Reckless fiscal and monetary policy have put the US government and the economy in this mess, and the Fed and the government will use reckless fiscal and monetary policy to try to escape it.
“The government will have to use more debt to pay off past debts.” When a company does not make enough profit to pay its bills, but instead borrows more and more to cover the losses, we call it a “zombie company.” By that standard, the United States is a “zombie country,” better known as a “failed state.”
I do like to point out what I believe is an overlooked function of Treasuries: that of safe storage of large amounts of USDs, such as the USDs you might receive in exchange when, I dunno, Chinese companies are selling stuff to U.S. consumers. What do you do with the USDs? It’s not like you’re getting FDIC insurance on deposits numbering in the hundreds of millions. So you buy Treasuries for storage, and it turns out those are pretty solid collateral for loans, and to boot over time have been sellable in a very deep and liquid market. I’m not saying that can’t all end someday, but for now, the USD is still a big, important currency in the world, and you need a place to park those USDs if only temporarily. So are Treasuries purchased as investments, or for storage? I think the latter is the more important reason.
That´s a great point! I see lots of commentary that China is trading stuff in yuan and Saudi Arabia is trading oil in INR ... but nothing rivals the dollar in market depth and liquidity, and you can´t put a billion dollars into your pillows. If you're interested, I wrote a post exactly on this topic a few days ago. Let me know what you think!
The reason why China has been building its gold reserves for years now is to use it to back the value of its currency when its currency becomes a reserve currency for countries tired of being beholden to the US because they have large holdings of trade surplus dollars. As that transition occurs and a large number of countries decide they want to be paid in Yuan for their products, China's currency will rival the dollar for liquidity and market depth. And by that time, which is not all too far into the future, China will have developed so many more markets for their products by virtue of their investment in the Belt & Road project that the Yuan will be traded in as many places in the world as the dollar. But there will be a higher demand to hold Yuan, since the government backs it with Gold reserves that limit the amount of Yuan that can be printed each year. That makes it more valuable than a currency like the dollar or the Euro whose government(s) prints as much of it as they want to finance an out of control level of spending that will bankrupt their economy and cause their currency to crash.
I see where you're coming from, and I agree, China has been buying gold. But in absolute terms, not nearly enough to become a meaningful factor to back its currency. Global central bank (meaning all central banks of the world) bought about 570 tons of gold last year, and their share of gold purchases compared to other buyers (jewelry, industrial uses, etc) isn´t really rising. 570 tons have a market value of about $36.5bn (and just to make sure we don´t forget - to buy gold you need dollars!). Again, that's globally. China bought about 2bn. That´s a rounding error on the balance sheets.
If other countries want to hold yuan, those reserves will be usable for China only, because there´s nothing else you can do with it, as yuan are not freely convertible. Do you want to expose yourself to that risk? Just a few days ago China imposed sell restrictions on the Beijing stock exchange, i.e. large investors can´t get their money out.
Even cash-strapped Russia is quickly getting tired of selling oil in local currencies, as those currencies are essentially useless in global trade.
We already are seeing the workarounds being put in place for the issues you raised. Countries that sell their goods for Yuan are able to exchange those Yuan for Gold at the Shanghai Gold Exchange, and the Gold can then be exchanged for other currencies or commodities. The Chinese are establishing swap lines between Yuan and the currencies of the nations they trade with to increase the global liquidity of the Yuan, and they next step will be to allow their trading partners to pay for Chinese goods and services with one or more commodities the Chinese will be willing to accept since they now import those goods anyway. So the Saudis can pay with crude oil for a new airport built by a Chinese construction company, Russia can pay with wheat or oil or nickel or aluminum for Chinese products, South Africa with diamonds or gold. There are numerous ways to finance global trade in a world where shipping huge amounts of cargo over long distances has become so commonplace.
Offshore Yuan already can be traded freely to facilitate the exchange of the currency between countries that trade with China. By pegging the Yuan money supply to the price of Gold, the currency should gain increased stability even if not convertible. There already exists about 41 trillion dollars worth of Yuan money supply, of which about 1.26 trillion dollars worth circulates globally.
About 8.3 trillion US dollars circulating in the world supports the approximately 24 trillion dollars of annual global trade today. So for the Chinese to achieve half of global trade being performed in Yuan, which would make it truly an alternative global reserve currency, the circulating Yuan would have to rise by a factor of 3.29 times. That amount will reduce as the price of Gold rises, since the existing Yuan becomes more valuable when pegged to Gold if Gold rises in price.
So the Chinese have enough currency available for them to support the Yuan as a global reserve currency, what they need to do is convince countries to trade in it and to hold it. The swap line extensions, the peg to the Gold price, and the convertibility to Gold through the Shanghai Exchange should all help that process. And allowing countries to pay for Chinese goods in products those countries make domestically that China needs also should increase the amount of trade China performs with other countries, which eventually will raise the utility of the Yuan across several continents.
The issue for the Chinese is having enough Gold to support the Shanghai Gold Exchange, as that is a critical element in promoting acceptance of the Yuan as a reserve currency. The Chinese eventually will need a value of Gold holdings at least as large as the amount of Yuan that will circulate to support global Yuan based trade, which as I wrote above would be about 4.15 trillion dollars worth of Yuan once half of global trade is performed in Yuan. That number gets reduced by perhaps 25-50% if countries chose to use their native commodities to exchange for imports. At $2100 per ounce of Gold, the 4.15 trillion dollars of Yuan would equate to about 60,000 tonnes of Gold reserves, at half that amount the Chinese would need 30,000 tonnes of Gold reserves.
Estimates of China's present Gold holdings range from 2000 tonnes to 33,000 tonnes, and no one other than a few Chinese leaders likely knows for sure. But we have to assume that it is significantly higher than the 2000 tonnes that are considered an official estimate, because that amount is not large enough for the Chinese to support their Shanghai Gold Exchange initiative. My guess is that the "official" estimate of their holdings are as undervalued as the US-stated holdings of 8800 tonnes are over-valued. So the Chinese likely have eight times as much Gold as the official estimate, which puts them at roughly 15,000 tonnes. Enough to support the Shanghai Exchange but only about half of what they will need to completely support the Yuan as a global reserve currency for half the world's trade.
They have been very smart and disciplined with how they have accumulated, buying on dips in price and not pushing the market to panic. As a result, the price of Gold has risen slowly over the last decade, and likely will continue to do so until supply available for sale actually gets tight. Then the price will jump sharply. I see the Chinese strategy as accumulating as much as they can while the Gold market steadily but slowly moves higher, and then once the panic sets in and the price jumps, the existing Chinese holdings will rise enough in value that they will be able to support the global trade in Yuan with the Gold they already own.
Now that's where the willingness to accept commodities for trade will really help the Chinese. For as the price of Gold rises, other commodities should rise as well since they will be in demand by countries that want to pay for Chinese imports with them. At the same time the buying power of the US dollar will be falling, and as a result, the number of countries that want to trade in Yuan or fungible commodities will increase, putting the Yuan as the predominant world reserve currency.
The danger of having the world's reserve currency, as both the British and the Americans have found out, is that they had to constantly run trade deficits so as to supply the world with the Sterling or dollars it needed to carry out its trade in dollars. Unfortunately for them, they did not have the shipping resources that would have allowed them to take payment for exports in commodities, which would have reduced the amount of currency they needed to supply the world to maintain their currency's reserve status. The Chinese seem to have solved that problem with their willingness to be paid in commodities and through the extension of Yuan swap lines, so they will not have to become a trade deficit country to ensure there are enough Yuan circulating in the world.
As with all economic forecasts and predictions, there are a lot of assumptions that may not come to pass, and the outcomes of the steps now being taken by the Chinese to become a dominant player in global trade through their currency may be far different than what they thought would occur. But to date they have shown that they are not going to make the mistakes their predecessors made, and will try several new approaches that incorporate historical wisdom with modern convenience and reality. I think the main advantage they have is that there are so many countries, especially in the global south, that want away out of the dollar-debt traps they have wound up in, where their commodities and currencies wound up being under-valued, and their costs to trade were over-valued. The advantages of the system the Chinese are establishing may help these countries realize greater opportunities than they had in the dollar-based system, and I think they will at least try this new system to see if it benefits them. Much of the benefit will be determined by the price of exchange the Chinese set for the commodities they accept in trade, along with the projects the Belt & Road initiative the Chinese open up to investment of trade surpluses of their trading partners and the resultant profitability of those projects. The entire transformation will not happen overnight, but so far the right foundations are being constructed.
The experience of the UK and the US as reserve currencies was very different between them. The UK was a large net exporter, and it had a large current account surplus in the 19th century. The current account can be expressed as CA = S - I. In the UK it played out that excess domestic savings were invested not locally (resulting in a balanced CA), but globally, as the UK essentially built much of the infrastructure in its colonies (roads, bridges, and especially railroads). This led to underinvestment at home and cost the country its leadership as the European industrial leader, which Germany took over quickly.
The US however started running a huge CA deficit, especially in the new millennium. I remember we ran large bets against the dollar around 20 years ago as the deficits escalated, and indeed the USD started declining.
I agree that many other countries are trying hard to get away from the dollar hegemony, but I don´t think they will succeed even in the medium term (unless the US self-demolishes the dollar, which is not unthinkable). There is no clear structure in those efforts, except that many countries are doing something and China is big. And IF they should really have some success, they will immediately start fighting over who gets the benefits. There are large power blocks - Russia and the Saudis, two of the three largest oil producers, and China, the largest user and importer, and one of the largest economies in the world. They all have their own but conflicting incentives. I just don´t think that having a common enemy, the US, will hold them together for long.
