget. As the economy grew, social programs expanded to include Social Security, Medicare, Medicaid, Food Stamps, Unemployment Compensation, Supplemental Security for the Disabled, and education programs.

In 1983 as the United States pulled out of an ugly recession and brought inflation under control, social programs consumed an estimated 26% of the budget, and pensions were over 23% of the budget. In fiscal year 2010, health and welfare ate up 38% of the budget, and pensions another 22%. (This paragraph was revised on November 17, 2013. Source of the numbers for 1950 and 2010 is www.usgovernmentspending.com and 1983 estimate is TSF.)

Spending Increases Outstripped Economic Growth

The original idea was that if everyone agreed to chip in a small percentage of ever growing income, the percentage of social spending would never have to change even if the programs grew.  The percentage for social programs could stay constant because if income doubled every twelve years or so, the amounts available for welfare would also double.  Military budgets soared, the U.S. waged unfunded wars, the banking system was bailed out of the consequences of unwise lending more than once, and government bureaucracy grew rapaciously.  All of this would likewise be covered by taxes assessed on growing income, or so the theory went.  Like many academic economic theories, it was a convenient but misguided story.  No country has ever managed to create a perpetual growth machine for its economy.

Time and again U.S. growth was brought to a standstill by (among other things) oil shocks of the kind the U.S. experienced in 1973 and 1979, monetary shocks of the kind the U.S. experienced in 1981, and systemic financial crises of the kind the U.S. experienced in 2008 and will likely experience again in the not too distant future.

Offshore Manufacturing

Growth in the U.S. has been hobbled by moving many of our smokestack industries and soft manufacturing industries offshore.  Traditionally weakening the dollar relative to stronger currencies like the Chinese yuan (the renminbi) stimulated growth as relative labor costs sank in the U.S.  Today, much of the benefit of this strategy leaks to offshore manufacturing facilities.

Higher Taxes Reach Point of Diminishing Stimulus Returns

Periods of anemic growth meant the U.S. had to raise taxes, but there is a limit to how much the economic engine and the population will tolerate.  Hiking tax rates invites inflation, and artificially low interest rates are a hidden tax that punishes savers while food, energy, and medical care costs have soared.   The U.S. can impose consumption taxes on liquor and other discretionary items, impose higher taxes on the rich, and possibly impose a confiscatory wealth tax, but eventually the U.S. will reach a point where this will be counterproductive.

U.S. debt now approaches 100% of GDP.  In the long run the U.S. will have to cut social programs and increase taxes, but in the short run the U.S. cannot adjust quickly enough.  If the U.S. has to pay its debts and it can’t tax more, then it must borrow more.  In fact, we are borrowing more, and how we borrow matters.

Increasing Debt to GDP and Foreign Borrowing

High rates of debt to GDP are the chief danger to any country’s economic future, and any method of borrowing holds its special brand of danger.  There are only three ways to fund a government deficit: foreign borrowing, domestic borrowing with monetary expansion, and domestic borrowing without monetary expansion.  The U.S. has chosen a combination of the first two.  Of the three, the way to get into big trouble very fast is to become dependent upon foreign borrowing.  Treasury note and T-bill issuance as of second quarter 2011 was around $14.4 trillion, and the total bond market size estimate by SIFMA (less intergovernmental debt held by the Federal Reserve and Social Security Trust) was around $9.2 trillion.  Total foreign holdings of $4.5 trillion represented around 31% of total Treasury issuance or around 48% of SIFMA’s estimated government bond market.  China’s and Japan’s combined holdings represent around 14% of total issuance or around 22% of SIFMA’s estimated traded government bond market.  As of June 2011, Japan held $911 billion or around 20% of U.S. foreign U.S. Treasury holdings, and China held around $1.16 trillion or approximately 26% of foreign U.S. Treasury holdings.

