THE AMERICAN DELUSION - TAKE 2

By: Thomas McKelvey Cleaver

A friend from the other side of the political spectrum and I were discussing the question of American international debt and its influence on policymaking. He commented that when Donald Trump was deeply in debt a few years ago, that he considered it a problem for his creditors, not for him. In many ways, the Bush Administration seems to think the same way as "The Donald" - but they fail to consider that there's a huge difference between an individual businessman, no matter how wealthy he is, going bankrupt and the world's most powerful state going through such an event.

In his masterful "The Rise and Fall of the Great Powers", historian Paul Kennedy argued that great powers typically fail when military reach outstrips that nation's economic strength.

Recent events point in that direction for the United States. Consider:

On Thursday, March 10, Japanese Prime Minister Junichiro Koizumi, when asked about the risks of having reserves too concentrated in one currency, told a parliamentary committee, "I believe diversification is necessary." His comment rekindled speculation in the currency market that the Japanese government - which with a total $840.6 billion in U.S. Treasury bonds holds the world's largest dollar-denominated foreign-exchange reserves - could shift out of dollars. The comment led to a drop in the dollar exchange rate with the yen, though the dollar recovered after the Ministry of Finance stated Japan had no plans to shift funds out of the dollar.

This latest gyration came after a downward spike in the dollar in February after the Korean central bank, which has the world's fourth-largest foreign-exchange reserves, referred in an annual report to possible diversification.

In January, speaking at the World Economic Forum in Davos, Switzerland, Fan Gang - Director of the National Economic Research Institute at the China Reform Foundation - said the issue for China isn't whether to devalue the Yuan but "to limit it from the U.S. Dollar." He went on to say (in English, to be sure he was not misunderstood): "The U.S. dollar, in our opinion, is no longer seen as a stable currency, and is devaluating all the time, and that's putting troubles all the time. So the real issue is how to change the regime from a U.S. dollar pegging to a more manageable reference...say Euros, Yen, Dollars, those kind of more diversified systems."

China now holds the second-largest dollar-denominated foreign-exchange reserves after Japan. In the past two years, China has replaced Japan as the largest trading partner of the United States.

Understanding all this depends on understanding the present situation of the current account deficit, which is an outgrowth of our biggest domestic economic problem - the shortfall of national saving. Since the First Quarter of 2002, our net national saving rate, which is the combined saving of individuals, businesses and government - adjusted for depreciation - is now at a record low of 1.5% of GDP. Because of this, the United States must import foreign savings in order to keep growing at acceptable rates. Thus, we run massive and ever-widening current account deficits to attract that foreign capital, making up for out lack of domestic savings.

As of the 4th Quarter of 2004, the current account deficit of the United States hit an all-time record of 6.3% of GDP, and the trade deficit on goods accounted for 98% of this because more and more the United States doesn't make things, at least not things the rest of the world wants to buy.

This current account deficit is a 1.8 percentage point deterioration from the 4.5% deficit announced a year earlier. This is not only a record current-account deficit for the United States, it is also a record financing burden for the rest of the world. We now require the rest of the world to buy an average of $2.9 billion of American debt - sold as Treasury Bonds - each and every business day just to keep the magic going. As a country, the United States is a family living paycheck to paycheck who has to go to the Payday Advance loan sharks every week, just to put food on the table and keep the bills paid.

This past Wednesday, March 16, the 4th Quarter 04 current account deficit was announced. On the same day General Motors announced a record earnings loss, and oil prices climbed to a record $56 per barrel.

This all comes together as results stemming from a single cause: The budget deficits run up by the Bush Administration in the past three years - now at record levels - have been crucial in pushing the national savings rate to a record lows. It is the capital inflows, and the trade deficits behind them, that are required to compensate for these budget deficits and so that a saving-short America can get the foreign aid it needs to keep on growing. This is "Big Government Conservatism" - otherwise known as "Bushonomics" - in action. We are running our own Ponzi scheme on ourselves.

The record increase in the price of oil is connected to all this. In real terms, $56 a barrel oil is a 400% increase in price from the lows of late 1998, which puts this on a par with the devastating blows we experienced in the 1970s. The sharp run-up of oil prices is the equivalent of a tax on household purchasing power that only digs the hole deeper for the already over-extended American consumer. Personally, I don't feel that bad watching SUV owners debate the question of whether to fill the tank or buy food for the family that week, but that's merely a personal feeling. In fact, as American families have to decide whether to fill the tank or buy food, this will lead to deferrals on other purchases that have kept the economy going over the past four years of the first Bush Administration. Falling demand for SUVs was reported on the business pages of the LA Times this past week. No wonder GM made the report it did - my bet is Ford and the others won't be far behind.

