Wednesday, May 12, 2010

Global sovereign debt crisis

Global sovereign debt crisis
By Henry C K Liu

This is the seventh article in a series.

Part 1: The crisis of wealth destruction
Part 2: Banks in crisis: 1929 and 2007
Part 3: The Fed's no-exit strategy
Part 4: Fed's double-edged rescue
Part 5: Too big to save
Part 6:
Public debt - prudence and folly

As a result of government bailouts and stimulus spending in response to the global financial crisis, gross government debts around the world have risen to unprecedented heights by 2010 and are expected to continue on an upward trend for the foreseeable future as recovery remains anemic in many regions in the world. Ironically, the list of countries with high sovereign debt is topped by Japan, notwithstanding Japan's huge foreign
currency reserve and its large export sector and persistent trade surplus.

Japan has been in permanent recession since the 1985 Plaza Accord pushed the exchange value of the yen up against the dollar without any significant effect on US-Japan trade imbalance in Japan's favor. Despite continuing trade surpluses, Japan's gross government debt rose from 170% of GDP in 2007 to nearly 200% in 2010 as the Japanese government revved up spending to stimulate in vain the structurally impaired export economy.

A similar fate will fall on all economies that depend excessively on export for growth as the traditional import markets in the advanced economies such as the United States and the European Union are themselves trapped in anemic growth by excessive debt for decades to come.

Yet the world, led by the US, has continued to waste
money on military spending in the middle of a ruinous financial crisis. In 2008, global military spending totaled US$1.5 trillion. The US alone spent $607 billion on defense (41% of world total) while many of its citizens were defenseless against losing their homes through mortgage foreclosure due to falling income.

Stimulus packages dwarfed by military spending
In 2008, congress approved a stimulus package of $819 billion that included regressive tax cuts, with spending to begin in 2009 and to end in 2019. Taking away tax cuts, the spending amounts to $637 billion, with peak spending at $263.4 billion in 2010 - less than half of US military spending in 2008.

Meanwhile, special appropriations have been used to fund most of the costs of war and occupation in Iraq and Afghanistan so far. Much of the costs for these conflicts have not been funded through regular appropriations bills but through emergency supplemental appropriations bills. As such, most of these expenses were not included in the budget deficit calculation prior to the financial year ending in September 30, 2010.

From 2001 through February 2009, the Congressional Research Service estimates that congress approved $864 billion in war-related funding for the Departments of Defense, State and Veterans Affairs. This total is allocated as $657 billion for Iraq, $173 billion for Afghanistan, $28 billion for enhanced military base security, and $5.5 billion that cannot be categorized. Aside from normal military spending, about $900 billion of US taxpayers' funds have been spent, or approved for spending, through September 2010 for the Iraq War alone.

Growth needs to come from development, not trade
Not withstanding the fact that in 2010, despite the global financial crisis, the EU and the US still remain the world's two largest economies by gross domestic product (GDP) the EU at $16.5 trillion, the US at $14.8 trillion, about 50% of the world total of $61.8 trillion, the days are numbered when theses two economies can continue to play the role of the world's main consumption engines and act as markets of last resort for the export-dependent economies.

For sustainable growth in the world economy, all national economies will have to concentrate on developing their own domestic markets and depend on domestic consumption for
economic growth.

International trade will return to playing an augmentation role to support the balanced development of domestic economies. The world can no longer be organized into two unequal halves of poor workers and rich consumers, which has been an imperialist distortion of the theory of division of labor into a theory of exploitation of labor, and of the theory of comparative advantage into a reality of absolute advantage for the rich economies.

Going forward, workers in all countries will have to receive a fair and larger share of the
wealth they produce in order to sustain aggregate consumer demand globally and to conduct fair trade between trading partners. Capital is increasingly sourced from the pensions and savings of workers. Thus it is common-sense logic that returns on capital cannot be achieved at the expense of fair wages. Moreover, capital needs to be recognized as belonging to the workers, not to the financial manipulators.

The idea that workers doing the same work are paid at vastly different wages in different parts of the world is not only unjust but also uneconomic. For example, there is no economic reason or purpose, much less moral justification, why workers in the US should command wages five times more than those of workers in China doing the same work. The solution is not to push down US wages, but to push up Chinese wages to reach bilateral parity between the two trading partners.

International trade driven by cross border wage and income disparity globally will wither away from its own internal contradiction which ultimately will lead to market failure. Low-paid workers are the fundamental obstacle to growth from operative demand management at both the domestic and international levels. Pitting workers in one country against workers in another will only destroy international trade with counterproductive protectionism, which is not to be confused with economic nationalism.