The US had and has a similar problem with having the dollar as the reserve currency as the British had when quid ruled the financial and industrial world. Its why the US had to abandon the Bretton Woods regime as far back as 1971, when the demands for gold and silver on the US Treasury by foreign nations seeking to convert their trade surplus dollars were greater than the reserve holdings of the Treasury, and President Nixon had to temporarily suspend gold convertibility.
It started in the car industry, as OPEC pushing up the price of oil led to heightened demand for gas efficient cars. Over the next twenty years the US trade deficit soared until the 1990s, when Chinese factories employing labor at far lower rates than workers received in the US caused American disinvestment to skyrocket as factories in the US were closed and the US trade deficit soared to its highest levels ever. To meet the drain on money supply within the States, the Federal Reserve had to allow money supply to grow at rates that ordinarily would have been inflationary, but the combination of lower prices due to lower labor costs that went into the imported products that Americans were buying from China, along with the productivity gains of computerization, offset the monetary effects of accelerated money growth to accommodate an import economy. That's why your bets against the dollar worked, because as a net importer the US is constantly having to print more money to facilitate that trade. And since China and other foreign exporters to the US began to accumulate large dollar reserves, the US government realized it could expand its deficit spending and finance it by borrowing back the dollars sent overseas to buy foreign goods. Hence the twin deficits that are soaking up capital from the US and leading to financial destruction.
But now the amount of dollars in the world has become burdensome to nations that are net exporters to the US, as well as anyone who produces a product that is traded predominantly in dollars. They are losing faith in the ability of the US to control its fiscal house, and when faith erodes credit tightens. That process is lethal toa fiat currency the intrinsic value of which is faith and credit in its issuer. Additionally I think a lot of net exporting countries to the US are tired of investing their trade surplus dollars to finance the fiscal irresponsibility of the US government. Instead of funding US transfer payments to the people that have been made unproductive as the US sold out its manufacturing industry, these exporting nations recognize there are capital-intensive projects waiting to be financed in Asia, Eastern Europe, and Africa that will be far more productive, beneficial to those regions, and profitable both directly and indirectly. Basically to bring areas and regions on the two continents fully into the industrial and then information age. And these currencies realize that if they could be paid in a currency tied to some stable fungible asset like a precious metal, energy resource or agricultural commodity, they will receive greater real value against inflation than to hold US dollars. It’s a similar motivation to the investment in crypto-currency, even though crypto I backed by faith and credit of trade counter-parties instead of a government issuing fiat currency. Investors of capital around the globe are coming to realize that there are too many dollars in the world for them to hold their value, and too much US debt in the world for anyone to be comfortable that they will be repaid their capital lent to the US government.
The problem for the countries that want to escape the dollar is what to use instead. The easy solutions to the problem already have been solved, thanks in large part to the thoughts of Russian economist Servie Glazyev. By making the new currency not sovereign to anyone nation but spread amongst all the nations that trade and invest with it, the problem of one nation having to explode its money supply to finance trade among then on-dollar countries is answered. It’s a similar solution to that which financial exchanges employ to spread counter-party risk among all the exchange’s members. Furthermore, by allowing member countries to obtain the new currency not just by exchanging their sovereign currency but also by pledging metal and commodity reserves of their respective countries, the new currency is ostensibly backed by real assets, which increases the real value of the new currency while reducing its volatility.
But the problem they haven’t solved is what to do with the trade surplus dollars generated by the trade surpluses of the countries that are net exporters to the US. All the new currency does to ameliorate that risk of holding dollars is transfer it to the new currency, which essentially leaves it as a risk to the nations transacting in that currency. Granted the risk is reduced because trade occurring between counter-parties other than the US will be free of any dollar inflationary effects. That is a significant risk reduction when you consider how much oil and other commodities are transacted in dollars even when neither of the parties to the transaction is a US entity. But the US keeps pumping nearly a trillion new dollars into the world every year through balance of payments deficit, adding to the many trillions of dollars already held by countries around the world. If the objective for the non-US world is to reduce its risk of holding dollars, the establishment of a new currency does not yet satisfy this objective. The Chinese answer is to replace a sizable amount of their present exports to the US with exports to other countries. Once accomplished, this change will reduce the annual increase in dollar holdings the Chinese absorb through their exporting activities, but takes a long time to develop. It is one of the main motivators for their Belt & Road initiatives, to build the strength of foreign economies so they can afford to consume greater amounts of Chinese goods and services. And in so doing, other exporting nations will be able to sell greater shares of their exports in exchange for currencies other than dollars, preferably the new currency.
Simultaneously, countries with high dollar reserves presently invested in dollar assets are liquidating these holdings slowly, and re-investing the dollars in other non-dollar assets. The progressively larger holdings of precious metals by the central banks of net exporters to the US is one sign of this re-balancing. I suspect that some of the re-investment may actually be going into crypto-currency as well, which is kind of ironic since nations have a vested interest in seeing crypto-currency collapse. As exporters send few goods to the US, inflation - due to supply shortages caused by fewer exports to the US, and then due to the US having to build manufacturing facilities and produce at higher labor costs the goods it no longer can buy from exporters – will exert downward pressure on the values of most dollar-priced investment instruments, which is another impetus forcing net exporters to the US to reduce their dollar-based investments now.
The entire process will take a few years if not longer. Countries that export to the US must reduce both their exports and their dollar holdings slowly lest the US government retaliate against them by erecting tariffs against their goods. And its going to take time to develop consumptive economies across Eastern Europe, Asia and Africa, even with the massive Belt & Road spending. But eventually it will be accomplished, and that’s when you’ll see the emergence of a new currency to rival the dollar. The process will be especially painful to the US if it does not reduce its budget deficits before the advent of the new currency. Losing a trillion dollars a year of new foreign purchases for the Treasury debt is going to be costly to replace, while at the same time structural supply side inflation will be causing interest rates to rise for US government borrowing. The point will come that equities will be sold in large numbers to invest in debt instead, causing a negative wealth effect that makes the economy recede and the deficits even wider. Its a classic debt trap that the US is heading into, and its going to cause tremendous social and economic problems within the States that a divided country may not survive. I don’t think for one moment that the Chinese have not factored this eventuality into their plans, and it’s the way they will counter the prospect of a war with the US.
So I have little doubt that this is what’s coming. The benefits will be divided in typical capitalist format, to each according to what they put into it. But the way the Chinese and other BRICs nations are constructing this consortium, it’s a win for everyone. More trade, more consumers, more choice for where they invest their trade profits, and more investment profits from investments that serve their constituents. This is the Asian Century, and this is how they will manifest it.
"The problem is multifaceted, but the origin is profligate government spending."
Let's be crystal clear with the term, "government spending." They are throwing out money on every level, from the illegal immigrant that just crossed the Rio Grand to the Fortune 500 company getting a bailout, subsidy, or pork filled government contract.
They are paying to keep the music playing. And their paying is destroying what little is left of a capitalistic, free market.......which in turn causes them to have to hand out even moar welfare.
But there is no competition.......nowhere to turn........especially for the American people. What will you do to stop it? How can you fight it? And that goes for 85% of the rest of the world. They are swimming in a pool of gasoline........called dollars........and dare not light a match. There are very few, if any countries on this planet, that can do what Russia did. Russia has all the energy it needs in-house; they grow their own food; they have all the natural resources to function as they are; AND they have the technology and military to defend it. I cannot think of another country so positioned.
The world is held hostage by the Lord of the Dollar. Of course the leadership of these countries is bought off and enjoys their servitude. They get everything the dollar can buy......to their heart's desire. Their "desire" continues to grow and places more bricks on the load we carry. "The tip of the pyramid is supported by the base."
There is no escaping a burning house when you are locked in with nowhere to go.........even if you got out. As long as they can keep printing dollars and throwing them on the fire, it goes on from here.
With one major caveat.............E N E R G Y. A reduction, in the amount of energy available, will put a wrinkle in their money printing. Energy is the bottom of the pyramid, human or otherwise. All the major policy and actions of today revolve around securing moar energy to keep the ponzi rolling.
The world is using a billion barrels of oil every ten days. That is unsustainable. "Growth" requires moar. If we cannot maintain our current energy use, we cannot grow. If we cannot grow, the debt ponzi collapses on itself. Energy is the key. Have you ever looked at the active inflow of millions of illegals into Western society as a form of "energy." Human energy/labor is the oldest, most basic form of energy in world history.
PS.....And people think slavery ended. In the 21st century we no longer have to go catch them.....they come to us.
I don’t disagree that the government is spending too much. Who would disagree with that! I’ve taken an accounting class or ten. My solution is about all that’s left in this ridiculous spending spree.
The refunding of the US debt problem is bad for the long run but not as bad as it seems for the present.
The Money Market Funds have about $6 trillion that gets rolled over once a year at least, so that provides a good source of funds for the Treasury every year.
Foreign investors hold $7 trillion of US government securities, and while that amount likely will go lower, it will happen slowly as foreign governments whose companies are exporting to the US and hence natural holders of dollars will not risk having trade tariffs imposed against their exporters by quickly reducing their lending to the US government.
The annual interest on the US debt is about a trillion dollars and likely will not move much lower, so that's another source of funds that usually is re-invested in US government securities.
