Drowning together in dollars

SCMP March 1


Last year, foreigners bought a net US$700 billion of American assets, mostly government, agency and corporate debt. Is this not utter folly? When, I ask, do they expect to get their money back?

The players in the international money game mostly seem to believe that this is a "pass the parcel" where the music never actually stops. Or, if is does, it is because of one-off commercial accidents, which leave only a limited number of participants holding the likes of Enron debt.

What is not being asked is whether the galloping buildup of US debt is going to cripple the whole system; the dollar-based world which has existed since America unilaterally trashed the Bretton Woods agreement in 1971.

History should teach us to be wary of central bankers as well as governments. Yet the horizons of those who make the bulk of portfolio management decisions, be they investment banks, monetary authorities or fund managers, seldom look beyond 30 weeks, let alone 30 months. As for 30 years, forget it.

But given the state of payment imbalances, any sensible discussion of the future needs to start with a look backwards to at least 30 years ago. It should include an understanding of the psychology of the deeply indebted.

America's net debt to the rest of the world is approaching US$2 trillion. The buildup has been apparently cheap and painless because of the dominant role of the dollar in the global system. But the persistence of gigantic deficits is not just raising the question of how long and at what price this can be financed. It is beginning to cast a shadow over the whole system, which hinges on confidence in the ability of the US to meet its obligations. It looks increasingly unlikely that it can do so, even assuming that either a major US recession or drastic Asian currency revaluations come soon enough to halt the debt buildup.

Two groups of people are responsible for the impending crisis in international finance, which could prove at least as damaging as that of 1971. First, there is Federal Reserve chairman Alan Greenspan and the ranks of media and political courtiers who surround him. His response to every problem has been ever easier monetary conditions. It was his response to the supposed Millennium bug, the collapse of the Nasdaq in 2000, the failure of the Wall Street insiders' scam know as long-term credit management, September 11, Enron and the mini-recession of 2002, for example.

Easy money naturally leads to debt buildups and bubbles as households are positively encouraged to go out and buy petrol-guzzling sports utility vehicles with 0 per cent finance, or extract equity from their inflated house prices. Meanwhile, President George W. Bush is borrowing hundreds of billions of dollars from the next generation to buy votes and illusions of national security. The other group consists of those who allow this process to continue, the mostly Asian central banks who buy all this debt and the US investment banks with a huge vested interest in selling mountains of dubious debt, and related instruments, to gullible foreigners. Those foolish enough to believe that US government debt is really that safe should examine the record. Foreign investors who believed in the word of the State of Mississippi are still waiting for the redemption of an issue made in 1833.

All right, so that was a state matter not a federal one and preceded the civil war. But fast forward to the 1930s, when president Franklin D. Roosevelt was searching for ways out of the depression. He not only devalued the dollar and took the US off the gold standard, but repudiated all contracts, public or private, which were denominated in gold.

Again, in 1971, president Richard Nixon ended the Bretton Woods system by stopping the exchangeability of dollars into gold. Gold was becoming attractive simply because of lack of faith in a US which was printing money to finance war and a prosperous peace. The net result was a decade or more of high inflation.

I am not suggesting that high inflation will return. But one must assume either a period of artificially low interest rates to enable households and the US government to manage its debt at the expense of the foreign suckers who bought it. Or there is going to be an upsurge in US protectionism as the great promoters of free trade and globalisation find it is not working out as planned. The success of John Edwards' campaign for the Democratic nomination shows the way the wind is blowing. Republicans may in principle be more free-trade oriented, but it is hard to imagine the Bush administration, with its contempt for foreign views, defending free trade.

The third possibility is that there will be some form of dollar crisis which will lead the US to freeze the dollar balances held by foreign central banks, and even private institutions. Perhaps they would continue to earn interest, but the principal would be subject to controls on how and when it could be spent. The world needs the dollar as it premier trading currency. It cannot be replaced, except over many years. But it is possible to imagine a two tier-exchange system which separated the dollar's trading role from that of the disastrous state of the US foreign asset-liability balance.

Some Hongkongers may remember the problems caused by its membership of the sterling area when Britain's own overseas position became too weak to sustain its reserve currency role. Hong Kong kept its fiscal reserves in sterling but following the devaluation in 1967 had to be offered guarantees to ensure it did not switch to dollars, further draining London's reserves.

The dollar problem is different. There is no alternative to the dollar. But the size of the US foreign-debt overhang relative to the economy is vastly greater than it was for Britain.

The crisis may be avoided. But as long as Asian governments continue to bury their heads, fail to look at the facts or history, they will contribute to the demise of a system they claim to be supporting. They are underwriting the Greenspan hubris and in the process leading US households into deep water, and America itself into a debt position which will have dire consequences for its own influence and for the system over which it has presided.

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