Tuesday, January 26, 2010
The Cure For The Crisis Was To Add More Disease
During the financial meltdown in the fall of 2008, central banks around the world — led by the Fed — pumped huge amounts of liquidity in the world financial system to stave off collapse. Much of the money was doled out to the biggest banks. Whatever wasn't printed out of thin air was financed through bond sales.
But the origin of the crisis was debt, and that problem has never been solved. It was just papered over by an absolutely massive government intervention.
The U.S. government, like others around the world, bailed out over-leveraged banks and initiated stimulus programs with borrowed money in the form of bonds. That simply deepened the debt problem and pushed it off into the future. In effect, while treating the symptoms, the disease itself was fueled.
For now, the U.S. continues to assume — or hope — that investors will continue to buy the bonds that finance its habitual deficit spending. That assumption may be overly optimistic.
In a recent discussion on the global role of the US dollar, Zhu Min, deputy governor of the People’s Bank of China, told an academic audience that, “The world does not have so much money to buy more US Treasuries.” He went on to say, “The United States cannot force foreign governments to increase their holdings of Treasuries… Double the holdings? It is definitely impossible.”
With interest rates near zero, a national debt exceeding $12 trillion (a sum so large that it can never be repaid), and a dangerously loose monetary policy, why would foreign governments, or citizens, maintain their faith in the U.S. and continue loaning it such massive sums of money?
What's more, the dollar has been in steady decline for years, causing it to lose value in relationship to foreign currencies. This has effectively increased the price of imports and resulted in Americans buying fewer foreign goods. That means there are fewer dollars available for foreigners to purchase future Treasury securities.
However, the weak dollar has tempted foreign investors, and even central banks, to pour their money into the stock market, excessively inflating its value. It is presently trading at 20 times earnings.
Though the dollar increased by 40 percent between 1995 and 2002, it then began a descent in 2003. That ultimately resulted in a 21 percent decline over the last decade, measured against a basket of six other currencies. Only a perceived flight to safety during the 2008 credit crisis kept the dollar's performance from being even worse.
But the dollar's decline in the last decade was only part of a much longer trend. Over the 25-year period since 1985, the dollar has lost more than half of its value.
That has not gone unnoticed. According to the IMF, around 40% of global reserves are now in dollars compared to 55% a decade ago. The difference has been lost to a range of currencies such as the euro, the yen, and particularly the Swiss franc.
Meanwhile, China has been adding to its gold holdings as an alternative to the dollar, which has clearly been losing favor.
Since the end of WWII, the U.S. has had the unique and extraordinary privilege of being the issuer of the world’s reserve currency. That position inspired confidence in the rest of the world and compelled them to buy our bonds. But those bonds look a lot less appealing these days.
The U.S. sold $2.1 trillion of notes and bonds last year. However, Treasuries were the worst performing sovereign debt market in 2009, losing 3.5%, on average. That won't encourage buyers this year. And the low yield on Treasuries only serves to further diminish their appeal.
Australia and Norway have already begun to raise interest rates, making their bonds more alluring to investors. And other central banks are expected to follow early this year. The Federal Reserve will try to hold the line in a futile effort to stimulate the U.S. economy. But sooner or later, it will have to cave to the demands of investors.
When the Fed eventually does raise rates, it will have a variety of consequences. Rising market interest rates automatically devalue older bonds issued at lower fixed rates. That will be none too pleasing to current holders of Treasuries.
Yet it appears that there may not be nearly as many of those bond holders as the Treasury would have us believe.
Last month, Sprott Asset Management told its investors that the Treasury is essentially creating its own debt market by conjuring up phony investors. According to Treasury data, a group cryptically referred to as "other investors" purchased $510 billion of Treasuries in just the first three quarters of last year, after buying just $90 billion in 2008.
This makes no sense whatsoever. Who on the planet, in these times, could afford to — or be willing to — increase their Treasury holdings more than five-fold, year-over-year? The whole claim appears to be a ruse for the Fed, as it printed half a trillion dollars to buy Treasuries.
So it's just a Ponzi, or pyramid, scheme. And like all, it's doomed to collapse.
By Sprott's analysis, America isn't finding enough investors to buy its massive supply of bonds. China's warning that there isn't enough money in the whole world to support the U.S.'s enormous appetite for debt sales seems accurate.
But the U.S. is not alone in its monumental debt problem.
If Portugal, Ireland, Iceland, Greece or Spain (known as the PIIGS) should default on their debt this year, or next, it could prove to be the canary in the coal mine for the rest of the world, including the U.S.
Ultimately, nothing has changed. The solution to the credit / financial crisis simply amounted to rearranging the deck chairs on the Titanic; nothing is different, except appearances. In the meantime, the problem of unsustainable debt has only grown worse, except that now much of the burden has been shifted to the taxpayers.
Politicians may crow about the need to reduce spending, but that won't get at the structural deficits that we are stuck with. And "pay as you go" won't chip away at our staggering debt burden, or pay the whopping interest payments on that debt.
As stated, our problems are structural, and they will haunt us for years to come.