Insurance companies will continue to be buyers of longer term US government debt as they need future revenues to match against the future liabilities of the life policies they sell.
The Federal Reserve still holds about $5 trillion in US government securities, and although they are reducing their holdings, they are doing so at a glacial pace so as not to adversely affect market interest rates, especially in the longer term securities.
The rest of the $33 trillion the US government needs to finance comes from investment funds of investment and banking institutions and funds that serve the general public. Considering the value of US equities is around $50 trillion and that amount is usually about one and a half times the capital invested by fund entities in debt securities, there is a pool of about $30 trillion from which the US government can borrow. Presently the Treasury is probably taking about $15 trillion from the $30 trillion each year, with the rest being invested in a host of different debt instruments like US Agency securities, corporate bonds, municipal bonds and mortgage/asset backed securities.
The problem gets a lot worse ten years into the future, for several reasons. First of all, the US debt is projected to reach $50 trillion by then, which would require the Treasury to be the sole borrower of all the capital presently dedicated to debt securities in the US. Now while the dollar money supply will be a lot larger in 2034 than it is now, the increasing demand for capital to fund the US debt will cause a "crowding out" effect for other entities that need to borrow dollars. The premium above the rate of inflation that borrowers will need to pay to borrow money (the "Credit Premium") will increase, making borrowing more costly in real terms than it is today.
Additionally, at least two other factors will make borrowing a lot more difficult than it is today, and the US government will pay a dear price for its past profligacy. Firstly, by 2034 virtually all Baby Boomers will have retired and many will need to draw down on investment capital to maintain the standard of living they want in retirement. Depending on what happens with life expectancy during the next ten years, there could be a great deal of investment liquidation by the surviving Baby Boomers in both equities and debt, and that liquidation could reduce the pool of capital available for borrowers to borrow. Secondly, the BRICs movement, if it develops as planned, could reduce significantly the amount of foreign investment in the US equity and debt instruments as BRICs members choose to convert more of their dollars into BRICs currencies so as to invest in capital intensive projects in their respective geographic locales that will provide higher returns than US debt instruments and also offer improved standards of living for their residents.
Both of these factors will increase the real cost of borrowing, and the reduced supply of capital available for US lending will put pressure on borrowers to bid up the rate of interest they are willing to pay for capital they need to borrow. Combined with the selling pressure of Baby Boomers needing to liquidate investments, the increased real cost of borrowing is likely to exert downward pressure on the value of US equity prices. That decline could be substantial depending on the number of Baby Boomers liquidating and the amounts of capital they withdraw from equity markets. One effect of the falling equity values could be a negative wealth effect that would result in a reduction of consumption across the economic landscape, causing an ongoing and lasting recession that in turn would push up government expenditures and debt at a time when the cost of borrowing in real terms already is rising. At that point, the value of the US currency would be in dire trouble, as the investment community's faith in the credit of the US government being able to meet its debt obligations would be seriously questioned. A negative feedback loop would then result as the falling currency value would cause further liquidation of equities which would deepen the recession and increase even further the growing government debt.
Of course, as with all predictions of the future, there are a lot of "ifs" attached to any outlook. But there are several factors that influence the eventual outcome about which we can be certain. There will be a tremendous number of Americans retiring during the next ten years and needing to liquidate a substantial portion of their investments. Absent the kind of crisis situation as I describe above occurring faster than the next ten years, the US government will meet if not exceed its own projections of $50 trillion in debt by 2034. And as the US government borrows more, there will be upward pressure on Credit Premia, making borrowing more costly in real terms, which will have a negative effect on corporate profits, and thus, equity prices. Knowing this much is certain, its difficult to have a positive outlook on the future fiscal health of the US government or its economy.
Great read. This will be put aside until it can’t and when it can’t watch out below. Yields will climb next year with election volatility and geo political tensions raised while we are distracted with our elections. Watch out for OPEC to coordinate an attack on U.S. through oil inflation.
The single largest remaining buyer of UST is hedge funds which are running the basis trade arbitrage (buying UST and selling futures on UST; around $600bn in the last 12 months). Not really a robust proposition. The Treasury is already maxing out all its options. Cutting spending is very difficult (apart from absolutely crazy programs like student loan forgiveness). My guess is: taxes ...
In a country where half the people -the half that take the greatest share of domestic government expenditures - don't pay any income taxes, and the other half that does pay taxes are the most prolific producers, raising tax rates inevitably will generate less tax revenue. Producers will have less incentive to risk capital and work longer hours if a greater share of the extra income goes to the government, so they won't take the risks and won't work the longer hours. Overall employment will fall and the economy will go into recession, creating extra costs to burden an already burdensome debt. This has been the experience in Europe, and its why half the continent's economies would be in perpetual recession if not for the Germans sub-contracting a portion of their factory work so as to prevent continental economic collapse and a crash in their common currency. Raising tax rates is never a good solution to a debt problem when you have economies that have substantial entitlements and high thresholds before income taxes begin to be paid.
So the next place to look is entitlements and the threshold at which earners begin to pay income taxes. The problem for America to go down that rabbit hole is that about 40% of the people in the country receive some form of entitlement, and then there are a substantial portion of the people in the country that pay no income taxes. All in, its more than half of the adults in the US, and no political party can afford to alienate that large a bloc of voters. So while the government can try to make changes at the margins -means testing for a portion of Social Security benefits, lower threshold for taxes to be paid, its not going to make much of a dent in the debt or the problems the debt is causing.
The one area of the economy that is under-taxed are the corporations, especially after they received windfall profits by being allowed to convert full pension plans to 401k plans, outsourced without penalty the nation's manufacturing industry, and enjoyed the positive effect on their corporate share prices that resulted from all the free money the Federal Reserve has printed. But the corporations and their senior management and directors are the main donors to political campaigns, and Congress has shown it will not bite the hand that keeps them in their cushy jobs.
So the only other place to look is the defense budget, and its quite fertile ground. The US spends twice as much per year on its military than its closest rival, China. America spends more than ten times per year than what Russia spends. This is the cost of having 750 military bases in 80 countries around the globe, multi-billion dollar steel bathtubs floating on the seas which can be taken out in a heartbeat by the far less expensive fleets of submarines our enemies have built, and when your foreign policy consists of "do what we say or we'll attack you: ultimatums. Its absolutely against what the Constitution dictates our military force is meant to be, and its killing our economy slowly but surely as we are burdened with unnecessary debt.
When push comes to shove in a fiscal crisis, military spending will be the area that sees the real cutbacks, and the majority of the electorate will support candidates that favor this approach because few people see any benefit from the last half of the annual military expenditure.
Unfortunately, even a 50% cutback in military spending will still leave us with an annual budget deficit of half a trillion dollars, and finding that savings will be a real challenge, especially since the government will have to start subsidizing Social Security payments. That's when this trillion dollar a year boondoggle called obama-care will see the pruning shears, and the government will re-configure the program to provide health care only to those who need it. Its also when the government finally will send a bill to the companies that help create unemployment and uninsured people.
During the decades preceding the passage of the Affordable Care Act, about 93% of Americans had health care insurance, mainly through either the companies where they worked or through Medicare/Medicaid. about 2% of the uninsured in America were illegal immigrants, and the other five percent either worked for small companies that did not provide health care insurance or were unemployed.
So instead of providing incentives for companies to stop paying for health care insurance or paying for the insurance of people here illegally, what a national health care plan should do is provide health care insurance just for people in the country legally and who have no other means of being insured. That means ending laws that mandate hospitals to provide care for anyone in the country illegally who walks into their emergency rooms. If a person can find the money to pay rent and eat, they can pay for a doctor when they are ill. It means that companies with more than 50 employees must provide health care insurance to both part-time and full-time workers, instead of limiting worker weekly hours to 29 so they don't have to pay health care insurance premia for them.
And it means that if a company errs and hires too many workers, when they correct their error they pay for it by providing the terminated employee with health insurance for the shorter of six months or when the employee finds another job. Companies will argue that this kind of policy will reduce overall employment, but what will reduce employment far more is if the economy collapses due to an unmanageable debt burden of the Federal government, in part because the government is paying for the mistakes of corporations. Keep the economy strong and companies will hire workers, and will do it more responsibly if they know there is a cost associated with being more optimistic than they should be.
So then, if companies pay the cost of short term unemployed workers, and the government doesn't have to pay the cost of illegal immigrants who need to see a doctor, then there is no need to provide health insurance to the entire nation. Instead, less than 5% of the people in America will need government assistance for health care insurance, and the trillion dollar cost of obama-care reduces down to maybe $100 billion at most. That savings combined with the reduction in military expenditures puts the budget in surplus, and allows the country to begin paying down its debt.
That's the plan that should be followed now, we should not have to wait for a crisis for the government to act in the country's best interest. And when the debt crisis finally forces Congress to make the difficult but necessary budget decisions, what they decide should be set in stone - like requiring a 75% super duper majority - for any changes to be made to these budget decisions thereafter. Because the worst result that could come of this crisis and the answer to it would be to go back to the old ways of Congressional deficits once the crisis passes.
thanks for those quite exhaustive comments! They would have made a nice, separate posting on Substack, you might want to consider it!
I agree there´s the phenomenon of a "peak tax rate", after which tax revenues actually decline because people start all kinds of tax-evasive behaviors. I just don´t think the US is there yet. Europe´s problems are not the taxes. It´s bureaucracy, insane economic policies (Germany´s mad energy transition and war on the car sector), shrinking population (Italy), and huge disparity inside the block and even inside countries (eg southern Spain or far Eastern Europe are essentially EM countries) - a mixed bag of issues.
