Foreign lenders to the US: Straining under limits

Doug Casey - Wed 11 Oct, 2006

...Two elements determine how far foreigners will go as lenders to the US. It is becoming increasingly difficult for the US to satisfy either of them...

 
 
Two elements determine how far foreigners will go as lenders to the US. The first is akin to a credit test. The second is a portfolio consideration. It is becoming increasingly difficult for the US to satisfy either of them.

Foreigners will accept T-bills and other dollar-denominated IOUs only so long as they believe US borrowers can make good on their debts. The concern is not primarily about explicit defaults. It is about the likelihood of a slow-motion default via inflation. It is a concern about the future value of the dollar. Confidence that the dollar will hold its value is strained with every increase in the US budget deficit (which increases the US government’s incentive to inflate) and with every increase in the overall level of US debt to foreigners (which encourages the public’s tolerance for inflation).

It would take a phenomenally slow person, say, a central banker, to have much faith in Uncle Sam’s good credit when the US can’t pay its current bills by a very wide margin — and has trouble saying "no" to new spending plans. But even the faith of a central banker must have its limits.

Foreign lenders to the US: Red ink

Perhaps the central bankers haven’t yet seen the Government Accounting Office’s latest projections of US federal government red ink. Based on straightforward assumptions that (i) regular income tax rates continue, (ii) the alternative minimum tax is adjusted and (iii) discretionary spending grows with GDP; the projection for spending, and thus the budget deficit, flies off the map. By 2040, the yearly deficit grows from the current 3% of GDP to 40%!

The second element in the calculations of foreign lenders is a portfolio consideration. Owning too much of anything is worrisome. So even if the risk of the dollar losing its value were modest (which it no longer is), as foreign holdings of dollar-denominated securities grow, the risk eventually becomes intolerable.

When it comes to foreign holdings of US investments, the numbers are enormous. Japan alone has bet over $1 trillion on the dollar’s ability to hold its value. That’s enough to breed uneasiness in any portfolio manager. And the numbers keep growing because the US keeps importing goods by the boatload and paying with dollar-denominated IOUs. The breaking point is getting closer at a rate of $2 billion per day.

The great irony is that the US is counting on foreigners to invest $2 billion per day...at a time when they are not winning many hearts and minds abroad. The counterproductive and unwinnable war in Iraq is just the unhappiest part of the current picture. Among other reasons why hatred for Americans is rising are:

1. America maintains military bases that locals don’t welcome, and not just in Islamic countries. Many Germans feel that their country is still occupied after a war that ended before they were born. The US keeps troops in over 130 countries, where most people are no happier to see them than Americans would be to see Russian or Iraqi soldiers shopping at their hometown Wal-Mart.

2. The US earnestly attempts to impose government-issued "American values" on others. Bush says he wants to democratize Iraq—with no regard for whether the Iraqis want to be "democratized" or not and with no thought to what actual practice will slither out of the slogan. The US chastises others, including China, about their human rights record, but their words now appear hypocritical given the heavy-handed US occupation of Iraq and the indefensible existence of the Guantanamo gulag.

3. The US helps governments run by dictators and murderers stay in power, and surviving victims remember. They won’t forget that Saddam Hussein was once an ally. Iranians who hate Americans don’t do so because they hate Calvin Klein underwear, but because they felt oppressed by our former protégé, the Shah. The same goes for many current US allies in "the stans," the most noticeable recent example being Vice President Cheney’s trip to Kazakhstan to cozy up with that country’s ruling despot. The pattern long held true in Latin America; the effectiveness of anti-American political rhetoric for politicians like Chavez, Morales and their ilk should come as no surprise.

4. The US talks about freedom and free trade, but the threat of massive violence seems to be the main tool of their diplomacy, and US subsidies for farmers don’t provide much of a free-trade lesson to third-world farmers.

Foreign lenders to the US: The US a "hypocritical thug"

In short, the American global cop, far from harvesting the gratitude of a world made safer, is perceived as a hypocritical and plundering thug—hardly the sort of thing that makes foreigners line up to invest in America.

US heavy-handedness abroad and the ill will it inspires are dangerous for many reasons, including their effect on the US dollar. War in Iraq and sabre-rattling over Iran are driving the price of the oil and other imports up in the US, which increases the trade deficit, which adds to the pile of dollar-denominated IOUs held by foreigners. And the same belligerence confirms in many Middle-Eastern minds that the US is driven by an anti-Islamic agenda. It gives them a non-financial motive for embracing alternatives to the dollar: the euro, the yen—anything not made in the US Other foreigners see the belligerence as more evidence that the US government is a reckless spender and heedless of the consequences of its growing debt.

Is there anything the US government can do to stop the train wreck? Earlier governments tried sacrificing virgins to the gods to ward off disaster, but the practice seldom worked and isn’t likely to be revived. The Federal Reserve could try raising interest rates still higher, high enough to convince foreign central banks to hold on to their dollar investments, but that has about the same chances of working as tossing gold-laden virgins into deep, water-filled sinkholes did. It might protect the Dollar Standard for a while, but it would turn residential real estate into a financial graveyard and trigger the depression the Fed is trying to avoid. Of course, the Fed could fight a contraction in the economy… by lowering interest rates. But that would bring on a flight from the dollar and a more rapid end to the Dollar Standard. There is no way out.

Foreign lenders to the US: Extreme volatility

If we’re right about a coming monetary regime change, it’s hard to imagine a future for the US that isn’t grim, with plenty of harm splashed around on its trading partners: inflation...currency crisis...dollar crash...government instability...internal conflict for scarce resources...welfare system collapse...skyrocketing unemployment...taxes raised on a population burdened with an uncompetitive US economy...dollar down 40%, 60%, 80%?...emergence of competitive economic battles on too many fronts: China, India, Japan, Russia—and on too many military fronts. End of empire/Fall of Rome redux...the Greater Depression.

We are already seeing extreme volatility in emerging markets as the hedge funds beat a hasty retreat for liquidity. Get used to it.

Remember, never before in history has the unbacked paper currency of a single country been used as the de facto reserves of the world’s central banks. We are truly in Terra Incognita, uncharted territory — and a hair trigger away from a currency crisis that, once begun, will quickly spin out of control.


Regards,

Doug Casey
for The Daily Reckoning
   

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