Shadows of Foreign Debt

One man’s debt is another man’s asset; the American deficit of some $700 billion signals foreign credits of the same amount. Dr. Hans Sennholz explores the United States’ ever-increasing indebtedness to the rest of the world…

Ever eager to observe and command, government officials like to record their countrymen’s economic dealings with people abroad. They create "balances of payments" which are to help them evaluate and manage economic relations.

Last year, the American balance posted extraordinary deficits of some $668 billion, or more than six percent of gross national product. This year it is estimated to exceed $700 billion. In any other country a deficit of just three percent would sound the alarm and could trigger a sudden flight of capital and a crash of the national currency. Moreover, the U.S. government itself is suffering huge budget deficits that amount to several hundred billion dollars annually and by now exceed a total of eight trillion dollars. Yet, few economists seemed to be disturbed; they apparently are guided by the old mott "A poor man’s debt makes a great noise; a rich man’s debt makes no sound."

Americans obviously spend more abroad than they earn, consuming more than they are producing, and ever increasing their indebtedness to the rest of the world. Only two other countries, Australia and the United Kingdom, presently suffer minor deficits. All other countries, large and small, rich and poor, finance the deficits with their trade surpluses. Japan is the biggest creditor with claims of some $170 billion. The petroleum exporting countries in the Near East follow with $110 billion, then China, Russia, and Switzerland. This worldwide imbalance of consumption and production obviously calls for an explanation and raises important questions of readjustment.

On first glance, the American payment deficit springs from a spending predilection of public, as well as private, profligacy. All levels of government are suffering budget deficits amounting to some 4.5 percent of gross national product. In less than a decade the federal government managed to turn a budget surplus into a deficit by way of tax reductions and spending increases. At the same time, the American savings rate fell to barely one percent. Consumption accelerated due to extremely low interest rates and rapidly rising real estate prices. Homeowners could convert their rising housing value into ready consumption, making their homes convenient bank automats. But some are fearful that such riches have their limits, as interest rates are bound to rise and real estate prices soon may stagnate or even decline.

American Indebtedness: Why American Business Enjoy the Situation

In their foreign dealings, many American businessmen are enjoying the present situation. Virtually all their international liabilities are denominated in U.S. dollars, while some 70 percent of their foreign assets are reckoned in foreign currencies. The value of foreign assets and liabilities obviously changes with every change in the exchange rates of the currencies. A fall of the U.S. dollar immediately trims the value of virtually all American liabilities, while it raises the value of American assets owned abroad; a rise of the dollar affects the opposite. The visible fall of the U.S. dollar since 2002 explains why the total current-account deficit of $1.7 trillion merely added some $200 billion in external liabilities – and why the 2004 current-account deficit of $668 billion raised external liabilities by $170 billion. Every penny of dollar depreciation benefits many American businessmen, either by depreciating their debt to foreigners or appreciates their foreign investments, or both. The federal government, with rapidly rising debt of more than $8 trillion, is by far the biggest beneficiary.

American officials and their academic friends are quick to reject such analyses and conclusions. They dismiss all thought of responsibility for the situation and instead point to an acute savings predisposition on the part of creditor countries. Ben Bernanke, former governor of the Federal Reserve and now chairman of the Council of Economic Advisers, insists that much of the world is suffering from an acute disorder of "savings glut"; the United States has no choice but to increase consumption. Fortunately, it is willing and ready to act as the "consumer of last resort." This valiant consumer also contravenes and offsets the savings glut of commerce and industry, in particular the entrepreneurial sector, which in many countries has begun to save more than it invests. It usually is the investor of the people’s savings, building plants, shops, mills, foundries, and other enterprises, ever eager to raise labor productivity. At this time many prefer to become creditors rather than entrepreneurial debtors, causing much stagnation throughout the industrial world.

Even in the United States, where economic expansion continues at modest rates, many corporations now prefer to invest in government securities rather than embark upon new production ventures. They are improving their balance sheets and getting ready for any conceivable readjustment.

Economists who observe such behavior may find no fault with their preparations, nor with the "savings predilection" of foreigners, the official scapegoats of the international imbalance. They may even sympathize with people who are enjoying the rising value of their homes. But these economists lay the blame for the ominous imbalance of trade relations on the Federal Reserve System, which in the service of Federal deficit financing, managed to cause unprecedented maladjustments. In order to finance huge Federal budget deficits and prevent painful economic readjustments, it lowered interest rates far below market rates and glutted credit markets, which deceived and misled millions of people all over the globe. No other central bank possesses such powers; any attempt to emulate the Fed’s policies would cause its currency to crash.

American Indebtedness: Glutting Credit Markets

Even the European Central Bank, which appeared on the scene in 1999, probably could not follow in Federal Reserve footsteps; it soon would damage the euro. Only the Federal Reserve still seems to have the capability to glut credit markets. Until the creation of the euro, the U.S. dollar was the sole reserve currency of the world, held and used not only by every other central bank but also by thousands of commercial banks and countless public and private corporations. It had replaced gold as the universal medium of exchange during the early 1970s and has functioned as world money ever since. This worldwide function obviously has given and continues to give it exceptional strength that affords its issuer an extraordinary leeway for monetary expansion. It receives further support and strength from the reputation of the United States as a safe harbor for foreign investments. A reputation for principle and rectitude is itself a fortune. But how long can the dollar withstand false interest rates and massive budget deficits?