In the US, sometime in the 90s I think, economist finally realized that the population pyramid was creating problems for the future, so the US introduced a 2% (? not sure anymore) surcharge to payroll taxes to set up a surplus fund for social security. That could be a template to restore the federal budget.
Corporate taxes - receipts seem to be on the low end in historical comparison (around 1.8% vs. 2 something ), but there´s not a lot of leverage here for the overall balance.
Don´t get me wrong, I'm not advocating higher taxes, but current deficits are a huge problem, especially because they are structural. There´s no special, temporary item which can be eradicated.
Another item which has received no attention at all: the Federal Reserve built a huge bond portfolio in its QE programs - 4bn until covid, 8bn during covid. At an investment income of around 2.5%, the Treasury received annual coupons worth $200bn. But as interest rates increased, the Fed actually pays more on reverse repo programs and on excess bank reserves (5.25% on repos and about the same as IORB), the Fed needs annual injections of about 100bn from the Treasury. I.e. a 200bn surplus turned into a 100bn deficit, an overall loss of $300bn - more than 1% of GDP.
The budget number which you refer to is the primary deficit - the budget balance from "operations", i.e. before financing costs = interest on debt. The main driver for rising deficits relative to GDP are debt costs which are already larger than defense spending. So bringing down debt (% of GDP) is the main issue.
Cuts in defense? Defense (a "discretionary" item on the budget) has been in the 6% range most of the time. "Mandatory" items have been rising, from the 13% range to 15%. You know what, the longer I think about it, the more another solution looks comes into focus: lifting the retirement age. That will address several expense and revenue line items at the same time. Curious what´s coming on that front.
The Laffer Curve - how revenues are inversely proportional to interest rates - only skews at the extremes. For example, revenues rise as rates fall, but at a zero rate revenues are zero. But the skew point is quite low, you have to get to a single digit tax rate before revenues begin declining. This has been proven time and again in the US, UK and elsewhere. As countries reduce their tax rates, they generate more tax revenue, and the difference per each 1% is rather large. The problem with governments that are elected is that the politicians have to discipline to save oney. The higher the tax revenues, the higher the deficits ! Its unfathomable, never under-estimate the willingness of national politicians to bankrupt the Treasury of their nation in efforts to buy votes for re-election. The problem for the US and most of the countries of Europe is on the spending side, and until politicians come to grips with that, the debts will grow until they collapse economies and lead to massive government and corporate defaults.
Most of the European countries have average income tax rates at 42% of income with fewer deductions than the US tax code allows, and they still run deficits even though the US subsidizes their defense to a large degree. The top tax rate in the UK prior to the reign of Margaret Thatcher was 90%, in the US it was 70% before Reagan. When Reagan brought income tax rates down to a maximum rate under 50% and average rates at about 20-28%, the US economy roared, and tax revenues jumed by $500 billion more than had been projected prior to Reagan'sfirst term. The Brits had a similar experience. And the phenomenon was repeated with the Bush II tax cuts as well as Trump's tax cut. What's happened during the last 15 years in the US, since the financial crisis, has been that we added the Affordable Care Act and a massive increase in Defense spending, along with the ridiculous expenditures made due to imbecilic public policy over Covid, and our debt went from $8 trillion to $33 trillion in 15 years. So toget the fiscal house in order, the first two places where spendingneeds tobe reduced dramatically are in the two areas that caused the debt to balloon Defense and Health Care spending. Raising tax rates on income earners will reduce tax revenues, widen the annual deficits, and expand the overall debt.The spending side of the ledger is the problem, governmentwasneverintended to serveall thepurposes thatit now serves and there isnoeconomicjustificationforthose excess services. I could spend hours writing about all the programs the US government funds that are completely unnecessary or should not be the government's role to provide. Beforethe governmentsticks their stickyfingers deeperintothepockets of the working Americans, who already worek fromJanuary untilsome timeinAprilorMay just to pay theirincome taxes, the government needs to redefine its role and pare its spending accordingly. If we as individuals have to live by a budget, so too should our government, who incidentally has not passed an actual budget in years, living off a string of consecutive temporary appropriations bills without any forward concern for spending trends or the deficits they produce.
Regarding the investment portfolio of the Federal Reserve, I gained a lot of insight into that over the years by knowing people who served on the Treasury Dealer Advisory Committee to the Fed, as well as the Chief Risk Officer of the Fed New York, which is the bank that manages the investment portfolio. The Fed has two big advantages over an investment bank when it comes to their investment portfolio management. First, they don't have to mark their portfolios to the market daily or weekly or ever, since they never have to liquidate the portfolio. And since they pay cash in full for their purchases, they never have any margin calls. When they need capital they print it, and when they report their P&L on an annual basis, all of the securities are shown to have par value. Because they can and usually intend to hold the securities to maturity. Which leads to their second advantage, they don't have to worry about market liquidity for the securities they purchase. So that allows them to buy almost everything they buy at a discounted price - off the run securities with terrible coupons -that will have a capital gain when they mature. Now yes, they will have a negative arbitrage when they are paying out more interest for funds deposited with them than the interest yield of their investment portfolio, but to cover that shortfall they just create more money, which they have the authority to do. Going forward, this negative arbitrage will start to become a large number, but the general feeling at the Fed is that as rates rise, there will be less excess liquidity, and the Fed will be able to restrict how many deposits they pay interest on based on what the overall short term financiang needs are in the Overnight Repo and Overnight Fed Funds markets. If banks and dealers who need financing cannot get it because holders of excess reserves choose to deposit with the Fed, the Fed desk in New York will lower the rate they pay on those deposits to a point where its prohibitively expensive for those holders of excess funds not to lend in the Overnight markets. In my view, the only time the Fed should be paying interest for excess reserves is when there is a systemic credit crisis affecting the nation's larger banks. Like in 2008/2009. Then the Fed facility serves a good purpose because of fears banks will have about counter-party risk. But when those fears subside, the Fed should close the window to excess reserve deposits and make the banks lend to each other.
The debt costs are the effect of the fiscal irresponsibilityin Washington. There's little that can be done about those, they already have tilted their borrowing toward the cheapest sectors of the yield curve, but when rates rise the borrowing costs go up. The only way to reduce the borrowingcosts is to deal with their cause, which is thedebt itself. The government needs to drastically re-define its purpose and reduce spending accordingly until they start making a profit of half a trillion to a trillion per year. Then the debt can be paid down in 50 or so years. But you can be sure that such a profound change in how government operates will not occur until there is an economic crisis that forces the issue.
using SOFR as a UST backed Repo asset, the US simply tells some of hundreds of its "client states" ie UAE, Qatar, Israel, maybe even Argentina (now that they want to dollarize), that they should lever up their central banks for a few months using SOFR backed assets (commodities, bonds, Magnificent 7, high yield corporates, even real estate backed assets). They will get a boost and take home a profit, while buying the US Govt time to figure out another scenario to pull their rabbit out of a hat. Hell, China needs the ganis as well... this is why its good to be the country with the reserve currency. Sorry if this blows the minds of the Austrian Econometric Model followers.
So what you'd like to do is figure out a way to expand this debt ridden, evil system?
Go take an accounting class or two. Just as there are laws of physics that cannot be broken, there are laws of finance that can only be bent and cheated so long before the consequences fall like an 800 lb anvil.
You crypto guys just can't wait for your digital prison cell, can you? You are running as fast as you can to lock yourself in your Ready-Player-One fantasy land.
Wake up, buttercup. When technology is being used at every turn to imprison you, don't imagine that technology is going to save you. You no more control technology/internet/your own computer than you control the interstate highway system.
Think about it. You don't control your own personal computer anymore. That's not your cellphone. That's not your vehicle. That's not your tractor. Hell, that's not even your TV.
There are multiple third parties that control and claim right to those things you bought and "paid" for.
Crypto will seem like the alternative until countries begin outlawing its use in commerce, including any bank transactions. Inevitably there will be no where to exchange the crypto back into a currency that can be used to actually buy goods and services.
Initially this will occur when governments will try to convert their paper currency and metal coins into a digital currency, and will not want competition from non-government electronic currencies. And that will occur when the US and EU countries realize that the only way out of their deb tcrises will be to entice their populations to exchange their physical currency for government digital currency at rates of exchange favorable to reducing government debt. These governments will realize that if they try to force the populations to make the exchange, then they will have Civil Wars to deal with that will topple their governments. So they will use other methods of persuassion, including the restriction against using non-government digital currency from commercial transactions within their countries.
You will know this all is about to happen when there appear large sellers - mainly the largest US investment houses, British clearing banks, and other banks in EU countries with close ties to their respective government - in the Bitcoin Futures markets. These sellers will be acting to fill orders that secretly were placed with them to execute by their respective governments, as the governments know they will reap huge profits to help pay down their national debts by being short Bitcoin just before those same governments proceed with the ban on commercial use of non-government digital currency.
Its probably a blatantly illegal scheme in most of the countries that will be taking part in it, but when the economic life of a nation is at signnifcicant risk as it is during a debt collapse, governments will not let laws stand in the way of dealing with national emergency. As the US government was allowed to confiscate all private non-jewelry holdings of Gold at an artificially low price, as it did in the US during the 1930s, you can bet that governments today will have no compunction in absconding with investors'capital placed in a financial instrument dedicated to competing with government-issued currencies.
