Uncle Sam's Debt Burden

Will the American people be able to stomach the bitter pill of fiscal and monetary restraint if they are faced with the same prescription asked of other debtor nations by the US-backed International Monetary Fund (IMF)? By Satyajit Das

Back on 30 October 1938, the American Radio Drama series Mercury Theatre aired the now infamous adaptation of HG Welles' novel, The War of the Worlds, one which script was interspersed with dramatic news bulletins of a Martian invasion. Listeners who had missed the opening credits assumed that the invasion was for real. Many fled their homes and police operators were swamped by panicked phone calls.

Today the financial equivalent of this broadcast would be the announcement: We interrupt regular programming to announce that the United States of America has defaulted on its debt!

Default entails failure to honour contractual obligations, which in the case of debt would mean non-payment of interest or principal payments due to the lender. The fact is that most long-term lenders to Uncle Sam have suffered significant losses, not directly from non-payment but because repayments have been based on a debased currency, namely the US dollar.

Just picture this. If you were a Japanese investor who bought and held on to 30-year US Treasury bond back in 1985 when the dollar to yen exchange rate was at $1 to 250 yen. With an exchange rate of $1 to 90 yen, you would have lost 64% of your investment. European investors who bought US government bonds in recent years would have also suffered significant losses. An investor who bought at the highest exchange rate of 1 euro to $0.85 would have lost 30% at current trading levels of about 1 euro to $1.40.

Given that in a typical sovereign default, an investor would lose 50% to 80% of the value of the investment, such losses are not far short of default. Despite the official policy of a "strong dollar," a case can be made that the US is in the process of defaulting on its obligations via a gradual systematic devaluation of its currency.

Spiraling Debt

Uncle Sam's problems are evident from a number of key indicators. Its national debt as of March 2008 stands at $9.4 trillion, or the equivalent of each American citizen in debt to the tune of $30,000, or a little over $60,000 per working adult in the US.

The US national debt has grown by $3 trillion, or 50% since 2000, when it was $6 trillion. In 2007 alone, it grew by $500 billion, from $8.7 trillion to $9.2 trillion. In 2005, it was 67% of US GDP, up from 51% in 1988. The Office of Management and Budget projects that total debt will rise to $12.3 trillion in 2013.

Of the $4.7 trillion currently in private hands, about half or $2.4 trillion is held by foreign investors. Japan holds around US$600 billion (24%) and China about US$500 billion (20%). The United Kingdom, Brazil and the oil exporting countries own about 6%. About another 8% may be stashed in offshore centres in the Caribbean and Luxembourg by Middle Eastern and Russian holding companies.

As James Fallow writing in The Atlantic noted: "Every person in the United States has over the past 10 years or so borrowed about $4,000 from someone in the (poor) People's Republic of China."

The debt figures do not include significant private sector debt at both corporate and consumer levels. Nor do they include hidden liabilities such as Social Security, as well as medical and health obligations such as Medicare and Medicaid and other private pension arrangements.

Neither do they take into account off-balance sheet liabilities such as the estimated $5 trillion in debt and guarantees of the government sponsored enterprises (GSE) such as the mortgage agencies, Fannie Mae and Freddie Mac. As of July 2008, these obligations became part of US national debt. Any problem with the solvency of either institution may have implications of the AAA credit rating of the US.

Such high levels of debt are compounded by the twin deficits. The forecast for the 2008 budget deficit is US$380 billion (2.4% of GDP) and the current account deficit is expected to exceed US$ 700 billion (4.6% of GDP).

Peter Orszag, Congressional Budget Office Director, did not mince words when he testified before the Senate Finance Committee in June, "The US economy faces the long-term threat of collapse unless major reforms on health care spending are instituted in the coming years." Unless health care spending is brought under control, Orszag warned that the American economy faces crippling problems that "would make our current economic difficulties look puny".

The US financial system has been badly affected by losses on sub-prime mortgages. Losses incurred are in excess of $300 billion. The Fed has provided over $400 billion in funding support to the financial system. Additional government borrowings to support the financial system may be necessary.

Lawrence Summers, who served as the Secretary of the Treasury during the Bill Clinton administration, once observed: "Only hard accurate information on reserves, current account and fiscal and monetary conditions will keep capital from fleeing precipitously at the first sign of trouble." So, why hasn't the electronic herd taken flight?

Printing money

The real reason that the US has not actually experienced any sovereign debt crisis is that it finances itself in it own currency. This means that the US can literally print dollars to service and repay it obligations.

High levels of debt are sustainable as long as the borrower can continue to service and finance it. The US has had no trouble attracting investors to date. In recent years, the United States has absorbed around 85% of total global capital flows (about US$500 billion each year) from Asia, Europe, Russia and the Middle East from investors who bought high quality debt such as US Treasury and AAA rated bonds including asset-backed securities (ABS) and mortgage-backed securities (MBS).

Such a development is only possible because of the special status of the greenback as the world's major reserve currency for purpose of trade. The aura of stability and a safe store of value of the dollar have been based on the strength of its economy.

Most global currencies are pegged to the dollar. In many instances, the links are deliberately set at artificially low rates – as in the case of the Chinese renminbi – to maintain export competitiveness and leads to a constant outflow of dollars. The excessive US demand for imports based on an overvalued dollar is what keeps driving America's trade deficit with the world ever deeper into the red.

