Why US Debt Dynamics Could Get Ugly

We’ve been making the case this week that 2013 represents another turning point in the demise of the American Empire. If you view it in economic (rather than ethical or moral) terms, the high water mark of Empire was probably in the late 1990s.

But the internet bubble and bust marked an important turning point. It coincided with the birth of the euro, a competing reserve currency that no doubt encouraged capital to flow back out of the world’s greatest economic empire. Before the euro come about, the US enjoyed unrivalled capital inflows. It pushed up the value of the (‘King’) dollar and inflated equity markets to historic levels.

From that point on, the US embarked on a desperate strategy of ‘stimulate and hope’. Fortuitously, China had just joined in the world trade system and needed a leg up. It wanted to peg its currency to the US dollar at a very competitive rate in order to build wealth and savings via a trade surplus.

This benefitted the US because the currency peg policy ensured that government and household deficits would be recycled back into the economy (i.e. by China buying US bonds), keeping interest rates low…low enough to fuel a property boom to take over form the internet boom (and bust).

But that got out of hand in a major way (as credit booms tend to do) and the subsequent bust in 2008 was disastrous. So you could put 2007 next to 1999 as the second turning point in the demise of the US economic empire.

Now here we are five years later – 2013 – possibly at the cusp of another pivotal year. On the surface it may look like this is all about the current US political debacle. But it’s been brewing for years. And it’s been brewing because the only solution the US has to its problems is to go further into debt. It’s a short term expedient, not a solution.

As we’ve said many times, the problems in the developed economies are structural. It’s the structure of the economy that needs changing. But it can’t happen without pain. You can’t have an economy rely on easy money and constant government spending and expect sustainable improvement.

If you just keep lowering interest rates you’ll end up having a nation full of real estate agents driving around in BMW 3, 5, or 7 Series cars.

Lowering interest rates or monetising debt via QE promotes short term bursts of activity, but it ALWAYS requires more. That’s why the post-2007 economic recovery has been so anaemic. There’s too much debt and the global economy is too badly structured to produce anywhere near historic rates of growth.

Writing in the New York Times, Stephen D. King (Chief Economist of HSBC) tells us:

We are reaching end times for Western affluence. Between 2000 and 2007, ahead of the Great Recession, the United States economy grew at a meager average of about 2.4 percent a year – a full percentage point below the 3.4 percent average of the 1980s and 1990s. From 2007 to 2012, annual growth amounted to just 0.8 percent. In Europe, as is well known, the situation is even worse. Both sides of the North Atlantic have already succumbed to a Japan-style "lost decade."

Yes, economic growth rates are grinding lower as we come to rely more and more on monetary policy to do the heavy lifting. This will only continue while weak politicians look to the Fed or the RBA to ‘do something’.

Speaking of growth, the IMF forecasts global economic growth of just 2.9% this year, the weakest rate of growth since 2009. It also downgraded Australian economic growth forecasts from typically over-optimistic levels of 3% and 3.3% for 2013 and 2014 respectively, to 2.5% and 2.8%.

That’s still optimistic if you read Dan Denning’s latest research on the Aussie economy. The IMF also points out that the Aussie economy has greater exposure to China than any other economy in the world – bar Mongolia, which shares a long border with the Middle Kingdom.

That’s not surprising, given around 35% of our exports go to China. And China’s got its own credit boom and resultant structural problems going on, so the bounty we have enjoyed over the past decade certainly won’t be replicated over the next 10 years.

Meanwhile, over at the APEC summit in Bali, we saw a rather humorous representation of the decline of the US Empire. President Obama couldn’t attend the summit, given he is stuck in Washington trying to avert a technical default on the nation’s huge debt levels.

It was Russian President Putin’s birthday, so Indonesian President and summit host Yudhoyono cranked out the guitar and played happy birthday, much to the delight of Chinese President Xi Jinping. So, it seems everyone was partying except Obama.

It’s probably not much of an analogy. But it goes to show, when you’re the world’s biggest debtor you can’t just down tools and go to the pub whenever you feel like it. You’ve got to make sure the money keeps coming in…because there are bills to pay and you can only pay those bills if the money keeps rolling in.

Yesterday we pointed out that the bond market wasn’t too perturbed by the US debt issues. At the long end of the curve it’s certainly not. But at the shorter end it’s a different story. Bloomberg has the story:

Treasury one-month bill rates surged to the highest since 2008 and yields on three-year notes rose as the U.S. sold $30 billion of the debt in the first auction of coupon securities since the start of the government shutdown.

The Treasury sold $30 billion of one-month bills at a rate of 0.35 percent, the highest since November 2008 and more than double the rate on comparable one-month securities yesterday.

While it’s still unlikely at this stage, US debt dynamics could get very ugly, very quickly. In the fiscal year 2013 the Treasury had to redeem (refinance) a record US$7.55 trillion in debt, largely because of the large amount of maturing short term debt.

In order to refinance that amount and pay for all its promises, it had to issue a massive US$8.32 trillion of debt, spanning short and long term duration. That’s quite a supply of paper the world has to digest.

This refinancing schedule will become a problem if short term rates continue to remain high. That’s because higher interest debt will replace very low yielding debt, which will put further pressure on the US’s debt servicing costs.

According to the latest Fed’s ‘Flow of Funds’ report, interest payments in the second quarter jumped 13.5% to US$438 billion (annualised). In nominal terms, that’s a record amount. If borrowing costs to continue to rise, soon the US will spend US$500 billion per year on simply servicing its debt.

That’s a lot of ‘cash’ flowing to the recipients. But the same creditors finance it anyway…it’s all just shuffling paper around. More importantly, it represents another major drain on the imperial credit line. In effect, the US is asking for credit to pay the cost of the credit it’s already drawn down on.

Yep, it’s all about credit and credibility. Cash in your previously earned credit and hope for the best. But at the rate things are going, a few more years of this and the US will have little credibility left. Once your credibility is gone, so is the money.
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Greg Canavan is a Contributing Editor at Markets & Money and Head of Research at Port Phillip Publishing. He advocates a counter-intuitive investment philosophy based on the old adage that ‘ignorance is bliss’. Greg says that investing in the ‘Information Age’ means you now have all the information you need. But is it really useful? Much of it is noise, and serves to confuse rather than inform investors. And, through the process of confirmation bias, you tend to sift the information that you agree with. As a result, you reinforce your biases. This gives you the impression that you know what is going on. But really, you don’t know. No one does. The world is far too complex to understand. When you accept this, your newfound ignorance becomes a formidable investment weapon. That’s because you’re not a slave to your emotions and biases. Greg puts this philosophy into action as the Editor of Crisis & Opportunity. He sees opportunities in crises. To find the opportunities, he uses a process called the ‘Fusion Method’, which combines charting analysis with more conventional valuation analysis. Charting is important because it contains no opinions or emotions. Combine that with traditional stock analysis, and you have a robust stock selection strategy. With Greg’s help, you can implement a long-term wealth-building strategy into your financial planning, be better prepared for the financial challenges ahead, and stop making the same mistakes that most private investors do every time they buy a stock. To find out more about Greg’s investing style and his financial worldview, take out a free subscription to Markets & Money here. And to discover more about Greg’s ‘ignorance is bliss’ investment strategy and the Fusion Method of investing, take out a 30-day trial to his value investing service Crisis & Opportunity here. Official websites and financial e-letters Greg writes for:

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