(Mr. Ben Mah, author of America and China, America and the World, America in the Age of Neoliberalism, and Financial Tsunami and Economic Crisis – The End of American Hegemony, is a frequent contributor to this website.)
In an hour-long news conference on June 29, 2011, President Obama warned Republican Congress that failure to come to an agreement to lift the debt ceiling from the current $14.3 trillion debt limit would have “significant consequences for the U.S. economy.” The president said that “if agreement is not reached by early August, then the U.S. risks default—a blow to international confidence in the American economy—and seeing its credit rating downgraded, which would make borrowing more expensive.”1.
Indeed, the specter of debt default has recently raised alarms in the international financial community, as U.S. Treasury Bonds, the reserved holdings of the world’s central banks, will be downgraded to “junk” status if the U.S. government misses debt payments. The rating will probably be lowered from the current AAA even if interest payments are restored. For this reason, James Bullard, president of St. Louis Federal Reserve and a member of U.S. Federal Reserve has warned that “the U.S. fiscal situation, if not handled correctly, could turn into a global macro shock.”2.
As a matter of fact, this dismal prospect was confirmed by U.S. Secretary of the Treasury Timothy Geithner, when he admitted that the U.S. government is insolvent: “Never in our history has Congress failed to increase the debt limit when necessary. Failure to raise the limit would precipitate a default by the United States.”3. The IMF has also pronounced that the U.S. is bankrupt. In a July 2010 statement the IMF stated that : “The U.S. fiscal gap associated with today’s federal fiscal policy is huge for plausible discount rates … closing the fiscal gap requires a permanent annual fiscal adjustment equal to about 14 percent of U.S. GDP.”3. Unfortunately, a permanent annual fiscal adjustment in an order of 14 percent of U.S. Gross Domestic Product would mean a doubling of income, corporate and payroll taxes forever in the United States.
Most ominously, based on the Congressional Budget Office data, the fiscal gap of the U.S. government, according to economist Laurence Kotlikoff, is “more than 15 times the official debt,” or a colossal sum of $202 trillion. By 2030, the U.S. will have 78 million retired baby boomers that “will collect benefit from Social Security, Medicare, and Medicaid that, on average, exceed per-capita GDP. The annual costs of these entitlements will total about $4 trillion in today’s dollars.”3.
However, despite this gloomy financial prospect, it is a certainty that the Obama administration will continue to pay interest on the Treasury Bonds. Default would be unthinkable for America, as it would have to pay a higher interest rate and go through a belt tightening process of government downsizing. The situation also affects dollar’s reserve-currency status. But one might argue that the United States is already defaulting its creditors through the process of stealth devaluation. As matter of fact, central banks all over the world have suffered enormous losses by lending money to the U.S. government. However, “the losses have not been from non-payment but because repayments have been in a constantly debased currency—the dollar.”4.
As a result, China has lost more than 20 percent of its vast dollar holding in the past few years. Japan’s central bank has suffered a loss of over 66% from the purchase of U.S. treasury bonds in 1985, while for the European banks the loss would be close to 50%.4. For this reason, new lenders might demand higher interest rates. The Federal Reserve, on the other hands, has already injected trillions of dollars through its QE1 and QE2 into the banking system, and will try to depress interest rates and support bond prices. But interest rates are likely to rise; as inflation is raising its ugly head when the Fed monetizes its debt. The debt monetization of the U.S. Federal Reserve is intended to avoid the failure of U.S. government bond offerings. The Fed hopes to raise asset prices especially in the housing sector and increase economic growth, but debt monetization will have serious consequences for the U.S. economy, especially the purchasing power of the dollar. It will usher in an era of hyperinflation.
The U.S. Federal Reserve started monetizing the Treasury debt in November 2010, a few months after Mr. Bernanke announced his QE2 program. As result, “a much-diminished U.S. dollar safe-haven status has become evident in early March 2011, along with serious calls for a new global reserve currency.”5. More ominously, despite all the official optimistic pronouncements, the U.S. economy has not recovered. The weakness of the U.S. economy and the expansive war commitments has serious implications for the U.S. budget deficit and the Treasury funding needs. That has led to the desperate move of debt monetization by U.S. economic policymakers in Washington.
To be sure, the U.S. has no alternative but to use the printing press to inflate its way out of debt, as this has been commonly done by bankrupt sovereign countries. “The alternative here would be for the U.S. eventually to renege on its existing debt and obligations, a solution for modern sovereign states rarely seen outside of governments overthrown in revolution, and a solution with no happier ending than simply printing the needed money.”5. Unfortunately, simply printing money will destroy the value of dollars and dollar-related assets.
In reality, the stage was set for hyperinflation long before the 2007 financial crisis. Since President Nixon abandoned the gold standard in 1971, successive U.S. administrations have expanded money supplies and taken on debt and future obligations to an astronomical level that could never be repaid through tax increases or reduced government spending. Moreover, “the U.S. economy already had entered a severe structural downturn, which helped to trigger the systemic-solvency crisis.”5.
In the aftermath of the U.S. economic crisis, the government rescue of AIG and the entire U.S. banking system have exacerbated the solvency crisis. Washington’s economic policymakers, oblivious to the criticisms of their important foreign creditors, proceeded to massive quantitative easing. As a result, foreign demand for Treasury offerings has been decidedly weak and, since December 2010, the U.S. Federal Reserve has fully funded the U.S. Treasury debt.5.
Unfortunately, the monetization of the Treasury debt has resulted in a sharp decline of the dollar against major currencies. “Looming with uncertain timing is a panicked dollar dumping and dumping of dollar-denominated paper assets, which remains the most likely event as proximal trigger for the onset of hyperinflation in the near-term.”5.
