Satyajit Das: America's Fiscal Cliffs and Debt Mountains
It is unlikely that America's problems will stay in America. The rest of the global economy is tied to the US as it edges closer to the cliff.
Given the magnitude of the challenge and the lack of political will, the US will continue to spend more than it receives in taxes for the indefinite future, resulting in increases in US government debt. This will force the Federal Reserve to continue existing policies, especially debt monetization by purchasing government bonds and the devaluation of the currency.
Debt monetization (printing money in popular parlance) will continue, entailing the US Federal Reserve purchasing government bonds in return for supplying reserves to the banking system. Zero interest rates policy (ZIRP) in conjunction with debt monetization will be used to devalue the US dollar.
Of the US gross government debt of US$16 trillion, the US government holds around 40% of the debt through the Federal Reserve, Social Security Trust Fund, and other government trust funds. Individuals, corporations, banks, insurance companies, pension funds, mutual funds, state or local governments, hold 25%. Foreigner investors -- China, Japan, oil exporting nations, Asian central banks, and sovereign wealth funds -- hold the remaining 35%.
Existing investors, like China, must now continue to purchase US dollars and government bonds to avoid a precipitous drop in the value of existing investments and to avoid a sharp rise in the value of their own currencies which would reduce export competitiveness.
Expedient in the short term, monetization risks debasing the currency. Despite bouts of dollar buying on its safe haven status, the US dollar has significantly weakened. On a trade weighted basis, the US dollar has lost around 20% against major currencies since 2009. The US dollar has lost around 30% against the Swiss Franc, 25% against the Canadian dollar, 35% against the Australian dollar and 20% against the Singapore dollar over the same period.
The weaker US dollar also allows the US to enhance its competitive position for exports; in effect the devaluation is a de facto cut in costs. This is designed to drive economic growth.
As the US dollar weakens it improves America’s external position. US foreign investments and overseas income gain in value. But the major benefit is in relation to debt owned by foreigners.
As almost of its government debt is denominated in US dollars, devaluation reduces the value of its outstanding debt. It forces existing foreign investors to keep rolling over debt to avoid realizing currency losses on their investments. It encourages existing investors to increase investment, to “double down” to lower their average cost of US dollars and US government debt. As John Connally, US Treasury Secretary under President Nixon belligerently observed: “Our dollar, but your problem.”
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