by Alexander G Rubio
Wed Feb 8th, 2006 at 10:15:57 PM EST
Back in the early Christmas shopping season of 2002, when most Americans were starting their annual quest for cheap Chinese produced clothes and CD players to bag and stack under the tree, armed with rectangular plastic cards, then Treasury Secretary of The United States, Paul O'Neill
knocked on the door to the office of his old friend Vice President Dick Cheney
He had a problem with the budget, he said. Deficits were piling up at an alarming rate. If something wasn't done about it, he said, it might well leave the public purse saddled with more debt than it could service, while still performing its tasks and making good on its obligations, creating a risk of a financial crisis.
According to O'Neill's later statements, Cheney looked him in the eye and said, "You know, Paul, Reagan proved deficits don't matter." This level of spending was their due after their good showing in the recent congressional elections. And with that he dismissed him from his office. A month later he dismissed him from his post in the cabinet.
In many ways it would seem that the years that followed have borne out Cheney's, and those who see increased deficits and looser credit as the cure for comparatively slow European growth's, view of things. So do deficits no longer matter?
Back in the days of the Viennese Waltz
Before even considering taking out a loan, whether you're a private individual looking for a mortgage, or a government looking to finance a deficit, there's the small matter of there having to be someone willing to loan you the money, and why they are willing to do it.
In the past countries were to a far greater extent closed systems. US debt was largely held by US citizens and organisations. Go far enough back and most western countries were also on the gold standard. You could walk into a bank and turn in your paper money for a fixed amount of gold. Both these things hampered government's ability to take on massive amounts of debt.
Being on the gold standard meant that you couldn't print up more money than you could cover with your gold reserves without risking national default. And the predominantly domestic sources of credit meant that any large scale government loans would suck up a lot of that credit, crowding out private individuals and enterprises seeking investment capital, and so harming the economy.
Now, a couple of things have changed since then. First of all, the need for massive loans and the ability to boost spending through monetary inflation during the war years and the Depression lead to most western nations dropping the gold standard. And more recent decades have seen the birth of a vast global integrated capital market, where credit can be summoned from any corner of the globe at the touch of a button. Which brings us to today...
New Rules, Baby! Do the Cha-Cha-China!
Foreign holdings of US Treasury debt
(graph from The Economist)
Just as loose lending practises lead to consumers taking on too much debt, the same is true on a macro-scale in an environment where a government can finance deficits with all too much ease. A major lender in recent years has been the Chinese central bank, having been handed the relay stick by former credit champion of the world, Japan. Now, aside from the strategic and political qualms the US may or may not have about China holding such massive amounts of US debt instruments, they are bound in a curious love-hate relationship with the Chinese economy in general, and Chinese currency policy
In general China produces the cheap goods that produce everyday big profits for US companies such as Wal-Mart, and they export wage deflation to the US and other industrialised countries, helping keep wages of workers in those countries at or below the rate of price inflation, in a paradoxical reverse colonial trade pattern that shifts capital and raw materials out of the imperial centre and manufactured goods back in.
On the other hand China produces cheap goods that decimate domestic manufacturing in the US and other industrialised countries, and export wage deflation, which pisses off workers in those countries to no end.
When it comes to currency policy in particular, China intervenes in the market, keeping their currency, the Yuan, at an artificially low exchange rate, to boost their exports. This has a negative effect on US and other nations' domestic manufacturing and export sectors. But, this intervention, buying up US bonds, is also what keeps US interest rates down, and fuels the housing bubble of recent years, and refinancing of said housing at lower rates, leaving consumers with more money to consume, as well as allowing the federal government to run deficits with little obvious pain. The status of the US dollar as the world's reserve currency, the thing people the world over traditionally have squirrelled away in their mattresses in times of trouble, with numerous other currencies tied to it in more or less formal ways, and all countries being forced to have it on hand to buy their oil, has also been an enormous shock absorber for economic stresses.
Some economists have fretted that international lenders would do the job of the Federal Reserve Chairman, and take away the punch bowl, but as economist Brad Setser points out, thus far any inclination in that direction has failed to materialise. In fact, for the time being, they seem willing and able to finance even larger infusions of capital into the US to cover the various deficits that country is running.
Brad SetserIs the world ready to finance a $1 trillion US current account deficit?
Judging from the capital inflow into the US in October, I guess the answer is yes. And I suspect the US may well give the world a chance to add $ 1 trillion to its dollar portfolio next year.
A trillion dollar US current account deficit in 2006, and a trillion dollar's in Chinese reserves in 2006. There would be a certain symmetry.
Obviously, a big fall in oil prices - or a big fall in non-oil imports - would keep the US from approaching that kind of deficit. But so far this year, neither the markets nor the world's central banks have demanded that the US adjust.
Of course, the US can only spend more than it earns so long as the rest of the world is willing to finance the US.
Doing the One-legged Keynesian Two-step
It's not that hard to figure out the reasons why. And it's all too easy to see ways in which this will lead to future problems. Yes, it's a nice life if you come across a bank willing to lend you far more than is warranted by your expected future income. But sooner or later that debt has to be, if not repaid, then at least serviced. And this debt is handled through the market, where pricing, in this case bond yields, are set on the margin. If buyers show up for only 95% of the bonds on offer at auction, yields will have to rise, and interest rates for both private and public debt will go up.
Yes, as in the housing market, it's the monthly payments that matter, far more than price. But if you're leveraged to the hilt and banking on low interest rates to keep the monthly payments down, and interest rates suddenly rise, as they do tend to on occasion, you're all kinds of screwed on the monthly budget, whether you're a home "owner" or the federal government.
Now some might counter that this is good Keynesian policy, cranking the economic engine to life and getting the wheels turning. But responsible Keynesian policy is predicated on cutting back on the stimulus when the economy is moving under its own power, and building up reserves for the next cyclical downturn. And in an environment where some governments can not only draw on a global market of capital seeking parking spaces, but one in which currencies and interest rates are manipulated on a vast scale, the need to do so is greatly reduced; the wish to do so, among industries profiting from the stimulus and the politicians profiting from the economic activity at the ballot box, has of course always been minimal.
The economy wonks at The Angry Bear
, along with Hale Stewart
and Stirling Newberry
, have been doing yeoman's work, in both tracking
the day to day workings of this economy, and its consequences
for ordinary men and women.
Of course, living high on the hog with borrowed money sure does look like fun, especially when you've got reputable economists claiming the whole thing will pay for itself in the long run. And deficit spending is increasingly a worry in the Euro zone too, following the accord of the heavy European nations to ease the requirement of a maximum 3% budget deficit back in March, pushed most vigorously by the very nation that championed the rule to begin with, Germany.
And in the end, even though governments never, or at least seldom, die, and can keep kicking those ever greater loans down Future Street, there's still that bill in the mail every month for interests due, which is getting bigger. And if, one day, loans can't be raised to cover the servicing of the old loans, well, then somebody's liable to stumble on the dance floor, and domino go the party.