Friday, May 29, 2009

Keep yer britches on: Nobody's replacing the dollar standard (yet) 

My dear friend Ed Morrissey opines yesterday that perhaps, just perhaps, the end of the "American Economic Era" is at hand.
Warning signs abound. Earlier this month, the Treasury discovered that demand had significantly decreased for its long-term bonds. In order to get buyers at its regular auction � the device by which the United States runs on deficit spending � it had to hike the interest rates it pays the bondholders. It signaled a lack of confidence in America's ability to sustain its debt expansion, which has the effect of worsening it through heavier debt service payments on the bonds they managed to sell.

That reinforcing cycle of cascading debt has analysts worried enough to openly discuss downgrading U.S. debt. Financial Times reported this week that Standard and Poor has already done that for Great Britain's foreign debt, issuing a �negative� rating that will require more generous interest terms in order to sell bonds in international markets. The same kind of deficit spending in the United States will eventually trigger a re-evaluation of the U.S. credit, as the United States and United Kingdom face similar debt spirals with no end in sight.
Now to be fair, Ed explains back on HotAir that "I allowed my imagination to run" and "I like to engage in a little speculative thinking," and that's great. I suppose I've done some of that on this blog. �But it's worth kicking the tires on this idea to understand what happened and why.

First, as regards the S&P warning, let us recall that these are the people who botched the rating of mortgages. �As Bob McTeer observes, the rating agencies cannot be discussing credit risk of sovereign debt: �It doesn't exist. �It has the ability to print non-interest-bearing money to extinguish its interest-bearing debt. �S&P might be saying something about inflation risk or interest rate risk, as McTeer acknowledges, but this isn't what rating agencies do. �Their ratings only speak to default risk, which doesn't happen with inflation. �(There are some that will conflate default with repudiation via inflation. �But officially, there's not been a default even in 1933. �And note that the preceding never applies to countries who, because of their inflationary tendencies, issue debt in foreign currencies.)

Second, nobody ever thought that central banks would continue to finance U.S. budget deficits ad infinitum, as they had in the previous administration. �Brad Setser seems to have the scoop on this: �The demand for U.S. assets has dried up because central banks overseas no longer have money to invest.
Looking at the 12m change actually understates the swing in central bank demand. In the first quarter of 09, the outstanding stock of longer-term Treasuries rose by $278 billion. Central banks � according to the Treasury data � only bought $25 billion of longer-term Treasuries (all in March, and likely mostly short-term notes). China only bought $15 billion (all in March). Over that time period, central banks bought $85 billion in short-term Treasury bills, including $32 billion from China.
Joshua Sharf thinks the Chinese are making a strategic investment in the U.S. economy, and Dallas Fed President Richard Fisher says all the Chinese talk about is monetizing the debt, but as I speculated a few months ago their motives are a little more basic: �They have no place else to turn. �And we know that China has had a decline in demand for bonds generally because their trade surplus has dried up in the global recession (even U.S. trade deficits with China have shrunk a little.) �China is warning now that they are not expecting to export as much capital as in the recent past.

This post should not be construed to minimize the potential damage done to the U.S. economy from high budget deficits and a rising debt-to-GDP ratio. �But the trouble for us is less than for other countries (including the U.K.) because there's no alternative to the dollar as a reserve currency, until someone builds it. �And that's not likely to happen as long as other countries have credit woes foremost on their minds.

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