“The government will have to use more debt to pay off past debts.” When a company does not make enough profit to pay its bills, but instead borrows more and more to cover the losses, we call it a “zombie company.” By that standard, the United States is a “zombie country,” better known as a “failed state.”
I do like to point out what I believe is an overlooked function of Treasuries: that of safe storage of large amounts of USDs, such as the USDs you might receive in exchange when, I dunno, Chinese companies are selling stuff to U.S. consumers. What do you do with the USDs? It’s not like you’re getting FDIC insurance on deposits numbering in the hundreds of millions. So you buy Treasuries for storage, and it turns out those are pretty solid collateral for loans, and to boot over time have been sellable in a very deep and liquid market. I’m not saying that can’t all end someday, but for now, the USD is still a big, important currency in the world, and you need a place to park those USDs if only temporarily. So are Treasuries purchased as investments, or for storage? I think the latter is the more important reason.
That´s a great point! I see lots of commentary that China is trading stuff in yuan and Saudi Arabia is trading oil in INR ... but nothing rivals the dollar in market depth and liquidity, and you can´t put a billion dollars into your pillows. If you're interested, I wrote a post exactly on this topic a few days ago. Let me know what you think!
https://econolog.substack.com/p/dollarization-or-dollar-debasing
The reason why China has been building its gold reserves for years now is to use it to back the value of its currency when its currency becomes a reserve currency for countries tired of being beholden to the US because they have large holdings of trade surplus dollars. As that transition occurs and a large number of countries decide they want to be paid in Yuan for their products, China's currency will rival the dollar for liquidity and market depth. And by that time, which is not all too far into the future, China will have developed so many more markets for their products by virtue of their investment in the Belt & Road project that the Yuan will be traded in as many places in the world as the dollar. But there will be a higher demand to hold Yuan, since the government backs it with Gold reserves that limit the amount of Yuan that can be printed each year. That makes it more valuable than a currency like the dollar or the Euro whose government(s) prints as much of it as they want to finance an out of control level of spending that will bankrupt their economy and cause their currency to crash.
I see where you're coming from, and I agree, China has been buying gold. But in absolute terms, not nearly enough to become a meaningful factor to back its currency. Global central bank (meaning all central banks of the world) bought about 570 tons of gold last year, and their share of gold purchases compared to other buyers (jewelry, industrial uses, etc) isn´t really rising. 570 tons have a market value of about $36.5bn (and just to make sure we don´t forget - to buy gold you need dollars!). Again, that's globally. China bought about 2bn. That´s a rounding error on the balance sheets.
If other countries want to hold yuan, those reserves will be usable for China only, because there´s nothing else you can do with it, as yuan are not freely convertible. Do you want to expose yourself to that risk? Just a few days ago China imposed sell restrictions on the Beijing stock exchange, i.e. large investors can´t get their money out.
Even cash-strapped Russia is quickly getting tired of selling oil in local currencies, as those currencies are essentially useless in global trade.
We already are seeing the workarounds being put in place for the issues you raised. Countries that sell their goods for Yuan are able to exchange those Yuan for Gold at the Shanghai Gold Exchange, and the Gold can then be exchanged for other currencies or commodities. The Chinese are establishing swap lines between Yuan and the currencies of the nations they trade with to increase the global liquidity of the Yuan, and they next step will be to allow their trading partners to pay for Chinese goods and services with one or more commodities the Chinese will be willing to accept since they now import those goods anyway. So the Saudis can pay with crude oil for a new airport built by a Chinese construction company, Russia can pay with wheat or oil or nickel or aluminum for Chinese products, South Africa with diamonds or gold. There are numerous ways to finance global trade in a world where shipping huge amounts of cargo over long distances has become so commonplace.
Offshore Yuan already can be traded freely to facilitate the exchange of the currency between countries that trade with China. By pegging the Yuan money supply to the price of Gold, the currency should gain increased stability even if not convertible. There already exists about 41 trillion dollars worth of Yuan money supply, of which about 1.26 trillion dollars worth circulates globally.
About 8.3 trillion US dollars circulating in the world supports the approximately 24 trillion dollars of annual global trade today. So for the Chinese to achieve half of global trade being performed in Yuan, which would make it truly an alternative global reserve currency, the circulating Yuan would have to rise by a factor of 3.29 times. That amount will reduce as the price of Gold rises, since the existing Yuan becomes more valuable when pegged to Gold if Gold rises in price.
So the Chinese have enough currency available for them to support the Yuan as a global reserve currency, what they need to do is convince countries to trade in it and to hold it. The swap line extensions, the peg to the Gold price, and the convertibility to Gold through the Shanghai Exchange should all help that process. And allowing countries to pay for Chinese goods in products those countries make domestically that China needs also should increase the amount of trade China performs with other countries, which eventually will raise the utility of the Yuan across several continents.
The issue for the Chinese is having enough Gold to support the Shanghai Gold Exchange, as that is a critical element in promoting acceptance of the Yuan as a reserve currency. The Chinese eventually will need a value of Gold holdings at least as large as the amount of Yuan that will circulate to support global Yuan based trade, which as I wrote above would be about 4.15 trillion dollars worth of Yuan once half of global trade is performed in Yuan. That number gets reduced by perhaps 25-50% if countries chose to use their native commodities to exchange for imports. At $2100 per ounce of Gold, the 4.15 trillion dollars of Yuan would equate to about 60,000 tonnes of Gold reserves, at half that amount the Chinese would need 30,000 tonnes of Gold reserves.
Estimates of China's present Gold holdings range from 2000 tonnes to 33,000 tonnes, and no one other than a few Chinese leaders likely knows for sure. But we have to assume that it is significantly higher than the 2000 tonnes that are considered an official estimate, because that amount is not large enough for the Chinese to support their Shanghai Gold Exchange initiative. My guess is that the "official" estimate of their holdings are as undervalued as the US-stated holdings of 8800 tonnes are over-valued. So the Chinese likely have eight times as much Gold as the official estimate, which puts them at roughly 15,000 tonnes. Enough to support the Shanghai Exchange but only about half of what they will need to completely support the Yuan as a global reserve currency for half the world's trade.
They have been very smart and disciplined with how they have accumulated, buying on dips in price and not pushing the market to panic. As a result, the price of Gold has risen slowly over the last decade, and likely will continue to do so until supply available for sale actually gets tight. Then the price will jump sharply. I see the Chinese strategy as accumulating as much as they can while the Gold market steadily but slowly moves higher, and then once the panic sets in and the price jumps, the existing Chinese holdings will rise enough in value that they will be able to support the global trade in Yuan with the Gold they already own.
Now that's where the willingness to accept commodities for trade will really help the Chinese. For as the price of Gold rises, other commodities should rise as well since they will be in demand by countries that want to pay for Chinese imports with them. At the same time the buying power of the US dollar will be falling, and as a result, the number of countries that want to trade in Yuan or fungible commodities will increase, putting the Yuan as the predominant world reserve currency.
The danger of having the world's reserve currency, as both the British and the Americans have found out, is that they had to constantly run trade deficits so as to supply the world with the Sterling or dollars it needed to carry out its trade in dollars. Unfortunately for them, they did not have the shipping resources that would have allowed them to take payment for exports in commodities, which would have reduced the amount of currency they needed to supply the world to maintain their currency's reserve status. The Chinese seem to have solved that problem with their willingness to be paid in commodities and through the extension of Yuan swap lines, so they will not have to become a trade deficit country to ensure there are enough Yuan circulating in the world.
As with all economic forecasts and predictions, there are a lot of assumptions that may not come to pass, and the outcomes of the steps now being taken by the Chinese to become a dominant player in global trade through their currency may be far different than what they thought would occur. But to date they have shown that they are not going to make the mistakes their predecessors made, and will try several new approaches that incorporate historical wisdom with modern convenience and reality. I think the main advantage they have is that there are so many countries, especially in the global south, that want away out of the dollar-debt traps they have wound up in, where their commodities and currencies wound up being under-valued, and their costs to trade were over-valued. The advantages of the system the Chinese are establishing may help these countries realize greater opportunities than they had in the dollar-based system, and I think they will at least try this new system to see if it benefits them. Much of the benefit will be determined by the price of exchange the Chinese set for the commodities they accept in trade, along with the projects the Belt & Road initiative the Chinese open up to investment of trade surpluses of their trading partners and the resultant profitability of those projects. The entire transformation will not happen overnight, but so far the right foundations are being constructed.
The experience of the UK and the US as reserve currencies was very different between them. The UK was a large net exporter, and it had a large current account surplus in the 19th century. The current account can be expressed as CA = S - I. In the UK it played out that excess domestic savings were invested not locally (resulting in a balanced CA), but globally, as the UK essentially built much of the infrastructure in its colonies (roads, bridges, and especially railroads). This led to underinvestment at home and cost the country its leadership as the European industrial leader, which Germany took over quickly.
The US however started running a huge CA deficit, especially in the new millennium. I remember we ran large bets against the dollar around 20 years ago as the deficits escalated, and indeed the USD started declining.
I agree that many other countries are trying hard to get away from the dollar hegemony, but I don´t think they will succeed even in the medium term (unless the US self-demolishes the dollar, which is not unthinkable). There is no clear structure in those efforts, except that many countries are doing something and China is big. And IF they should really have some success, they will immediately start fighting over who gets the benefits. There are large power blocks - Russia and the Saudis, two of the three largest oil producers, and China, the largest user and importer, and one of the largest economies in the world. They all have their own but conflicting incentives. I just don´t think that having a common enemy, the US, will hold them together for long.
