donsutherland1

The financial rescue package now moving toward completion is essential to stabilize the U.S. financial system. It is not risk-free, but the nation’s biggest financial risks lie beyond the ongoing financial crisis.

With respect to the rescue plan, aside from possible losses that might be incurred by taxpayers should the mortgage-backed securities acquired by the Treasury fail to regain sufficient value, the plan’s reliance on borrowing for all of its financing has implications for the nation’s credit standing. The plan will likely increase the nation’s debt, perhaps by 5% or more. As the U.S. has been suffering from a lack of fiscal restraint in recent years, that increased debt burden could translate into a reduced value for the U.S. dollar on foreign exchange markets and, in the absence of a sustained effort to restore fiscal discipline in Washington afterward, higher long-term borrowing costs. Should those outcomes occur, the U.S. would find itself in a relatively weaker position in global finance.

Earlier in the year, as the U.S. dollar fell relentlessly, there were growing calls from abroad for the U.S. to adopt a credible policy to shore up the value of its currency. OPEC began exploring the idea of denominating the price of oil against a currency basket and some of the Persian Gulf states came under pressure to consider de-pegging their currencies to the U.S. dollar. As economies slowed in Europe and Japan later in the summer, the dollar staged a comeback of sorts.

However, that comeback ended as money markets began breaking down last week. Now, the earlier concerns about the dollar are resurfacing. On September 17, China’s People’s Daily, the official newspaper of China’s ruling Communist Party carried a column by Tojgji University professor Shi Jianxun advising, “The world urgently needs to create a diversified currency and financial system and fair and just financial order that is not dependent on the United States.” With foreigners having purchased $0.56 of every $1.00 of new non-intragovernmental debt issued by the federal government since 2004, a gradual shift away from dollars by foreigners would have broad adverse implications for the United States. Over time, foreign nations would have a reduced stake in dollar stability.

To date, the dollar’s world reserve role has helped buffer the U.S. from a disorderly sell-off of the dollar. On September 20, The Washington Post reported, “Japan is a captive of its investment in the United States economy and its central bank has no real alternative other than to hold on to the massive amounts of U.S. Treasury bonds it owns… China has a direct interest in the U.S. crisis. It is estimated to hold a fifth of its currency reserves—as much as $400 billion in Fannie Mae and Freddie Mac debt.” Together, Japan and China hold more than $1.1 trillion in Treasury securities. A significant and sudden decline in the U.S. dollar or sudden large decline in Treasury prices would impair the value of those massive portfolios when both nations have had little chance to diversify their risk exposure.

However, over time, both countries could favor a gradual diversification of their portfolios, even slowly unwinding their Treasury holdings, especially if the U.S. remains on a fiscally risky course. Once that happens, the risk of a disorderly dollar sell-off would become higher than it is on account of its reserve status. Professor Shi is not alone in envisioning a world in which the U.S. places a smaller financial role. Earlier today, German Finance Minister Peer Steinbrueck predicted that on account of the U.S. financial crisis, “The United States will lose its superpower status in the world financial system. The world financial system will become more multi-polar.” In my view, at least for the foreseeable future, the U.S. will remain a Great Power in the world of finance even as its role diminishes somewhat. New centers of finance will likely ascend. For example, China could become Asia’s leading financial center should it sustain its remarkable economic boom.

It should be noted that the loss of reserve status for the dollar is not assured. Even if such an evolution occurs, its early stages would likely be gradual. It is the latter stages where the risks of such a decline would increase dramatically.

In my opinion, the current financial crisis, by itself, will not bring about the dollar’s decline as a world reserve currency. Instead, the gravest threat to the dollar’s role remains the nation’s long-term fiscal imbalances. Former U.S. Comptroller General David Walker warned in a recent Financial Times op-ed, “Beyond the turmoil for banks and homeowners, however, there is a super-sub-prime crisis brewing in Washington… Washington has charged everything to the nation’s credit card—engaging in tax cuts and spending increases without paying for them.” He added that on September 30, 2007, the nation’s unfunded liability stood at $53 trillion ($455,000 per household/$175,000 per person) and that it was rising each year by $6,600-$9,900 per American. That is an unsustainable course. In May, Dallas Federal Reserve President Richard Fisher warned that if that situation is “left unchanged,” it would be “nothing short of catastrophic.”