Some small countries may have no easy option other than to depend on export for growth. These countries, such as the small Asian tigers, are condemned to zero growth for the coming transitional decade as the world economy shifts from export-led growth to domestic-development-led growth. They may have to seek balanced domestic growth through true comparative advantage by symbiotic integration in large super-national economic blocks, to shift export into intra-regional trade.

For example, unlike China, Japan's domestic market is simply not big enough to make up for a rapid slowdown of its huge export sector. Thus Japan will have to find ways to further boost already saturated domestic consumption while shrinking its export sector, most likely facing negative growth until the protracted restructuring of its dysfunctional export-dependent economy is completed.

One option would be for Japan to integrate its oversized national economy with that of China so that the huge Japanese export sector can be transformed into a super-national domestic sector of a Sino-Japanese common market. South Korea faces the same problem and may have to consider the option of integration into a super-national East Asian economy. However, the East Asian model needs to be different than that employed by the EU for what are by now obvious reasons.

In 2010, on a purchasing power parity basis, China's GDP is $9.7 trillion, Japan's is $4.3 trillion and South Korea's is $1.4 trillion. An integrated East Asian super-national economy will have a PPP (purchasing power parity) GDP of $15.4 trillion, bigger than that of the US of $14.8 trillion.

The availability of a large domestic market with a large population and ample land are the reasons why large countries such as the BRIC (Brazil, Russia, India, China) are going to be dominant core economies going forward with symbiotic integration with neighboring smaller countries.

Foreign holders of US sovereign debt
China's foreign reserve hit $2.5 trillion in March 2010. In April 2010, Japan's foreign reserves fell below $1 trillion. By another calculation, at the end of March 2010, China's total funds outstanding for foreign exchange were around 20 trillion yuan ($2.93 trillion at concurrent exchange rate), showing around $110 billion of growth compared to the end of 2009.

On February 16, 2010, the US Department of Treasury reported that Japan boosted its holdings of US Treasuries by $11.5 billion in December 2009, bringing the total to $768.8 billion, making Japan once again the largest creditor to the US. China, after briefly occupying top position, became once again the second-largest holder of US Treasuries, having sold $122.1 billion earlier to bring its total to $755.4 billion, down from $877.5 billion in January, relinquishing the top position creditor back to Japan.

The most US Treasuries China had held in reserve was $939.3 billion in July 2009, two years after the global financial crisis broke out in July 2007 and five months after congress approved the $787 billion stimulus package to be funded with debt.

Outside of Asia, the United Kingdom bought $24.9 billion of US sovereign debt during the same month, bringing its total to $302.5 billion. Brazil bought $3.5 billion, bringing its total to $160.6 billion. Russia sold $9.6 billion, reducing its total to $118.5 billion. Foreign creditors, nervous about US stimulus spending, of future money sold the most amount of US sovereign debt in December 2009, $53 billion, surpassing the previous record drop of $44.5 billion in April 2009. At the end of February 2010, total Treasuries outstanding were around $13 trillion; the amount held by foreigners was around $3.75 trillion.

As of March 2010, China's foreign exchange reserve totaled $2.45 trillion, about 60% of which was invested in US securities. These securities include long-term Treasury debt, long-term agency debt, long-term corporate debt, long-term
equities, and short-term debt.

Hillary Clinton during her first visit to China as secretary of state in February 2009 urged China to continue to buy US Treasury securities. A month later, in March 2009, Chinese Premier Wen Jiabao responded by stating publicly that he was "a little worried" about the safety of China's holdings of US sovereign debt. In addition, some Chinese government officials have called for replacing the dollar as the world's main foreign reserve currency with International Monetary Fund special drawing rights, harking back to John Maynard Keynes' proposal of "bancors" for an international clearing union at the Bretton Woods Conference in 1943.

Foreign investors had been a mainstay of the market for US government-sponsored enterprise (GSE) debt (such as that issued by Fannie Mae and Freddie Mac), but uncertainty over the GSE mortgage financiers' capital positions and the timing and structure of an anticipated government rescue by September 2008 made investors reassess their risk exposures. Asian investors in particular became net sellers of US agency

Federal Reserve custody data show that for 2008 up to July, foreign government and private investors bought a monthly average of $20 billion of US agency debt issued by GSEs such as Ginnie Mae, Freddie Mac and the Federal Home Loan banks. Foreign purchases of US Treasuries averaged $9.25 billion a month. All told, the average monthly purchase of US public debt by foreigners was around $30 billion.

