“A catastrophe on multiple levels.”
That’s how New York Times columnist Paul Krugman characterised the US debt deal brokered this week between Democrats and Republicans.
President Obama on Tuesday signed a bill that raises the US borrowing limit by up to $US2.4 trillion. What should have been a routine piece of legislation rapidly degenerated into a power struggle between the White House and the Republican-dominated Congress.
Obama agreed to a $US2.1 trillion haircut for the Federal budget and dropped his demand for tax hikes – for now. An infuriated Krugman, once Obama’s economic adviser, declared that the president had “surrendered”.
There was always going to be a deal, albeit at five minutes to midnight. But even a partial default by the US government would have derailed public services, spooked share markets and sent chills throughout the entire global financial system. Hold onto your hats: it’s going to be a hell of a ride.
How did we get here?
Cast your mind back exactly 40 years. In August 1971, without consulting his allies, President Nixon abandoned the gold-dollar fixed exchange-rate system, which had provided the bedrock of the post-war boom.
At Bretton Woods in 1944, the western allies agreed upon a set of international financial institutions to govern the post-war world. This ‘holy trinity’ comprised the IMF, the World Bank and the International Trade Organisation (the latter eventually finding expression in the form of the GATT and WTO).
But the fourth pillar was perhaps the most crucial: the US dollar would be backed by all the gold in Fort Knox. And one ounce of gold was worth $US35.
From 1944, that meant dollars were “as good as gold”. Every other currency had a US dollar value. And what better reason to hoard gold? Or dollars? One was easily and automatically convertible into the other. Even the Soviets recognised the benefits of accumulating gold stocks.
All that glitters
If you had a gold dollar and a paper dollar, which would you spend and which would keep? The answer’s obvious: save the first, spend the other.
The Bretton Woods system would have persisted if US governments had backed each dollar the Treasury printed with an equivalent in gold. But, as Elizabeth I’s financier, Sir Thomas Gresham argued, “bad money chases out good”.
In economics, this became known as “Gresham’s law”, where the incentive to debase the currency is greater than the incentive to maintain its value. The Dutch knew this better than anybody: in the 17th century, the Netherlands backed every bank deposit with gold and silver. That is why the Dutch, when they weren’t busy discovering Australia, became a world power.
Meanwhile, over in New Amsterdam, now Manhattan, President Grover Cleveland was compelled to strike a deal with JP Morgan in the wake of the 1893–95 financial panic.
The US government could no longer back dollars with gold. Morgan agreed to loan the government $60 million – a colossal sum – demonstrating the financial power of the great 19th-century private banking houses.
Nixon chose the other option in 1971: he closed the gold window permanently, abandoned fixed exchange rates and floated the dollar.
In 2007–08, during the global financial crisis, banks such as Bear Stearns discovered it wasn’t 1895 anymore: they were compelled to plead for assistance from President Bush. Instead, Bush let JP Morgan Chase buy Bear Stearns at a firesale price.
Why US hegemony isn’t over (yet)
You want to buy oil? Try dealing with OPEC. They only take dollars. And not the Australian kind. Saddam Hussein toyed with euros for a while, but we all know what happened to him. Sure, you can buy Russian, Iranian or Venezuelan black gold with euros, but everyone from Brussels to Beijing knows that everything from shares to satellites is paid for in dollars.
In March 2009, Zhou Xiaochuan, China’s central bank governor, called for the establishment of a new global reserve currency to end the dominant role of the dollar.
However, for all its financial sabre-rattling, China remains heavily dependent upon the US economy; 25% of Chinese exports go to the US, and Beijing’s exchange-rate policy demands that the central bank maintains a deliberately-undervalued yuan in order to maintain export competitiveness.
That’s why Chinese communists keep buying every US Treasury note they can get their hands on. Because the Chinese yuan is a non-convertible currency, and China needs some form of foreign exchange as it greedily sucks in resources and energy at an ever-escalating pace. The result? China holds $US1.16 trillion in Treasuries.
Consequently, Beijing’s attempts at undermining the dollar’s role in the global economy have been amateurish and unconvincing. The reluctance of other states to support Beijing’s scheme, apart from China’s partner, Russia, itself a victim of a weak ruble, indicates the extent to which the US dollar remains enmeshed and dominant within the international financial system.
Even now, with a fast-depreciating dollar, the greenback constitutes over 60% of all global reserves. At its worst (under Clinton in 1995), the dollar reached its nadir at 59% of reserves. Compare that with the measly position of the euro (26.5%). The pound? 4%. The yen? Surely you jest? (3.8%).
What’s more, the euro figure is artificially inflated by Euro (debt) bonds that are issued predominantly in the Eurozone. And you know what happens when Eurozone countries issue Eurobonds? Greece. That’s what happens.
China, like Japan and every other holder of US Treasuries, is deeply embedded in the global “dollar economy”. They can use them to buy US dollar-denominated assets. But they can’t dump huge tranches of Treasuries on global markets as the value of their remaining holdings would diminish alarmingly. And if central banks stop buying Treasuries, they destroy their biggest export market: the US. This is one Gordian knot that cannot be sliced, as the consequences would be catastrophic for the world economy.
This is the crux of the issue: somewhat ironically, US debt drives the global economy. The world’s major export centres – China, the EU and Japan – depend upon American conspicuous consumption.
So when Russian president Vladimir Putin excoriates the US as a “leech” on the world economy, and when Beijing deplores the volatility wrought by Washington’s profligacy, this smacks of the deepest hypocrisy. Frankly, the last thing the world’s central bankers want is an austere, fiscally-responsible US Congress.
They hired the money, didn’t they?
There is a downside to debt: inflation. The US simply prints IOUs in the form of Treasuries and inflates away its debt by steadily depreciating the US dollar. When a 30-year Treasury note is issued today for $US50 million, what will that $50 million (plus negligible 4.75% interest) be worth in 2041?
Who pays for this depreciating currency? Everyone. Every country that holds US dollars does so knowing that Washington abandoned the ‘strong dollar’ policy under Reagan in 1985. Why is virtually every country now experiencing mounting inflation? Lax interest rates and massive injections of liquidity by governments into national economies, that’s why. And because of the US dollar glut as Washington pumps more of its debased currency into global foreign debt markets.
Déjà vu all over again
There are eerie parallels with the 1970s in the contemporary financial crisis. Oil prices are relatively high; the Middle East is politically unstable; bears dominate fragile markets; and the spectre of raging inflation looms.
Global economic growth is slow or low, sovereign debt is spiralling and unemployment high. Official US interest rates have been close to zero since late 2008 and America is still in the midst of a jobless recovery.
This is what economists called stagflation: a combination of high inflation, high unemployment and stagnant or zero growth. It was sparked by US dollar printing to pay for the Vietnam War, exacerbated by the 1971 Nixon shock and prolonged by the 1973-74 oil crisis. Stagflation ended only when – you guessed it – Reagan ended the era of relative US austerity and transformed the US from the world’s largest creditor to the globe’s biggest debtor. All in the space of a decade.
Washington gets away with this kind of profligacy because the US dollar economy was carved in granite at Bretton Woods in 1944. Why pay your debts when you can simply keep printing dollars?
Is spiralling debt sustainable? So long as the US government continues to meet its debt obligations, of course it is. But an increasing debt-servicing ratio means less public investment, cuts in federal programs and reduced welfare spending in areas like social security and Medicare.
Inevitably, Obama – or a future president – will be forced to cut the deficit and raise taxes. But for now, Gresham’s Law holds true: bad money will always chase out good.