Well before then, foreign investors would have begun to flee in increasing numbers to safer, more attractive financial havens. In turn, that investor flight could accelerate the onset of what would almost certainly become the nation’s biggest financial and economic crisis. Worse, it would be a crisis that could not be resolved by the kind of financial system rescue that is now in the works. It would also be a crisis that would last far longer than months or years given the slow nature of demographic change.

All said, the current rescue package entails risks. But, those risks appear to be relatively modest when compared to the nation’s longer-term risks associated with its growing fiscal imbalances from its mandatory spending programs. Therefore, once lawmakers stabilize the financial system and adopt the necessary regulatory changes to reduce prospects of a near- or medium-term recurrence of the present financial crisis, they should devote their full attention to addressing the nation’s long-term fiscal imbalances. Otherwise, the evolution of that future crisis, which is now unfolding in slow motion and still subtle fashion as the enormous Baby Boom generation is in the early stages of retiring, could quicken, especially if foreign investors begin to flee the United States. That future crisis can still be averted. Early action can also reduce the costs associated with the transition from today’s unsustainable mandatory spending infrastructure to a sustainable one for the future.

jfuh

Thanks for the summary to put things in perspective

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The facts and science of the theory of anthropogenic Global warming

Kernel Sanders

Thank you for the analysis of our current economic position. If I'm missing the point of the post I apologize, but while all of that is true and all of that is very scary, none of it explains why the bailout is necessary

donsutherland1

Kernel Sanders,

I just looked at some implications if something along the lines of the Paulson plan is adopted and a longer-term fiscal threat of potentially greater magnitude and duration.

I believe some plan along the lines of the Treasury proposal with perhaps some stronger mechanisms for oversight, accountability, etc. is necessary to avoid the potential failure of the nation's financial system.

There are two big reasons to avoid systemic financial system failure: 1) The economic and budgetary costs (not to mention social impact) would be far greater than possible losses under the Treasury initiative; and, 2) The risk of debt-deflation.

Economic and Budgetary Costs:
Based on the World Bank's database of banking crisis, if one examines the fiscal cost and lost output as a percentage of GDP for the five systemic crises that occurred since 1990 in developed countries, one finds:

Median cost: Equivalent of $1.603 trillion of U.S. GDP
Mean cost: Equivalent of $1.680 trillion of U.S. GDP

Losses in economic output ran 1.5 to 2.0 times the fiscal cost. For example, Finland's lost economic output (21% of GDP) was the equivalent of $3.006 trillion in U.S. GDP. Japan's lost economic output came to 48% of GDP, the equivalent of $6.870 trillion in U.S. GDP.

Debt-Deflation:
Irving Fisher's classic work on the subject provides the following illustration:

[D]eflation caused by the debt reacts on the debt. Each dollar of debt still unpaid becomes a bigger dollar, and if the over-indebtedness with which we started was great enough, the liquidation of debts cannot keep up with the fall of prices which it causes. In that case, the liquidation defeats itself. While it diminishes the number of dollars owed, it may not do so as fast as it increases the value of each dollar owed. Then, the very effort of individuals to lessen their burden of debts increases it, because of the mass effect of the stampede to liquidate in swelling each dollar owed. Then we have the great paradox...of most, if not all, great depressions: The more the debtors pay, the more they owe.

Consider this for illustrative purposes, only:

A person owes, let's say $100,000 on a mortgage. He/She pays 10%. Deflation runs at 20%. In real dollars, the remaining mortgage has now become the equivalent of $108,000. That's what happens during the kind of destructive debt-deflation cycle Fisher described.

It should also be noted that during deflation, a nation falls into what's known as a "liquidity trap." A central bank can cut interest rates to 0%, but that does not increase bank lending, because the real interest rate is positive on account of deflation.

In such an environment, banks are unwilling to lend (deflation would lead to real returns on their loans being negative) and investors are unwilling to purchase financial assets (such assets lose real value on account of deflation). Instead, banks and investors have a powerful incentive to hoard cash. That's what happened in Japan in the 1990s.