The US had and has a similar problem with having the dollar as the reserve currency as the British had when quid ruled the financial and industrial world. Its why the US had to abandon the Bretton Woods regime as far back as 1971, when the demands for gold and silver on the US Treasury by foreign nations seeking to convert their trade surplus dollars were greater than the reserve holdings of the Treasury, and President Nixon had to temporarily suspend gold convertibility.
It started in the car industry, as OPEC pushing up the price of oil led to heightened demand for gas efficient cars. Over the next twenty years the US trade deficit soared until the 1990s, when Chinese factories employing labor at far lower rates than workers received in the US caused American disinvestment to skyrocket as factories in the US were closed and the US trade deficit soared to its highest levels ever. To meet the drain on money supply within the States, the Federal Reserve had to allow money supply to grow at rates that ordinarily would have been inflationary, but the combination of lower prices due to lower labor costs that went into the imported products that Americans were buying from China, along with the productivity gains of computerization, offset the monetary effects of accelerated money growth to accommodate an import economy. That's why your bets against the dollar worked, because as a net importer the US is constantly having to print more money to facilitate that trade. And since China and other foreign exporters to the US began to accumulate large dollar reserves, the US government realized it could expand its deficit spending and finance it by borrowing back the dollars sent overseas to buy foreign goods. Hence the twin deficits that are soaking up capital from the US and leading to financial destruction.
But now the amount of dollars in the world has become burdensome to nations that are net exporters to the US, as well as anyone who produces a product that is traded predominantly in dollars. They are losing faith in the ability of the US to control its fiscal house, and when faith erodes credit tightens. That process is lethal toa fiat currency the intrinsic value of which is faith and credit in its issuer. Additionally I think a lot of net exporting countries to the US are tired of investing their trade surplus dollars to finance the fiscal irresponsibility of the US government. Instead of funding US transfer payments to the people that have been made unproductive as the US sold out its manufacturing industry, these exporting nations recognize there are capital-intensive projects waiting to be financed in Asia, Eastern Europe, and Africa that will be far more productive, beneficial to those regions, and profitable both directly and indirectly. Basically to bring areas and regions on the two continents fully into the industrial and then information age. And these currencies realize that if they could be paid in a currency tied to some stable fungible asset like a precious metal, energy resource or agricultural commodity, they will receive greater real value against inflation than to hold US dollars. It’s a similar motivation to the investment in crypto-currency, even though crypto I backed by faith and credit of trade counter-parties instead of a government issuing fiat currency. Investors of capital around the globe are coming to realize that there are too many dollars in the world for them to hold their value, and too much US debt in the world for anyone to be comfortable that they will be repaid their capital lent to the US government.
The problem for the countries that want to escape the dollar is what to use instead. The easy solutions to the problem already have been solved, thanks in large part to the thoughts of Russian economist Servie Glazyev. By making the new currency not sovereign to anyone nation but spread amongst all the nations that trade and invest with it, the problem of one nation having to explode its money supply to finance trade among then on-dollar countries is answered. It’s a similar solution to that which financial exchanges employ to spread counter-party risk among all the exchange’s members. Furthermore, by allowing member countries to obtain the new currency not just by exchanging their sovereign currency but also by pledging metal and commodity reserves of their respective countries, the new currency is ostensibly backed by real assets, which increases the real value of the new currency while reducing its volatility.
But the problem they haven’t solved is what to do with the trade surplus dollars generated by the trade surpluses of the countries that are net exporters to the US. All the new currency does to ameliorate that risk of holding dollars is transfer it to the new currency, which essentially leaves it as a risk to the nations transacting in that currency. Granted the risk is reduced because trade occurring between counter-parties other than the US will be free of any dollar inflationary effects. That is a significant risk reduction when you consider how much oil and other commodities are transacted in dollars even when neither of the parties to the transaction is a US entity. But the US keeps pumping nearly a trillion new dollars into the world every year through balance of payments deficit, adding to the many trillions of dollars already held by countries around the world. If the objective for the non-US world is to reduce its risk of holding dollars, the establishment of a new currency does not yet satisfy this objective. The Chinese answer is to replace a sizable amount of their present exports to the US with exports to other countries. Once accomplished, this change will reduce the annual increase in dollar holdings the Chinese absorb through their exporting activities, but takes a long time to develop. It is one of the main motivators for their Belt & Road initiatives, to build the strength of foreign economies so they can afford to consume greater amounts of Chinese goods and services. And in so doing, other exporting nations will be able to sell greater shares of their exports in exchange for currencies other than dollars, preferably the new currency.
Simultaneously, countries with high dollar reserves presently invested in dollar assets are liquidating these holdings slowly, and re-investing the dollars in other non-dollar assets. The progressively larger holdings of precious metals by the central banks of net exporters to the US is one sign of this re-balancing. I suspect that some of the re-investment may actually be going into crypto-currency as well, which is kind of ironic since nations have a vested interest in seeing crypto-currency collapse. As exporters send few goods to the US, inflation - due to supply shortages caused by fewer exports to the US, and then due to the US having to build manufacturing facilities and produce at higher labor costs the goods it no longer can buy from exporters – will exert downward pressure on the values of most dollar-priced investment instruments, which is another impetus forcing net exporters to the US to reduce their dollar-based investments now.
The entire process will take a few years if not longer. Countries that export to the US must reduce both their exports and their dollar holdings slowly lest the US government retaliate against them by erecting tariffs against their goods. And its going to take time to develop consumptive economies across Eastern Europe, Asia and Africa, even with the massive Belt & Road spending. But eventually it will be accomplished, and that’s when you’ll see the emergence of a new currency to rival the dollar. The process will be especially painful to the US if it does not reduce its budget deficits before the advent of the new currency. Losing a trillion dollars a year of new foreign purchases for the Treasury debt is going to be costly to replace, while at the same time structural supply side inflation will be causing interest rates to rise for US government borrowing. The point will come that equities will be sold in large numbers to invest in debt instead, causing a negative wealth effect that makes the economy recede and the deficits even wider. Its a classic debt trap that the US is heading into, and its going to cause tremendous social and economic problems within the States that a divided country may not survive. I don’t think for one moment that the Chinese have not factored this eventuality into their plans, and it’s the way they will counter the prospect of a war with the US.
So I have little doubt that this is what’s coming. The benefits will be divided in typical capitalist format, to each according to what they put into it. But the way the Chinese and other BRICs nations are constructing this consortium, it’s a win for everyone. More trade, more consumers, more choice for where they invest their trade profits, and more investment profits from investments that serve their constituents. This is the Asian Century, and this is how they will manifest it.
No way out of the years of excess, doom loop
They will try higher taxes too. Much higher.
"The problem is multifaceted, but the origin is profligate government spending."
Let's be crystal clear with the term, "government spending." They are throwing out money on every level, from the illegal immigrant that just crossed the Rio Grand to the Fortune 500 company getting a bailout, subsidy, or pork filled government contract.
They are paying to keep the music playing. And their paying is destroying what little is left of a capitalistic, free market.......which in turn causes them to have to hand out even moar welfare.
But there is no competition.......nowhere to turn........especially for the American people. What will you do to stop it? How can you fight it? And that goes for 85% of the rest of the world. They are swimming in a pool of gasoline........called dollars........and dare not light a match. There are very few, if any countries on this planet, that can do what Russia did. Russia has all the energy it needs in-house; they grow their own food; they have all the natural resources to function as they are; AND they have the technology and military to defend it. I cannot think of another country so positioned.
The world is held hostage by the Lord of the Dollar. Of course the leadership of these countries is bought off and enjoys their servitude. They get everything the dollar can buy......to their heart's desire. Their "desire" continues to grow and places more bricks on the load we carry. "The tip of the pyramid is supported by the base."
There is no escaping a burning house when you are locked in with nowhere to go.........even if you got out. As long as they can keep printing dollars and throwing them on the fire, it goes on from here.
With one major caveat.............E N E R G Y. A reduction, in the amount of energy available, will put a wrinkle in their money printing. Energy is the bottom of the pyramid, human or otherwise. All the major policy and actions of today revolve around securing moar energy to keep the ponzi rolling.
The world is using a billion barrels of oil every ten days. That is unsustainable. "Growth" requires moar. If we cannot maintain our current energy use, we cannot grow. If we cannot grow, the debt ponzi collapses on itself. Energy is the key. Have you ever looked at the active inflow of millions of illegals into Western society as a form of "energy." Human energy/labor is the oldest, most basic form of energy in world history.
PS.....And people think slavery ended. In the 21st century we no longer have to go catch them.....they come to us.
I don’t disagree that the government is spending too much. Who would disagree with that! I’ve taken an accounting class or ten. My solution is about all that’s left in this ridiculous spending spree.
The refunding of the US debt problem is bad for the long run but not as bad as it seems for the present.
The Money Market Funds have about $6 trillion that gets rolled over once a year at least, so that provides a good source of funds for the Treasury every year.
Foreign investors hold $7 trillion of US government securities, and while that amount likely will go lower, it will happen slowly as foreign governments whose companies are exporting to the US and hence natural holders of dollars will not risk having trade tariffs imposed against their exporters by quickly reducing their lending to the US government.
The annual interest on the US debt is about a trillion dollars and likely will not move much lower, so that's another source of funds that usually is re-invested in US government securities.
Insurance companies will continue to be buyers of longer term US government debt as they need future revenues to match against the future liabilities of the life policies they sell.