From July 16 to August 20, 2008, foreign buyers sold $14.7 billion of US agency debt, trimming their overall holdings to $972 billion. They purchased $71.1 billion of Treasuries in the same period with dollars earned from trade surplus.

Bailing out GSEs to protect foreigners' exposure
In his just published memoir, On The Brink, former Treasury secretary Henry Paulson revealed that Russia made a "top-level approach" to China "that together they might sell big chunks of their GSE holdings to force the US to use its emergency authorities to prop up these companies". Paulson wrote he learned of the "disruptive scheme" while attending the Beijing Summer Olympics. "The report was deeply troubling - heavy selling could create a sudden loss of confidence in the GSEs and shake the capital markets," Paulson wrote. "I waited till I was back home and in a secure environment to inform the president."

The Bank of China, the nation's major foreign exchange bank, cut its portfolio of securities issued or guaranteed by troubled US GSE
home mortgage financiers Fannie Mae and Freddie Mac by 25% since the end of June 2008. The sale by the Bank of China, which reduced its holdings of US agency debt by $4.6 billion to about $14 billion, was a sign of nervousness among foreign buyers of Fannie and Freddie's bonds and guaranteed securities. China holds about $400 billion of US agency debt in total.

A month after secretary Paulson returned from the Beijing Olympics with the disturbing message for President George W Bush, the Treasury on September 7, 2008, unveiled its extraordinary takeover of GSEs Fannie Mae and Freddie Mac, by invoking Section (14) authority under of the 1932 Federal Reserve Act, as amended by the Banking Act of 1935 and the FDIC Improvement Act of 1991.

This permits any Federal Reserve Bank to conduct open market operations under rules and regulations prescribed by the board of governors of the Federal Reserve System, to purchase and sell in the open market, at home or abroad, either from or to domestic or foreign banks, firms, corporations, or individuals, cable transfers and bankers' acceptances and bills of exchange of the kinds and maturities that were by this Act made eligible for rediscount, with or without the endorsement of a member bank, putting the government in charge of the twin mortgage giants and liable for the $5 trillion in home loans the GSEs had guaranteed.

The move, which extended as much as $200 billion in direct Treasury support to the two GSEs, marked the government's most dramatic attempt yet to shore up the nation's collapsed housing market to try to slow down record foreclosures and falling home prices. The sweeping plan, announced by Paulson and James Lockhart, director of the Federal Housing
Finance Agency (FHFA), placed the two government sponsored enterprises into a "conservatorship" to be overseen by the FHFA. Under conservatorship, the government would run Fannie and Freddie "temporarily" until these entities regained stronger footing. Some analysts have suggested that the move was partly motivated by the need to reassure China and Russia of the safety of GSE debt to discourage them from selling their substantial holdings.

Economic head wind from government exit strategies
In coming years, the global business climate can be expected to face a headwind even when the initial crisis has been stabilized by government bailouts of big distressed financial institutions, as government stimulus spending ends in several major economies and governments are forced to execute exit strategies for their extraordinary bailout measures even amid weak economic conditions, in order to prevent inflationary pressure and expectation from building and to address the danger of excessive public debt.

In the US, the Fed and the Treasury are expected to gradually withdraw stimulus measures, such as the ending of government aid to the auto industry and restoring the balance sheet of central banks by shedding toxic assets taken from insolvent financial institutions. Yet the Fed and the Treasury are caught between a rock and a hard place. Stimulus cannot be exited unless employment picks up to restore demand, but stimulus packages have been ineffective in reducing unemployment. So far, the main effect of stimulus spending has been to save the insolvent financial sector from total collapse, not to create new jobs.

Central banks and
finance ministries around the world would need to coordinate the timing of the ending of the near-zero interest rate regime to prevent extreme volatility and speculative arbitrage in the exchange values of their respective currencies and to dampen "carry trades" by banks eager to profit from cross-border interest rate arbitrage. This coordinated exit would be extremely difficult to manage because national economies are not likely to recovery at the same pace, and national policies tend to be governed more by domestic politics than by international coordination.

For the European Union, national GDP figures for Q4 2009 were disappointing: Germany posted zero growth even against weak expectations of 0.2%; Italy posted a 0.2% contraction against expectations of 0.1% growth; and the Netherlands posted 0.3% growth against expectations of 0.5%. Eurozone GDP grew just 0.1%, merely one third against weak expectations of 0.3%, bringing GDP contraction for the full year to negative 2.1% against expectations of only a negative 1.9%.

