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Politicians, the media and business have called these economic conditions unprecedented, uncharted waters, we’ve never had so much uncertainty. I disagree.
The US only has a limited set of options
With the need for a second bail out package of 600-700 billion dollars, the current government deficit will be well over a trillion dollars. The total cumulative debt of the government since the 1800’s is over 54 trillion dollars. That’s more money then what is currently in circulation. This dire position leaves the US with very few limited option, which increases certainty, not the other way around. What we are not sure is which path policy makers will take.
These include maintaining trust in the financial system, so that foreign (Chinese, Japanese and others) and domestic investors prop up the unsustainable US debt and continue to purchase low interest-bearing (approaching zero) T-bills and bonds.
In stories such as “China Will Keep Buying U.S. Government Debt Michael Pettis. The Wall Street Journal Asia. Hong Kong: Dec 1, 2008. pg. 15
We see that commentators from Newsweek's Fareed Zakaria to British economic historian Niall Ferguson argue that Washington needs China to buy U.S. Treasury bonds to fund U.S. fiscal spending. This “maintain the pain” or “prolong the phony or virtual growth scenario” can only be stretched so far.
In an articles called Turmoil could spark the unraveling of 'Chimerica' Michael Richardson. South China Morning Post. Hong Kong: Dec 12, 2008. pg. 21 question the current trust relationship between the US and China and if it can last
In his book, The Ascent of Money, historian Niall Ferguson describes the emergence of a new post-cold-war superstate, Chimerica, a fictional combination of China and the US. "For a time, it seemed like a marriage made in heaven," he writes. "The east Chimericans did the saving, the west Chimericans did the spending." Chinese benefited from export-oriented economic growth and rising living standards; the Americans from cheap imports and low inflation. ..[..].. Will the bond of mutual interest survive the global financial turmoil and deepening recession?
Some facts to remember
• “China's accumulated trade surpluses, particularly with the US and Europe, have helped it amass the world's largest foreign exchange reserves, some US$2 trillion.
• “Analysts say China has invested up to US$1.5 trillion of that in US debt, including that issued by the now government-controlled mortgage finance giants Fannie Mae and Freddie Mac.
• “China's prominent role as creditor to an increasingly indebted US was underlined by US Treasury figures released last month showing that, in September, China overtook Japan to become the largest owner of Treasury bonds, bills and notes, with US$585 billion of these securities”
• “The unwritten compact between Beijing and Washington is: Chinese credit in exchange for access to the US market. China needs to export to earn foreign exchange and for US consumers to keep buying its goods. So mutually dependent are the two economies that, if the US slowed by 1 per cent, China would slow by 1.3 per cent, Citigroup researchers estimate
Chinese officials and analysts suggest that China will retain, and probably increase, its holding of US Treasury securities for the foreseeable future, provided it is confident America will recover from the credit crunch and recession.
What is this doesn’t work?.
This leaves only a small range of limited options: 1) slow debt reduction or de-leveraging 2) severe debt reduction, according the story The age of obligation by Niall Ferguson, Financial Times. London (UK): Dec 19, 2008. pg. 7
1) “When economists talk about "deleveraging" they usually have in mind a rather slow process whereby companies and households increase their savings in order to pay off debt. But the paradox of thrift means that a concerted effort along these lines will drive an economy such as that of the US deeper into recession, raising debt-to-income ratios.”
2) The alternative is a more radical reduction of debt.
Historically, such reductions have been done in one of four ways: 2.1) outright default, 2.2) restructuring (for instance, bankruptcy), 2.3) inflation or 2.4) conversion.
At the moment, more and more American households are choosing the first as a way of dealing with the problem of negative equity, while more and more companies are being driven towards bankruptcy. But mass foreclosures and bankruptcies are not a pretty prospect.
Outright default could also include the possibility that the $US dollar, will tank and be replace by some new currency. Some people have even been floating the idea of the Amero (like the Euro) that would replace the US dollar, the Mexican Peso and the Canadian “looney”. Don’t dismiss this outright and say no, because it’s happened more then once in the last 200 years in many countries around the world.
Commenting on the prospect of inflation. Ferguson says: “Inflation, by contrast, is hard to worry about in the short term, not least because the Fed's expansion of the monetary base is leading to no commensurate expansion of the broad money supply; the banks would rather shrink than expand their balance sheets.”
“That leaves conversion, whereby, for example, all existing mortgage debts could be wholly or partly converted into long-term, low and fixed-interest loans, as recently suggested by Harvard's Martin Feldstein. (In his scheme, the government would offer any homeowner with a mortgage the option to replace 20 per cent of the mortgage with a low-interest loan from the government, subject to a maximum of $80,000. The annual interest rate could be as low as 2 per cent and the loan would be amortised over 30 years.”
Then there are a number of other wild cards. The “Russian forgiveness scenario” sees a country such as Russia forgiving old historical foreign debts that have no chance of being reasonably being paid off. In return that for new debt, Russian offers new loans, if you buy our arms. In another loans-for-oil scenario, see countries like Russia and China, swapping loans (from China to Russia) in exchange for future oil supplies.
One other wild card is the question of the $1.7 trillion dollars of petrofunds in Sovereign Wealth Funds. Will they come back to save the US economy or tank it through strategic investments?
Business needs to consider each one of these multiple scenarios in turn, how it will affect their business and plan advance contingencies.
Depending on how deep and long the recession / depression stretches, unique depression precipitated circumstances will emerge. I anticipate a dozen or more factors (What-if’s such as runaway deflation, hyperinflation caused by the unlimited printing of currency, runs on banks, shortages of basic raw materials etc ) that will need to urgently explored and anticipated. We need to ask ourselves- how consumers will likely react in each circumstance and how should our business adjust? How will we mitigating the threats and ceasing the unique once-in-a-lifetime opportunity windows ?
See Opportunity Recognition in Difficult Times and Master Class in Opportunity Recognition for entrepreneurs and intrapreneurs> May 30th 2008> University of Toronto
Walter Derzko
See link
<http://smarteconomy.typepad.com/smart_economy/2008/12/dealing-with-the-us-national-debt-how-should-business-and-consumers-react.html>
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