Foreign Borrowers Can Cause a Run on the Dollar

Why are foreign borrowings such a huge risk for the United States?  The funds are currently kept in dollars a lot of which is with American banks.  That money is yankable and that can cause a run on the dollar.  Military leadership addresses the threat of attacks, and administrative leadership must address the clear and present danger of financial withdrawals.  The dollar is still the world’s reserve currency, but that advantage doesn’t make the dollar bullet proof.  U.S. dollars can be converted to yen or to euros.  On October 17, China took a key step to internationalizing the yuan and making it an alternative to petrodollars if not an alternative reserve currency; Hong Kong’s Chinese Gold & Silver Exchange Society now offers gold quoted in yuan.

Debt: Transfer Payments, Subsidies and Fed Monetization v. Investment

This might have been worth the risk if foreign borrowing had been invested for roads, high speed railroads, new industries, cheap energy, airports, and to fund scientific research.  The debt would self-liquidate.  Instead, some of the debt has been used for transfer payments to fuel current consumption or for items like farm subsidies.  It’s as if you mortgaged your house to buy groceries.  Eventually you’ll have no house and no food either.  Moreover, a very large chunk of the debt has been monetized through Federal Reserve Bank purchases and used to fill gaping holes in bank balance sheets.  Unrepentant banks resist reform and dilute attempts at regulation while soaking up ongoing subsidies.  All of this is dead-end financing at the expense of citizens that saved their money and pay taxes.

Greece’s distress is an extreme example of what happens when debt service is high but investment in the economy is insufficient.  According the Wall Street Journal, “Parliament member Panagiotis Kouroumplis…supported the first bailout, but, he says, ‘every single euro we got went for debt. We haven’t spent a single euro on development.’” The U.S. has a bigger and broader economy, but our bailouts—and the financial malfeasance that preceded and follow them—have nonetheless given our producing economy a body blow while chiefly benefiting fee-seeking dead-end financiers that eat up an outsized percentage of the nation’s GDP.

In 1978, we averted a near-crash of our financial system after Kuwait refused to renew a more than $1 billion deposit with J.P. Morgan (then Morgan Guaranty).  The Federal Reserve intervened to stabilize the dollar and averted a “19th Century financial panic” that would have triggered a “genuine depression.”1 In 1979 as tensions escalated with Iran, the U.S. sequestered Iranian assets to prevent a repeat of the near-crash in 1978.  In the first years after these events, the U.S. seemed to have learned its lesson and reduced foreign borrowings—including borrowings from the Saudi’s and Kuwait—to around 7% of total borrowings.  Decades of bad policies, unfunded wars, and uncontrolled chaos in the financial system ballooned our debts and our foreign borrowings.  Today’s foreign borrowings are 31% of total issuance or 48% of the estimated government bond market.  The U.S. is in hock to foreigners again, particularly to Asia.

How does the U.S. try to counter the danger represented by foreign borrowings?  After exporting our profligate spending to China with no intention of reform, we wield the implied threat that if China doesn’t continue to lend to us, it will go down with us.  The Chinese may not see it that way as they feel the pinch of inflation, experience inevitable cyclical growth slowdowns, and develop new trading partners.

Emergency Measure: Sequester Foreign Funds, If Possible

Foreign borrowings of the United States represent a clear and present danger to the U.S. dollar and to the U.S. financial system.  Potential dumping of U.S. dollars would start a run on the currency and a financial panic that would tip our already precarious economy into a deep depression.  No matter how much currency central banks use to try to manipulate exchange rates, the market always has more.  The U.S. needs contingency plans against a large scale withdrawal of funds from the U.S. and from U.S. financial institutions.  In the gravest extreme to avoid a run on the U.S. currency and a collapse of the U.S. economy, the U.S. requires a standby plan to sequester a foreign nation’s funds, just as we have done in the past.

1 Janssen, Richard F., and Levine, Richard J., “A Threat to Economy Was Factor in Pressing U.S. to Defend Dollar,” Wall Street Journal (Front Page), November 6, 1978.

Read more finance articles by Janet Tavakoli