The Federal Reserve still holds about $5 trillion in US government securities, and although they are reducing their holdings, they are doing so at a glacial pace so as not to adversely affect market interest rates, especially in the longer term securities.
The rest of the $33 trillion the US government needs to finance comes from investment funds of investment and banking institutions and funds that serve the general public. Considering the value of US equities is around $50 trillion and that amount is usually about one and a half times the capital invested by fund entities in debt securities, there is a pool of about $30 trillion from which the US government can borrow. Presently the Treasury is probably taking about $15 trillion from the $30 trillion each year, with the rest being invested in a host of different debt instruments like US Agency securities, corporate bonds, municipal bonds and mortgage/asset backed securities.
The problem gets a lot worse ten years into the future, for several reasons. First of all, the US debt is projected to reach $50 trillion by then, which would require the Treasury to be the sole borrower of all the capital presently dedicated to debt securities in the US. Now while the dollar money supply will be a lot larger in 2034 than it is now, the increasing demand for capital to fund the US debt will cause a "crowding out" effect for other entities that need to borrow dollars. The premium above the rate of inflation that borrowers will need to pay to borrow money (the "Credit Premium") will increase, making borrowing more costly in real terms than it is today.
Additionally, at least two other factors will make borrowing a lot more difficult than it is today, and the US government will pay a dear price for its past profligacy. Firstly, by 2034 virtually all Baby Boomers will have retired and many will need to draw down on investment capital to maintain the standard of living they want in retirement. Depending on what happens with life expectancy during the next ten years, there could be a great deal of investment liquidation by the surviving Baby Boomers in both equities and debt, and that liquidation could reduce the pool of capital available for borrowers to borrow. Secondly, the BRICs movement, if it develops as planned, could reduce significantly the amount of foreign investment in the US equity and debt instruments as BRICs members choose to convert more of their dollars into BRICs currencies so as to invest in capital intensive projects in their respective geographic locales that will provide higher returns than US debt instruments and also offer improved standards of living for their residents.
Both of these factors will increase the real cost of borrowing, and the reduced supply of capital available for US lending will put pressure on borrowers to bid up the rate of interest they are willing to pay for capital they need to borrow. Combined with the selling pressure of Baby Boomers needing to liquidate investments, the increased real cost of borrowing is likely to exert downward pressure on the value of US equity prices. That decline could be substantial depending on the number of Baby Boomers liquidating and the amounts of capital they withdraw from equity markets. One effect of the falling equity values could be a negative wealth effect that would result in a reduction of consumption across the economic landscape, causing an ongoing and lasting recession that in turn would push up government expenditures and debt at a time when the cost of borrowing in real terms already is rising. At that point, the value of the US currency would be in dire trouble, as the investment community's faith in the credit of the US government being able to meet its debt obligations would be seriously questioned. A negative feedback loop would then result as the falling currency value would cause further liquidation of equities which would deepen the recession and increase even further the growing government debt.
Of course, as with all predictions of the future, there are a lot of "ifs" attached to any outlook. But there are several factors that influence the eventual outcome about which we can be certain. There will be a tremendous number of Americans retiring during the next ten years and needing to liquidate a substantial portion of their investments. Absent the kind of crisis situation as I describe above occurring faster than the next ten years, the US government will meet if not exceed its own projections of $50 trillion in debt by 2034. And as the US government borrows more, there will be upward pressure on Credit Premia, making borrowing more costly in real terms, which will have a negative effect on corporate profits, and thus, equity prices. Knowing this much is certain, its difficult to have a positive outlook on the future fiscal health of the US government or its economy.
Great read. This will be put aside until it can’t and when it can’t watch out below. Yields will climb next year with election volatility and geo political tensions raised while we are distracted with our elections. Watch out for OPEC to coordinate an attack on U.S. through oil inflation.
The single largest remaining buyer of UST is hedge funds which are running the basis trade arbitrage (buying UST and selling futures on UST; around $600bn in the last 12 months). Not really a robust proposition. The Treasury is already maxing out all its options. Cutting spending is very difficult (apart from absolutely crazy programs like student loan forgiveness). My guess is: taxes ...
https://econolog.substack.com/p/do-bonds-finally-make-sense-again
In a country where half the people -the half that take the greatest share of domestic government expenditures - don't pay any income taxes, and the other half that does pay taxes are the most prolific producers, raising tax rates inevitably will generate less tax revenue. Producers will have less incentive to risk capital and work longer hours if a greater share of the extra income goes to the government, so they won't take the risks and won't work the longer hours. Overall employment will fall and the economy will go into recession, creating extra costs to burden an already burdensome debt. This has been the experience in Europe, and its why half the continent's economies would be in perpetual recession if not for the Germans sub-contracting a portion of their factory work so as to prevent continental economic collapse and a crash in their common currency. Raising tax rates is never a good solution to a debt problem when you have economies that have substantial entitlements and high thresholds before income taxes begin to be paid.
So the next place to look is entitlements and the threshold at which earners begin to pay income taxes. The problem for America to go down that rabbit hole is that about 40% of the people in the country receive some form of entitlement, and then there are a substantial portion of the people in the country that pay no income taxes. All in, its more than half of the adults in the US, and no political party can afford to alienate that large a bloc of voters. So while the government can try to make changes at the margins -means testing for a portion of Social Security benefits, lower threshold for taxes to be paid, its not going to make much of a dent in the debt or the problems the debt is causing.
The one area of the economy that is under-taxed are the corporations, especially after they received windfall profits by being allowed to convert full pension plans to 401k plans, outsourced without penalty the nation's manufacturing industry, and enjoyed the positive effect on their corporate share prices that resulted from all the free money the Federal Reserve has printed. But the corporations and their senior management and directors are the main donors to political campaigns, and Congress has shown it will not bite the hand that keeps them in their cushy jobs.
So the only other place to look is the defense budget, and its quite fertile ground. The US spends twice as much per year on its military than its closest rival, China. America spends more than ten times per year than what Russia spends. This is the cost of having 750 military bases in 80 countries around the globe, multi-billion dollar steel bathtubs floating on the seas which can be taken out in a heartbeat by the far less expensive fleets of submarines our enemies have built, and when your foreign policy consists of "do what we say or we'll attack you: ultimatums. Its absolutely against what the Constitution dictates our military force is meant to be, and its killing our economy slowly but surely as we are burdened with unnecessary debt.
When push comes to shove in a fiscal crisis, military spending will be the area that sees the real cutbacks, and the majority of the electorate will support candidates that favor this approach because few people see any benefit from the last half of the annual military expenditure.
Unfortunately, even a 50% cutback in military spending will still leave us with an annual budget deficit of half a trillion dollars, and finding that savings will be a real challenge, especially since the government will have to start subsidizing Social Security payments. That's when this trillion dollar a year boondoggle called obama-care will see the pruning shears, and the government will re-configure the program to provide health care only to those who need it. Its also when the government finally will send a bill to the companies that help create unemployment and uninsured people.
During the decades preceding the passage of the Affordable Care Act, about 93% of Americans had health care insurance, mainly through either the companies where they worked or through Medicare/Medicaid. about 2% of the uninsured in America were illegal immigrants, and the other five percent either worked for small companies that did not provide health care insurance or were unemployed.
So instead of providing incentives for companies to stop paying for health care insurance or paying for the insurance of people here illegally, what a national health care plan should do is provide health care insurance just for people in the country legally and who have no other means of being insured. That means ending laws that mandate hospitals to provide care for anyone in the country illegally who walks into their emergency rooms. If a person can find the money to pay rent and eat, they can pay for a doctor when they are ill. It means that companies with more than 50 employees must provide health care insurance to both part-time and full-time workers, instead of limiting worker weekly hours to 29 so they don't have to pay health care insurance premia for them.
And it means that if a company errs and hires too many workers, when they correct their error they pay for it by providing the terminated employee with health insurance for the shorter of six months or when the employee finds another job. Companies will argue that this kind of policy will reduce overall employment, but what will reduce employment far more is if the economy collapses due to an unmanageable debt burden of the Federal government, in part because the government is paying for the mistakes of corporations. Keep the economy strong and companies will hire workers, and will do it more responsibly if they know there is a cost associated with being more optimistic than they should be.
So then, if companies pay the cost of short term unemployed workers, and the government doesn't have to pay the cost of illegal immigrants who need to see a doctor, then there is no need to provide health insurance to the entire nation. Instead, less than 5% of the people in America will need government assistance for health care insurance, and the trillion dollar cost of obama-care reduces down to maybe $100 billion at most. That savings combined with the reduction in military expenditures puts the budget in surplus, and allows the country to begin paying down its debt.
That's the plan that should be followed now, we should not have to wait for a crisis for the government to act in the country's best interest. And when the debt crisis finally forces Congress to make the difficult but necessary budget decisions, what they decide should be set in stone - like requiring a 75% super duper majority - for any changes to be made to these budget decisions thereafter. Because the worst result that could come of this crisis and the answer to it would be to go back to the old ways of Congressional deficits once the crisis passes.
thanks for those quite exhaustive comments! They would have made a nice, separate posting on Substack, you might want to consider it!
I agree there´s the phenomenon of a "peak tax rate", after which tax revenues actually decline because people start all kinds of tax-evasive behaviors. I just don´t think the US is there yet. Europe´s problems are not the taxes. It´s bureaucracy, insane economic policies (Germany´s mad energy transition and war on the car sector), shrinking population (Italy), and huge disparity inside the block and even inside countries (eg southern Spain or far Eastern Europe are essentially EM countries) - a mixed bag of issues.