Of course, the Bush Administration's spin is that the rest of the world can't get enough of dollar-denominated assets because of the returns they offer in an otherwise return-starved economic environment. This is about as accurate a view of what is really what as "Saddam had WMDs" and "We're winning in Iraq."

The truth is the foreign capital pouring in at $2.9 billion a day is not the result of private investors plunging back into American assets. It is the result of policy decisions by foreign central banks. Total reserves increased by about $700 billion from year-end 2003 to year-end 2004, which implies an increase of nearly $500 billion in dollar-denominated holdings by the world's central banks. In other words, foreign central banks financed approximately 75% of America's current account deficit last year.

It is here that the Donald Trump analogy comes into play. This purchase of American debt is a bold attempt by foreign central banks to keep their dollar exchange rates from rising - thus maintaining their current account surpluses - and thus defer what could be a painfully-classic U.S. current account adjustment complete with a further decline in the dollar and sharply higher US interest rates. In other words, the central banks are providing a subsidy to American interest rates, which have allowed for such events as the drastic increase in housing value to the point where people like me are starting to remember the Real Estate Bust of 1989-90 here in California. This subsidy has been what has cushioned the blows of stagnant real wages and surging oil prices that would otherwise clobber the American consumer, and allows Bush to maintain his policy of coddling the comfortable.

When I was a teenager, I worked as a lifeguard at the local swimming pool. One thing we learned in water safety class was that our job did not include "going down with the ship." In other words, there comes a point where a would-be rescuer might have to let go of the drowning man. That is the point at which the rescuer realizes the drowning man can pull the rescuer down with him. The message that has been delivered at Davos, in Tokyo and Seoul in the past sixty days is that the central bankers are close to realizing they may have to let go of the drowning man.

The message is that the Republican's game is just about over. One by one, the Asian central banks who hold our Payday Advance checks have dropped increasingly less-subtle hints that they are saturated with dollar-denominated holdings. Korea, Japan, China, India, Malaysia, Hong Kong, and Singapore - all are coming to see these massive dollar overweights as a threat to their continued well-being.

Like Donald Trump, the standard Bush response borders on arrogance: "What choice do they have?" This comes from the presumption that we export-driven Asian economies over a barrel, that they are unwilling to accept the deterioration in export competitiveness currency appreciation might bring. This misses the key cost-benefit tradeoff - the moment when the rescuer has to decide whether or not to be dragged down by the drowning man - as the governments of these countries weigh the damage to exports against the fiscal cost of a loss on holdings of dollar-denominated assets. These are not private investors who have to worry only about themselves - these are governments who are ultimately responsible to their citizens and must inevitably think in terms of national interest. The bigger the dollar reserves, the more this cost-benefit analysis is likely to come to the policy decision of dollar diversification. And this spells the end of America's cut-rate foreign financing.

In addition to the economic news of the past two weeks, there is political news of more than passing interest. The People's Congress, meeting in Beijing, passed a law making any attempt by Taiwan to declare independence a cause for war. Bush recently declared that it is American official policy to support Taiwan in the event of a war between them and the mainland. We even got the Japanese to formally declare a national interest in maintaining the current status of Taiwan.

Consider the day that the Taiwanese declare independence. It won't be a struggle between the Chinese Navy and two American carrier battle groups in the Taiwan Straits. The Chinese in Beijing will only need to put in a call to Washington and inform the Secretary of the Treasury that they are planning to diversify their foreign exchange reserves into Euros.

The result of that move - with the Japanese, Koreans, and all the others following suit in order to protect their own national economies - will be an American economy that makes 1929 look like Good Times. Is there an American President of either party - or an American political party - that could take that sort of hit?

Taiwan independence is only one of several possible scenarios that hold this sort of outcome for the United States. The rest of the world doesn't need to draft a single soldier to bring the greatest superpower in history to its knees. As Paul Kennedy has pointed out, every Great Power going back to the Roman Empire has fallen when military reach outstrips that nation's economic strength.