China is the Only Winner in America’s Future Debt-Induced Economic Meltdown
by Andrew Alexander
The views represented in this article are solely those of the author and may not be construed as in any way representative of the views or policies of Oxford Royale Summer Schools.
The Federal Reserve
America is far from unique in being a Western economy with a dangerous debt problem.
It is unique in its position and importance. The United States is the standard bearer for Western civilisation. What it does with its money matters – not only to America’s position in the world, but also insofar as the ideas and values inherent in the U.S. moral view stand and fall on their ability to make men prosperous, and with it free. For this reason it ought to be of great concern to the world that America’s economy and finances are being managed with spectacular incompetence by academics who use patently incorrect models to justify their policies.
America’s debt binge – still going strong
Let’s start with the numbers. At present, America’s national debt stands at $17 trillion. This sum of money is growing at $1 trillion a year, and has increased from $10.6 trillion when President Obama took office. It includes only the liability for sums already borrowed. The U.S. has committed to spending on social security and Medicare programmes, which creates liabilities which are unfunded. Forbes notes that some commentators put these unfunded liabilities at around $126 trillion, or $1.1m per taxpayer. The total GDP of the U.S. in 2012 was $15.7 trillion.
We are used to incomprehensibly large numbers being bandied about in terms of debt, and we have grown inured to them. But think of that deficit number this way – every single year, the U.S. government over-spends by an amount of money so vast that if you had been born in the same year as Christ, and spent $1m every single day since then, you would still be more than 700 years away from reaching a cumulative $1 trillion.
No economy can comfortably add 6.4% a year to its debt burden in perpetuity, and America is highly unlikely to grow its way out of the problem. From 1870 to 1999, U.S. economic growth averaged out at 3.7% each year. Since 2000, that growth has dropped to a much more sedate 1.8% per annum. At the same time, government debt has been growing at around 4.5% per year, as opposed to around 3.3% per year between 1929 and 2000. Given that the period between 1870 and 1999 saw the last blast of the industrial revolution, both of America’s industrial rivals bringing one another to bankruptcy on the battlefields of France, an enormous natural endowment from the Gulf of Mexico, the internet revolution and the dawning of the digital age, it does not seem fanciful to suggest that a great deal of optimism is required to believe that the twentieth century growth rate can be recaptured.
The status quo is unsustainable. Even given the lowest interest rates in history, debt interest alone accounted for $415bn in the last 12 months, equal to 15% of federal income. As the debt grows, so too does the interest burden. The White House itself foresees an annual increase in net interest payments of 14.6% between 2012 and 2022, outstripping the growth rate of any major world economy and growing at nearly double the 7.6% projected annual increase in tax take. The debt has already become self-sustaining, given that almost half of the annual deficit is constituted by interest payments.
A problem as old as statecraft
Economics is a remarkably simple discipline, albeit one clothed in the rich regalia of impenetrable academic jargon. It is also one in which history repeats with tiresome regularity. As can be seen in the analysis above, the United States, along with Britain, Japan and the Eurozone, is faced with a problem as old as empires: the state’s spending is not covered by its tax take, nor has it been for some time, nor will it be for some time into the future.
There are three ways out of this dilemma, none of which are pretty, and none of which are discrete. A prudent policy mixture probably involves all of them. In increasing degrees of damage: shrink the state, expand the tax take, print money.
Whatever the conceptual arguments for or against a great state, reducing it in size to save money will, all things being equal, hit household incomes, certainly the households of state employees, those who do business with the state, and those who receive some form of allowance from it. This is to say — everyone. Expanding the tax take is arguably an even worse move – it takes money from households to be spent by the state. Unfortunately, the multiplier effect of household spending tends to be larger than that of state spending, meaning that a transfer from the former to the latter lowers the growth trajectory of the economy permanently.
