Tuesday, January 12, 2010

Bankruptcy could be good for america?

Wow, that ought to spook a bunch of people including myself. The FT is rallying the excitable fringe with a well written piece on the virtue of sovereign default.

In Winnie-the-Pooh, there is a significant moment when the bear is asked whether he wants honey or condensed milk with his bread. He replies “both”. You can get away with this sort of thing if you are a much loved character in children’s literature. But it is more problematic when great nations start behaving in a childish fashion. When Americans are asked what they want – lower taxes, more lavish social spending or the world’s best-funded military machine – their collective answer tends to be “all of the above”.

The result is that the US is piling up debt. A budget deficit of about 12 per cent of gross domestic product is understandable as a short-term reaction to a huge financial crisis. What should worry Americans is that, with entitlement spending set to surge, there is no credible plan to bring the budget deficit under control over the medium term.

The US has formidable strengths that will allow its government to be profligate for far longer than other nations could get away with. But if the US keeps running huge deficits, sooner or later the country will start flirting with bankruptcy. Oddly, it might be best if the crisis came sooner rather than later. For a surprising number of countries, running out of money has been the prelude to national renewal.


At a moral and individual level, I agree with the sentiment expressed in the article, namely that deleveraging is a good thing, don't buy more than you can afford is the basic tenet of sound personal finance. It is already under way.

However, in analyzing this passage, one must remember that when it comes to balancing a budget, what applies to individuals does not apply to the world economy. Basically a government that issues debt in its own currency can print money. Most of the examples Gideon gives in his article are about countries that emit debt in foreign currency. They will default if they can't meet payments in that foreign currency. This is not the case of the US. The US IS printing massive amounts of money.

The USD is still the currency of choice for world trade. It is also the reserve currency for the world. This is unlikely to change in the short term. China is printing tit for tat to peg its currency to the USD and the EU will have no choice but to follow suit if it wants to stay competitive. This all means we are in the midst of a massive world experiment in quantitative easing. Everyone is printing money.

Now, printing money is an inflationary force but when it is countering large deflationary forces like the current post-crisis deleveraging, you sum it all up and the sum is still negative or deflationary. This is what is happening in the US and what has happened for the past 2 decades in Japan.

China can force a default by nuking the dollar. It can do so (hypothetical) by doing a "pearl harbor" on ITS OWN reserves. A serious case of cutting your nose to spite your face. What they would do is first they would buy up all HARD ASSETS (commodity raid) in USD and then stop accepting USD as payment for exports. This will sink the USD and their own exports. And the net result of that is anyone's guess. It would be the first global economic war. I don't buy it. But then I am an optimist.

"This time it is different"
-- famous last words

1 comment:

oogifu said...

China is probably preparing for the fallout of its future actions :-)