The onset of hyperinflation has been marked by an increase in the price of consumer goods, as we have witnessed with the rising food and energy prices in the first quarter of 2011 in the United States. The U.S. government’s actions in response to the early stages of hyperinflation would be price control, state intervention in the dollar or to restrict capital flow, but the remedial effect of such interventions would be short-lived and may make the situation worse. This could be a painful experience for many Americans, and the “trouble could range from turmoil in the food distribution chain and electronic cash and credit systems unable to handle rapidly changing circumstances, to political instability. The situation would quickly devolve from a deepening depression, to an intensifying hyperinflationary great depression.”5. Hyperinflation is an “extreme inflation, minimally in excess of four-digit annual percent change, where the involved currency becomes worthless.”5. This will be a Weimer style hyperinflation.
In the aftermath of the First World War, Germany’s central bank, pressed by Britain and France for high reparation payments, dramatically increased money supply. The excessive money printing turned inflation into hyperinflation in Germany.
According to Milton Friedman and Anna Schwartz, the early stage of Weimer Republic hyperinflation saw a speculative foreign capital inflow, as has happened in the United States in recent years. This was accompanied by a rapid depreciation of the mark, but “as the mark depreciated, foreigners at first were persuaded that it would subsequently appreciate and so bought a large volume of mark assets…As German inflation went on, expectations were reversed, the inflow of capital was replaced by an outflow, and the mark depreciated more rapidly.”5.
As a result, the German currency was in ruins and the mark dropped to 18,000 to the dollar by January, 1923.7. “During the first few months of 1923, prices climbed astronomically higher, with no end in sight…The nation was effective[ly] shut down by currency collapse. Mailing a letter in late 1923 cost 21,500,000,000 marks.”5.
One might ask, given the fact that the U.S. is the world’s lone superpower while the Weimer Republic was a vanquished regime, is the United States comparable to Germany after the First World War? Unfortunately, “in certain aspects, the current U.S. situation is even worse than the Weimer situation,”5. according to American economist John Williams. The structural problems of the United States are: the outsourcing of manufacturing jobs; the “expensive social programs”; the excessive credit expansion as encouraged by the Federal Reserve to stimulate economic growth that leads to dollar debasement. Above all, the successive U.S. administrations’ commitment to wars and overseas military expansion has resulted in record-breaking trade and budget deficits. Consequently, the dollar, the world reserve currency, has experienced broad weakness as the U.S. economy has deteriorated. Therefore, “in today’s environment, both central banks and major private investors know that the U.S. dollar will be a losing proposition. They either expect and/or hope that they can get out of the dollar in time to avoid losses, or, in the case of the central banks, that they can forestall the ultimate global economic crisis. Such expectations and hopes have dimmed markedly in the last several years, as the untenable U.S. fiscal condition has gained more public and global recognition.”5.
As far back as 2005, the late prominent international economist Andre Gunder Frank used these words to describe the dollar Ponzi Scheme: “The Uncle Sam Ponzi Scheme Confidence Racket would -or will? - come crashing down, like all other such schemes before, only this time with a worldwide bang. It would cut the present U.S. consumer demand down to realistic size and hurt many exporters and producers elsewhere in the world. In fact, it may involve a wholesale fundamental reorganization of the world political economy now run by Uncle Sam.”6.
As a result of using trade as a driver for the Chinese economy and welcoming foreign direct investment with open arms, China has accumulated plenty of dollar assets. In fact, China’s foreign currency reserves, much of it in the form of U.S. Treasury bonds, has increased from around $600 billion in 2005 to over $3 trillion in 2010, a five-fold increase in five years. Consequently, any drastic dollar devaluation or hyperinflation in America will be a calamity for China. Chinese policymakers have only themselves to blame, as they have long been warned by international economists such as the late Andre Gunder Frank about the danger of the massive accumulation of U.S. dollar reserves, and Professor Michael Hudson about how the U.S. came to achieve world economic dominance. Economists such as Zuo Da Pei, Gu Genliang, Yan Bin and Han Deqiang in China have written about the pitfalls of foreign direct investment, the onerous conditions imposed on China for its WTO entry and dollar hegemony. In his letter to the Chinese premier, Dr. Hudson urged China to use the excess foreign currency reserves to buy out American and other multinationals’ subsidiaries in China. This writer in his book “America and China” also sounded the alarm about China’s massive purchase of U.S. mortgage-backed securities of Fannie Mae and Freddie Mac—to the tune of $450 billion, long before the financial crisis, and warned about the unpleasant consequences of opening China’s markets and embracing the WTO. Unfortunately, without exception, all these suggestions have fallen on deaf ears in Beijing.
Sadly, China is now facing the possibility of a U.S. default on its debt and, most ominously, the prospect of hyperinflation in the U.S., which will make China’s entire dollar holdings worthless. This indeed will be a huge disaster for China
Notes:
1. McGreal, Chris: “Barack Obama tells Republicans to take on sacred cows over borrowing talks”, June 29, 2011 Guardian co.uk.
2. Brandimarte, Walter Kaiser Emily: “Worries grow that the U.S. could default on debt:, June 8, 2011 Reuter
3. Kotikoff, Lawrence: “U.S. is Bankrupt and We don’t even Know it”, August 10, 2010 Bloomberg
4. Das, Satyajet: “Don’t be surprised if the U.S. Government default on debt”, September 13, 2008 SIFY.com
5. Williams, John: “Hyperinflation Update 2011”, March 15, 2011 Shadow Government Statistics
6. Frank, Andre Gunder: “The Naked Hegemony—Why the Emperor has no clothes?”, January 6, 2005 Asia Times
7. Engdahl, William: “A Century of War”, P 72 Pluto Press 2004
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