The worst way out, by far, and the most tempting, is the resort to the printing press. Since the abolition of the gold standard, the Western world has lived on fiat currency, backed only by trust in the sound sense and moral inhibitions of the central banks which print it. The formal independence of central banks from the government is intended to remove the temptation to abuse this trust.
It’s easy to see why this should be of concern. When a great empire falls, it is usually presaged by a collapse in the currency. Between 218 and 271, a period during which the Roman Empire lost Britain, France, Spain, and most of modern coastal Turkey, the silver content of its coins fell to just one five thousandth of its original level. The French Revolutionaries, having deposed a King, managed to bankrupt a peasantry also through the ruinous assignat system which saw inflation peak at 143% a month. It took delivery of the Republic to another absolute ruler in Napoleon to restore order. This parallels the German experience a century and a half later as she slipped from the flawed democracy of Weimar to the barbarous state evil of the Nazi system.
The lesson is always the same. When the value of money is in a state of flux, social order will break down also. This is understandable – men revolt when their standard of living is in sharp decline. When a government creates money to sustain itself, it diminishes the value of money held by individuals, as a greater amount of cash is now chasing an identical number of goods, meaning prices go up. Most production is temporary – the farmer converts corn to cash as a store of value. In so doing, he ensures his wealth will not wither and die over the years as corn does when left unharvested. When his store of value is rendered worthless by the deliberate action of the state, the state creates for itself a grave enemy.
These lessons are well understood. It is a testament, then, to the genius of the central bankers and finance ministers on both sides of the Atlantic that they have persuaded themselves a fourth way exists to deal with the debt problem – permanently low bond yields.
High debt levels are serviceable for longer when rates on government bonds are low. Rates on government bonds are low when they are in great demand. In this view, a state may suspend the difficult fiscal choices inherent in expanding its tax take (43% of U.S. households do not pay federal income tax), or cutting its spending.
China won’t prop up U.S. debt accumulation forever
At present, U.S. debt interest yields are forced down by demand from two sources. The first of these is China. The Chinese hold $1.25 trillion in U.S. government bonds, with around a further $122 billion held independently by the government of the port city of Hong Kong. This is around 8% of the entire U.S. debt.
[pullquote]The Fed intends to sell down its U.S. treasury holdings eventually. There is no possibility that it will do so.[/pullquote]There is a solid historical rationale for this. China’s emergence as a global exporter has flooded its exchequer with foreign capital, a result of the large number of state-owned enterprises which are now global producers, as well as a comment on the general tax rate. One support of this export strategy is that the Chinese currency has not floated. Converting foreign export earnings into renminbi would therefore both destroy value and also present the serious danger of unwanted currency appreciation. Foreign earnings have, therefore, been largely parked in U.S. treasuries as a store of value. In addition, by supplying credit to the U.S., the Chinese have sustained their largest client market. A collapse in U.S. borrowing translates to a collapse in an export industry worth $438bn last year and growing at an annualised rate of 8.2%.
However, Chinese capital cannot underpin treasury prices forever. There are two good reasons for this. The first is that China’s view of its role in the world is not as a subordinate partner to an indebted U.S. hegemon. The Chinese government has repeatedly called for an alternative to dollar dominance, and both culture and gold buying statistics suggest that they would like it to be underpinned with something more substantive than trust and promises.
This will be a process which takes considerable time to unwind fully. However, the beginnings of a coherent move towards a free-floating renminbi are already in evidence. This is not least the case in the country’s dealings with Great Britain. In June the two countries’ central banks opened a swap line worth $32.6bn. In a visit this October, George Osborne signed an agreement which will see direct trading of sterling against the renminbi, one of only four pairs with the Chinese currency, in exchange for looser regulation of Chinese banks in London. UK institutions were also given a £8.2bn investment allocation in Chinese companies.
This activity also makes sense in the context of China’s second rationale for reigning in dollar investment. A semi-autocratic political system has been sustained in the information age by virtue of the rapidly improving living conditions of the population – 79% of Chinese feel their standard of living is improving each year. This prosperity fuels demand both for raw materials and high-end manufactured goods. These are more affordable with a stronger currency, particularly when they are dollar-denominated. The drive to support living standards in China will implicitly require a withdrawal of support for U.S. treasuries, and hence the dollar, over time.