Many countries, rich and poor, now are supporting the richest country on earth. This odd situation raises serious questions of consequences if the creditor countries should suddenly tire of their chore and call a halt to the burden. What would happen if, for instance, the Asian central banks should suddenly refuse to add to their dollar holdings or even reduce them and instead decide to invest their surpluses in euros? Surely, such a reaction would lead to much international turbulence and severe economic crisis.

Economists may point to the dollar crisis of 1979 and 1980, when the dollar was under persistent pressure from abroad its value was falling rapidly in relation to the currencies of other trading nations – and to gold, which was deemed to be a safer repository for reserves. Fueled by rising oil prices, the consumer price index soared nearly one percent every month and interest rates climbed to the highest level of the century. With markets for currencies, metals, and other commodities thrown into disarray and the rate of unemployment higher than seven percent, the Federal Reserve (under the direction of chairman Paul Volcker) finally "took away the punch bowl" by raising the member bank discount rate to twelve percent and boosting marginal reserve requirements for member banks. A degree of hope was restored as many Americans realized that their government had to balance its budget and that people must live within their means, produce more efficiently, and conserve, save, and build for the future.

What we look for may not come to pass; yet we must not let the future frighten us. The present situation of American deficits and foreign credits may continue as far as the eye can see. After all, an old monetary order, which had been created at the 1944 Bretton Woods Conference, withstood much international disorder for more than thirty years. Some economists and their friends in government like to note the similarities of that order with the new. But this economist does not see the semblance. With his eyes on huge trade deficits and foreign debts and on grave international conflict and strife he braces for more commotion and crises to come.


Hans Sennholz
for The Daily Reckoning

October 18, 2005

Dr. Hans Sennholz is president emeritus of The Foundation for Economic Education (FEE) in Irvington, NY. His essays and articles have appeared in over thirty- six major German journals and newspapers, and 500 more that reach American audiences. Dr. Sennholz is also the author of 17 books covering the Great Depression, Gold, Central Banking and Monetary Policy.

When U.S. Secretary Snow urged the Chinese to learn from America’s example by spending more, saving less, and taking advantage of the "financial sophistication" on offer by Wall Street, we do not suppose he had Refco in mind. Until a few days ago, Refco was the world’s largest broker of futures contracts. But now the company’s 2012 notes trade for only 16 cents on the dollar and trading in the stock was halted on October 13th, after shares had lost 64% of their value.

He probably wasn’t thinking of the geniuses at G.M. and Delphi either. The businesses are among the biggest in the country. They can afford to pay the brightest minds on Wall Street to come up with the most sophisticated products ever invented. Still, one company struggles to strip its workers of the money they were promised; the other is already broke.

What we haven’t been able to figure out is how "sophistication" actually works. We know how it works at dinner parties. The most sophisticated guests are always the most insufferable. They are the ones who will tell you which restaurant in Cairo deserves your custom, how the Iraq mess could be resolved with greater international cooperation, whose exhibits at the Tate are the most "engaging" and why your tastes in wine make you seem like a bumpkin.

The problem with being an international sophisticate, as we are discovering, is that it is very expensive, and getting more expensive all the time.

Coutts, the private bank whose most illustrious client is Britain’s Royal Family, recently noted that the price of being rich had gone up. The number of millionaires in Britain has gone up by more than 80% in the last four years, thanks largely to increasing in property prices. The average house has gone up 64% in that same period, so that anyone with an un-mortgaged house in central London is a millionaire. Since the 1990s, says Coutts, real estate has approximately tripled in price, as has the cost of being rich. Now, you must have at least three million pounds (about five million dollars) before you can enjoy a "millionaire’s lifestyle."

In London, it now takes an annual income of 298,000 pounds – about half a million dollars – to live a "luxury" lifestyle, according to the bank. "A millionaire’s lifestyle" includes a "Five-bedroom house with two staff, two luxury cars, an apartment and 90,000-pound yacht in St. Tropez, 12,000 pounds on eating out and luxury holidays worth 19,000 pounds per year."

Hmmm…it sounds to us as though the bank has badly miscalculated. Five million dollars of assets, at 5% interest, produces only $250,000 of annual income. That is, before tax. After tax, a household would only have about $150,000. The garage…we mean, coach house…we rent in South Kensington costs us nearly that much alone.

"They are being absolutely ridiculous," comments Michael Winner. "To live like a millionaire on three million pounds you’d have to live in the Outer Hebrides… All in all, to live the traditional millionaire’s lifestyle I would say would cost 600,000 pounds to 700,000 pounds a year…with just three million [pounds], you would have to be living at the YMCA."