Foreign central bankers are often forced to purchase US debt with dollars to mitigate upward pressures on their domestic currencies. The recycled dollars flow back to the US to finance the spending. This merry-go-round is the single most significant source of liquidity creation in financial markets, and helps maintain the dollar's status as a reserve currency. There is the threat that such dominance may be coming to an end. There has been increasing calls in some quarters to facilitate trade flows in currencies other than the greenback.

For example, some exporters are slowly leaning towards payment in euros or yen. About half of Japanese exports are now invoiced in dollars, down from 1971 when it was almost exclusively in dollars. The volume of exports invoiced in yen has on the other hand increased from 34% in 2001 to currently, about 40%. Apparently, it has been reported that supermodels and drug dealers are leaning towards payment in euros rather than dollars.

There have also been proposals to price commodities such as oil and agricultural goods in currencies other than the dollar. Some countries have abandoned or loosened the linkage of their domestic currency to the dollar. Foreign investors, including central banks have reduced investment allocations to the dollar. The dollar's share of reserves has fallen from a high of 72% to around 60%.

Foreign investors may not continue to finance the US binge at the current rate. At a minimum, the US will at some stage have to pay higher rates to finance its borrowing requirements. Ultimately, the US may be forced to finance itself in foreign currency. This would expose the US to currency risk but most importantly – it will not be able to service its debt by printing money. The US, like all borrowers, will become subject to the discipline of creditors.

For the moment, the dollar is hanging on – but only just, mainly because of the structural weakness in the euro and yen due to deep-seated problems in the respective economies. The dollar is also a beneficiary of the "too big to fail" syndrome. Many central banks and sovereign investors in East and South Asia, Russia and the Gulf have substantial dollar investments that would incur catastrophic losses if the US were to default. The International Monetary Fund (IMF) estimated that Gulf states including Saudi Arabia, Qatar and the United Arab Emirates (UAE) might lose at least US$400 billion if they decide to stop pegging their currencies to the dollar.

Every lender knows Keynes' famous observation: "If I owe you a pound, I have a problem; but if I owe you a million, the problem is yours." So as a result of history's largest Ponzi scheme, foreign creditors must keep supporting the US currency. As the adage goes: "The only man who sticks closer to you in times of adversity other than a friend is a creditor."

The present MAD (mutually assured destruction) pact that binds the US and its creditors is fragile. Dollar holders are acting like a cartel. A break in the cartel such as a major investor deciding to exit in the belief that it can get out could be extremely disruptive.

What's the cure?

So what must the US do in order to remedy the problem and stem the erosion of confidence?

In 1989, the Washington-based US economist, John Williamson spelled out a list of economic prescriptions that have since become the standard International Monetary Fund (IMF) reform package for debt-stricken economies. One that includes recommendations such as fiscal policy discipline, cutback in state subsidies, tax reform, competitive exchange rates; liberalization of trade and foreign direct investment; privatization of state enterprises and deregulation.

The US will now need to adopt many elements of this reform package originally prescribed for emerging markets, to tackle its own woes. Some like fiscal and monetary discipline are politically difficult. Any reform of farm subsidies will have to overcome deep-seated resistance.

But global markets are restless for action. The US dollar has already weakened and is likely to decline further. While such a development favours American exporters and the tourism sector, it will ultimately also attract foreign investors. The closing down sale of US assets including real estate, companies and infrastructure assets may have already started.

The Belgian brewer, InBev has launched an unsolicited bid of $46 billion for Anheuser-Busch, the brewer of the quintessential American beer, Budweiser. The Spanish infrastructure company, Abertis Infraestructuras has teamed up with Citigroup to table a $12.8 billion bid for the rights to lease the Pennsylvania turnpike for the next 75 years.

The US and the dollar overtook Great Britain and the pound sterling as the pre-eminent global economic power and currency in the twentieth century. A similar epochal tectonic shift in the global economic order may be underway.

The shift however is not inevitable. There is still much to admire about the US system. It remains wealthier than other nations including the new titans – China and India. America is a science and technology powerhouse. It accounts for 40% of total world spending on research and development, and outperforms Europe and Japan. Between 1993-2003, America's growth rate in patents averaged 6.6% a year compared with 5.1% for the European Union and 4.1% for Japan. America's economy with its growing population, secure legal and property rights and well-developed financial markets is still attractive to investors.

However as Buffett had observed: "We have used up our bank account and turned to our credit card. And, like everyone who gets in hock, the US will now experience 'reverse compounding' as we pay ever-increasing amounts of interest on interest.

"Borrowing on top of borrowing is not a great long-term financial plan. I believe that at some point in the future, US workers and voters will find this annual "tribute" (in interest payments on debt incurred) so onerous that there will be a severe political backlash. How that will play out in markets is impossible to predict – but to expect a 'soft landing' seems like wishful thinking."

Without drastic and radical action, America's ability to continue to borrow from foreign investors to meet its financing requirement is likely to become increasingly difficult.

It will also have a dire impact on Yankee pride if the US fails to re-establish its economic credentials. Americans could do well to ponder on what a character in Siri Hustvedt's novel The Sorrows of an American has to say about the impact of an enduring downturn. "A depression entails more than economic hardship, more than making do with less. That may be the least of it. People with pride find themselves beset by misfortunes they did not create; yet because of this pride, they still feel a pervasive sense of failure. People become powerless."

________________________________________________________________________________________ Satyajit Das is a risk consultant and author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives (2006, FT-Prentice Hall).