This is not to suggest that China will dump its stock of treasuries. Only in extreme circumstances, such as a military stand-off over Taiwan, could it conceivably be in China’s interest to realise a large paper loss in order to spite a strategic rival. What is more likely to happen is a slow withdrawal of support – bond holdings not rolled over, a gradual diversification away from dollar-backed securities – and as the Chinese credit tide ebbs out, so the U.S. will find debts harder to finance.
However, the Chinese are not the only large-scale state purchasers of U.S. assets. In fact, they are dwarfed by the holdings of the U.S. itself. At the end of September, the U.S. Government owed $4.76 trillion, or 28.4% of its debt in issue, to itself. Of this, $2.1 trillion was owed to the Federal Reserve, the vast majority acquired under Quantitative Easing (QE). Two social security trust funds hold a further $2.76 trillion between them – a legacy of the days when social security receipts exceeded obligations and the balance was invested in treasuries.
QE – reinventing the breaking wheel
QE is the fourth way out of the debt dilemma. It amounts to a scheme in which the Federal Reserve buys up the U.S. government treasuries held by banks at market value. Initially, this scheme was seen as a way of recapitalising banks and providing cash which would be lent in the real economy, mitigating the effects of the crunch on consumer credit seen in the financial crisis. To this end it was quite successful, certainly it prevented deflation, although in reality, banks tended to diversify into other assets when they sold treasuries, rather than commit to loans.
Unfortunately, this gave rise to an unintended consequence. The very lack of success which QE met with in transferring capital into the ‘real world’ economy has now become its prime attraction to policy makers. At present, central banks create new money, then they use this money to finance government debt through the debt markets – one arm of the state printing money to support the spending of another. So far, so Weimar. However, because the Fed buys bonds from banks, using the secondary market, the capital goes to a financial institution rather than an individual. The bank uses this capital to buy other assets. The result in a great inflation in other asset categories – particularly shares – but not a large driver of inflation on Main Street. In this fashion, the academics and technocrats who run central banks worldwide imagine that they have re-invented the wheel – a solution to the debt problem which is neither inflationary nor which requires a fundamental rebalancing of the state.
On an intellectual level, it is possible to argue that QE is not money printing, as it is intended to be reversed – eventually, the Fed intends to sell down its U.S. treasury holdings. There is no possibility that it will do so. The level of U.S. debt means that if it is to be financed over the long term, there must be very low interest rates. The larger the debt burden, the higher the market interest rate. The higher the market interest rate, the higher the need for QE as a corrective. There is no possibility of America exiting QE while it has such a large debt load, and there is no chance of it dealing with its debt burden while QE is acting as a painkiller and masking the long-term damage.
That, then, is the real consequence of the U.S.’s debt binge – permanent QE. This will have many consequences itself, not least of which is creating a large inequality gap between asset owners and wage earners, as asset price inflation becomes the main tenet of the U.S. economy. The longer this system persists, the more instability it brings. Eventually, it will lead to the ruin of the currency – the circular flow of money between Fed and Capitol Hill being such that the cost of dollar-denominated assets gradually outstrips the ability of those holding dollars to pay for them. The mechanism is new, but the result of printing money will be the same as in post-revolutionary France.
Thirty years after Napoleon seized power in France, a Frenchman of the old order, Alexis de Tocqueville, took stock of the great republic across the water in his most famous book Democracy in America. More than 20 years later, he reflected in The Old Regime and the Revolution on why it should be that America made the revolution work while France’s floundered on the printing press. One of the reasons he cited was that in America, practical men held the status that the irresponsible intellectual class behind the assignat held in France. If it was true then, it isn’t now, and the cleverest men in the room are on course to wreck America, and with it, the West.