Why has the cost of living the high life gone so high? We have an answer for everything, dear reader. The Chinese export things that you find at Wal-Mart. That is why the "cost of living" for the average lumpenconsumer is rising only modestly (Oops…what’s this? Last month the CPI in the United States shot up 1.2% – the biggest increase in 25 years).

But the money-shuffling, property-developing, house-flipping, debt-mongering super-sophisticated businesses of The City and Wall Street are hugely profitable. They throw off large amounts of cash…money that doesn’t go shopping at Wal-Mart. Instead, these high earners want what the Chinese cannot produce: houses in South Kensington, apartments in St. Tropez, dinners at Lucas Carton, and ugly modernist paintings sold at auction at Christies. The high rollers are desperate for status, and status symbols are going up in price as more and more rich people bid for them. Each purchase of a rare vintage wine or automobile, a Picasso or Modigliano, an apartment on the avenue Foch, or Cadogan Gardens makes them more sophisticated.

See how simple it is, dear reader? If the Chinese were only to avail themselves of these sophisticated services offered by the City or Wall Street, they could have enough money to live sophisticated lives.

Of course, we can’t help but recall the most sophisticated financial company of all time: Long Term Capital Management. The firm had not one, but two Nobel laureates in economics on its staff, and a team of dozens of PhDs from the worlds leading universities. You can’t get more sophisticated than that. Like all financially sophisticated enterprises, LTCM used debt – leverage – to increase the rate of return on its sophisticated investments. If only the Chinese had known about it!

But we are sorry to report that Long Term went bust in the short term, owing billions to its counter-parties, and almost brought the entire world’s financial system to its knees. Then, central bankers and loan sharks came to the rescue with more credit, more leverage, and more sophisticated ways of getting people in over their heads.

And that is where we are now. Our credit industry is so sophisticated…which is to say, it has so many tricks up its sleeve…that the entire nation is practically broke.

More news from our pals at The Rude Awakening…


Justice Litle, reporting from Nevada:

"I’m firing off this response to my friend and colleague Chris Mayer’s recent Rude Awakening essay, ‘The Other Oil Crisis.’ On bourbon we agree, on oil and energy, we do not."


Bill Bonner, back in London with more views…

*** Poor G.M. and Delphi factory workers. Delphi’s chief executive says he will work for $1 a year, which is probably more than he is worth. The man pocketed a $3 million signing bonus in June. We are not shareholders; it is none of our business. But we would be not terribly surprised that he is leaving a few months from now – further enriched by an exit bonus on the way out.

The man is up against the forces of history. He has a labor force 10 times as expensive as his rivals in Asia. Press reports, today, said that the poor shleppers, toters, and bussers might have to give up more than half their hourly wages in order for the industries to stay in business.

"That will mark the end of the era in which ordinary working Americans could be part of the middle class," writes Paul Krugman in the International Herald Tribune. "America is a much richer country than it was 30 years ago," he continues, explaining why mommas don’t want their babies to grow up to be working stiffs, "but since the early 1970s the hourly wage of the typical worker has barely kept up with inflation." In 2004, for example, a year in which the U.S. economy boomed…far outpacing its rivals in Europe…the median real income of full-time, year-round male workers fell more than two percent."


*** Here, a letter from a DR reader:

"Dear Mr. Bonner:

"I am confused.

"As a fully paid-up subscriber, I have unqualified admiration for your reflections on the state of the world, the state of your own household, and also for your thoughts on the state of the American empire.

"I am having difficulty reconciling your expectations of a dollar decline with your oft-repeated axiom that people (especially investors) get not what they expect, but what they deserve. In your commentaries we are frequently reminded of the virtuous, hard-working, and most of all THRIFTY Asians who are over there toiling away at rock-bottom wages so that we can buy a cheaper gadget from Wal-Mart. They then take the proceeds of our purchase and lend it back to us so we can repeat. Or start wars. There is also just as frequently a reference to a dollar decline as the inevitable consequence of a nation of wastrels leaving beyond our means.

"Here’s the question: Is that what Asian savers deserve? To have their investments, the fruit of all that hard earned saving, vanish as the dollar performs a swan dive? And what of the borrower? If I borrow millions from the Chinese, financing my own consumption with nothing more taxing than filing out a mortgage application, should I enjoy a de-facto default? Is that what I deserve, to have my liability effectively reduced while I continue to enjoy whatever gaudy, charmless McMansion I acquired with the loan? All the while channeling Harold Wilson and making reassuring noises about the pound (dollar) in your pocket?

"Either the dollar declines, in which case no one appears to be getting what they deserve, or it does not, in which case everyone gets what’s coming to them. Yet in your commentary it seems like a declining dollar is a forgone conclusion.

"It appears to me that a declining house price coupled with a liability whose value is NOT being whittled away in real terms by a declining dollar is precisely the dose of cod-liver oil that is required if that is, we get what we deserve."

*** It is not for us to decide what anyone really deserves. Still, when we look for poetic justice in modern finance we see the same rhyming scheme our reader sees. It would be too easy for Americans to escape their debts by inflation. That is why we have always anticipated a period of Japan-like slump…with falling prices, and rising bankruptcies…before the Argentine-style inflation wipes out everyone.