In the US, sometime in the 90s I think, economist finally realized that the population pyramid was creating problems for the future, so the US introduced a 2% (? not sure anymore) surcharge to payroll taxes to set up a surplus fund for social security. That could be a template to restore the federal budget.
Corporate taxes - receipts seem to be on the low end in historical comparison (around 1.8% vs. 2 something ), but there´s not a lot of leverage here for the overall balance.
Don´t get me wrong, I'm not advocating higher taxes, but current deficits are a huge problem, especially because they are structural. There´s no special, temporary item which can be eradicated.
Another item which has received no attention at all: the Federal Reserve built a huge bond portfolio in its QE programs - 4bn until covid, 8bn during covid. At an investment income of around 2.5%, the Treasury received annual coupons worth $200bn. But as interest rates increased, the Fed actually pays more on reverse repo programs and on excess bank reserves (5.25% on repos and about the same as IORB), the Fed needs annual injections of about 100bn from the Treasury. I.e. a 200bn surplus turned into a 100bn deficit, an overall loss of $300bn - more than 1% of GDP.
The budget number which you refer to is the primary deficit - the budget balance from "operations", i.e. before financing costs = interest on debt. The main driver for rising deficits relative to GDP are debt costs which are already larger than defense spending. So bringing down debt (% of GDP) is the main issue.
Cuts in defense? Defense (a "discretionary" item on the budget) has been in the 6% range most of the time. "Mandatory" items have been rising, from the 13% range to 15%. You know what, the longer I think about it, the more another solution looks comes into focus: lifting the retirement age. That will address several expense and revenue line items at the same time. Curious what´s coming on that front.
The Laffer Curve - how revenues are inversely proportional to interest rates - only skews at the extremes. For example, revenues rise as rates fall, but at a zero rate revenues are zero. But the skew point is quite low, you have to get to a single digit tax rate before revenues begin declining. This has been proven time and again in the US, UK and elsewhere. As countries reduce their tax rates, they generate more tax revenue, and the difference per each 1% is rather large. The problem with governments that are elected is that the politicians have to discipline to save oney. The higher the tax revenues, the higher the deficits ! Its unfathomable, never under-estimate the willingness of national politicians to bankrupt the Treasury of their nation in efforts to buy votes for re-election. The problem for the US and most of the countries of Europe is on the spending side, and until politicians come to grips with that, the debts will grow until they collapse economies and lead to massive government and corporate defaults.
Most of the European countries have average income tax rates at 42% of income with fewer deductions than the US tax code allows, and they still run deficits even though the US subsidizes their defense to a large degree. The top tax rate in the UK prior to the reign of Margaret Thatcher was 90%, in the US it was 70% before Reagan. When Reagan brought income tax rates down to a maximum rate under 50% and average rates at about 20-28%, the US economy roared, and tax revenues jumed by $500 billion more than had been projected prior to Reagan'sfirst term. The Brits had a similar experience. And the phenomenon was repeated with the Bush II tax cuts as well as Trump's tax cut. What's happened during the last 15 years in the US, since the financial crisis, has been that we added the Affordable Care Act and a massive increase in Defense spending, along with the ridiculous expenditures made due to imbecilic public policy over Covid, and our debt went from $8 trillion to $33 trillion in 15 years. So toget the fiscal house in order, the first two places where spendingneeds tobe reduced dramatically are in the two areas that caused the debt to balloon Defense and Health Care spending. Raising tax rates on income earners will reduce tax revenues, widen the annual deficits, and expand the overall debt.The spending side of the ledger is the problem, governmentwasneverintended to serveall thepurposes thatit now serves and there isnoeconomicjustificationforthose excess services. I could spend hours writing about all the programs the US government funds that are completely unnecessary or should not be the government's role to provide. Beforethe governmentsticks their stickyfingers deeperintothepockets of the working Americans, who already worek fromJanuary untilsome timeinAprilorMay just to pay theirincome taxes, the government needs to redefine its role and pare its spending accordingly. If we as individuals have to live by a budget, so too should our government, who incidentally has not passed an actual budget in years, living off a string of consecutive temporary appropriations bills without any forward concern for spending trends or the deficits they produce.
Regarding the investment portfolio of the Federal Reserve, I gained a lot of insight into that over the years by knowing people who served on the Treasury Dealer Advisory Committee to the Fed, as well as the Chief Risk Officer of the Fed New York, which is the bank that manages the investment portfolio. The Fed has two big advantages over an investment bank when it comes to their investment portfolio management. First, they don't have to mark their portfolios to the market daily or weekly or ever, since they never have to liquidate the portfolio. And since they pay cash in full for their purchases, they never have any margin calls. When they need capital they print it, and when they report their P&L on an annual basis, all of the securities are shown to have par value. Because they can and usually intend to hold the securities to maturity. Which leads to their second advantage, they don't have to worry about market liquidity for the securities they purchase. So that allows them to buy almost everything they buy at a discounted price - off the run securities with terrible coupons -that will have a capital gain when they mature. Now yes, they will have a negative arbitrage when they are paying out more interest for funds deposited with them than the interest yield of their investment portfolio, but to cover that shortfall they just create more money, which they have the authority to do. Going forward, this negative arbitrage will start to become a large number, but the general feeling at the Fed is that as rates rise, there will be less excess liquidity, and the Fed will be able to restrict how many deposits they pay interest on based on what the overall short term financiang needs are in the Overnight Repo and Overnight Fed Funds markets. If banks and dealers who need financing cannot get it because holders of excess reserves choose to deposit with the Fed, the Fed desk in New York will lower the rate they pay on those deposits to a point where its prohibitively expensive for those holders of excess funds not to lend in the Overnight markets. In my view, the only time the Fed should be paying interest for excess reserves is when there is a systemic credit crisis affecting the nation's larger banks. Like in 2008/2009. Then the Fed facility serves a good purpose because of fears banks will have about counter-party risk. But when those fears subside, the Fed should close the window to excess reserve deposits and make the banks lend to each other.
The debt costs are the effect of the fiscal irresponsibilityin Washington. There's little that can be done about those, they already have tilted their borrowing toward the cheapest sectors of the yield curve, but when rates rise the borrowing costs go up. The only way to reduce the borrowingcosts is to deal with their cause, which is thedebt itself. The government needs to drastically re-define its purpose and reduce spending accordingly until they start making a profit of half a trillion to a trillion per year. Then the debt can be paid down in 50 or so years. But you can be sure that such a profound change in how government operates will not occur until there is an economic crisis that forces the issue.
using SOFR as a UST backed Repo asset, the US simply tells some of hundreds of its "client states" ie UAE, Qatar, Israel, maybe even Argentina (now that they want to dollarize), that they should lever up their central banks for a few months using SOFR backed assets (commodities, bonds, Magnificent 7, high yield corporates, even real estate backed assets). They will get a boost and take home a profit, while buying the US Govt time to figure out another scenario to pull their rabbit out of a hat. Hell, China needs the ganis as well... this is why its good to be the country with the reserve currency. Sorry if this blows the minds of the Austrian Econometric Model followers.
Stablecoins can absorb this deficit.
So what you'd like to do is figure out a way to expand this debt ridden, evil system?
Go take an accounting class or two. Just as there are laws of physics that cannot be broken, there are laws of finance that can only be bent and cheated so long before the consequences fall like an 800 lb anvil.
You crypto guys just can't wait for your digital prison cell, can you? You are running as fast as you can to lock yourself in your Ready-Player-One fantasy land.
Wake up, buttercup. When technology is being used at every turn to imprison you, don't imagine that technology is going to save you. You no more control technology/internet/your own computer than you control the interstate highway system.
Think about it. You don't control your own personal computer anymore. That's not your cellphone. That's not your vehicle. That's not your tractor. Hell, that's not even your TV.
There are multiple third parties that control and claim right to those things you bought and "paid" for.
Crypto will seem like the alternative until countries begin outlawing its use in commerce, including any bank transactions. Inevitably there will be no where to exchange the crypto back into a currency that can be used to actually buy goods and services.
Initially this will occur when governments will try to convert their paper currency and metal coins into a digital currency, and will not want competition from non-government electronic currencies. And that will occur when the US and EU countries realize that the only way out of their deb tcrises will be to entice their populations to exchange their physical currency for government digital currency at rates of exchange favorable to reducing government debt. These governments will realize that if they try to force the populations to make the exchange, then they will have Civil Wars to deal with that will topple their governments. So they will use other methods of persuassion, including the restriction against using non-government digital currency from commercial transactions within their countries.
You will know this all is about to happen when there appear large sellers - mainly the largest US investment houses, British clearing banks, and other banks in EU countries with close ties to their respective government - in the Bitcoin Futures markets. These sellers will be acting to fill orders that secretly were placed with them to execute by their respective governments, as the governments know they will reap huge profits to help pay down their national debts by being short Bitcoin just before those same governments proceed with the ban on commercial use of non-government digital currency.
Its probably a blatantly illegal scheme in most of the countries that will be taking part in it, but when the economic life of a nation is at signnifcicant risk as it is during a debt collapse, governments will not let laws stand in the way of dealing with national emergency. As the US government was allowed to confiscate all private non-jewelry holdings of Gold at an artificially low price, as it did in the US during the 1930s, you can bet that governments today will have no compunction in absconding with investors'capital placed in a financial instrument dedicated to competing with government-issued currencies.