In France, January 2010 retail sales fell 2.4% on the month, food fell 4.4%, auto fell 5.1% autos, apparel fell 2.7%, with supermarkets falling 4.1% and hypermarkets particularly hard hit, falling 3.8%. This drop is exacerbated by a rise in inflation rate to 1% in December 2009. Given that of the 0.6% GDP growth in Q4 2009, 0.9%% stemmed from a rebound in consumption (+8% in automobiles), this hardly augurs well for GDP in 2010. GDP for the second quarter of 2010 will be worse because of the sovereign debt crisis in Eurozone.

Sovereign debt crisis
After Japan, whose government debt reaches nearly 200% of GDP in 2010, the PIIG economies (Portugal, Italy, Ireland and Greece) of the European Union (EU) all show projected 2010 public
debt above or headed for 100% of GDP, with Italy leading the pack at 127%, Greece at 120%, Portugal at 90% and Ireland at 65%.

The EU as a whole was not in any better fix at the end of Q4 2009, with public debt at 80% of GDP, slightly below the US at 90% and above the UK at 75%.

The PIGS (Portugal, Ireland, Greece and Spain) are visibly in hopeless trouble. But even in other EU countries normally considered financially more solid, public debt levels are unsustainably high: Belgium's is at 105%. Banks in Austria face deep exposure to recession-hit Eastern Europe.

Normally, sovereign debt denominated in the national currency needs never default because the government can always print more money to meet public debt service requirements. While sovereign debt denominated in the national currency does not face default risk, it does face risks of currency devaluation and inflation. Excessive sovereign debt can also cause hyperinflation with the collapse of the exchange value of the denominated currency, but outright default can always be avoided by central bank quantitative easing to meet debt service of sovereign obligations. A sovereign government only faces default on sovereign debt denominated in a foreign currency that it cannot print and must earn from export or purchase through the foreign exchange market.

The US, through dollar hegemony, can print dollars without fear of inflation because low cost imports keep US inflation low and her trading partners must buy US sovereign debt with their dollar denominated trade surplus to finance the US trade deficit. (See
US dollar hegemony has got to go, Asia Times Online, April 11, 2002.)

Euro preempts monetary sovereignty of EU members
EU member states are in an unusual situation - being constituents of a monetary union without a political union. Sovereign states within the EU by agreement have to denominate their sovereign debts in euros, which is a super-national currency of the EU governed by treaty conditions that prevent individual sovereign states within the union from printing euros at will to meet their separate monetary needs. At the same time, the European Central Bank (ECB) conducts its monetary policy for the benefit of the European Union, not for the needs of the constituent economies which are expected to conduct their respective fiscal policy in accordance with the rules of the European Monetary Union (EMU) to support the monetary policy of the ECB.

Many have warned that operating a monetary union without having first establishing a political union was putting the monetary cart before the geo-economic horse. By joining the EMU, a member country agrees to observe its monetary and fiscal rules regardless of what is needed by its national economy. Since EMU member states are at different stages of development with different socioeconomic conditions, EMU monetary and fiscal rules are not suitable for all members all the time.

EMU member states, such as Greece, know that adopting a stable currency that is not controlled by their own central banks implies a voluntary compromise in national sovereignty on monetary affairs. Normal sovereign options, such as devaluation of the national currency or an accommodative inflationary monetary policy are not available options for EMU member states. A single monetary policy for the euro is implemented solely by the ECB and it is the responsibility of each country to adjust its fiscal and economic policies to meet the "one size fits all" monetary criteria of the EMU.

Participation in the EMU does bring financial and economic advantages to the member states. The benefits of joining a stable large economic area with no monetary, economic and financial borders are great for the strong economies, but they are greatest for countries with historically weak economies that before joining were unable to achieve such conditions and were denied access to such a large market. Financially, adopting the euro allows previously weak economies, such as Greece, to enjoy easy access to
loans at lower long-term interest rates.

Unfortunately, instead of delivering on their commitments made at the time of entry to the EMU to reduce public debt levels, many new member states have used potential benefits not to strengthen their economy but to engage in a frenzy spending of
easy money.

Future of euro at stake
Monetarists point out that the crisis these economies face currently is not caused by any natural "external shock", such as an earthquake, but is the result of bad, even deceptive national policies pursued over many years masked by fraudulent data. They warn that bailing out these wayward economies, such as Greece, would reward poor behavior and create moral hazard of a dimension that will threaten the EMU itself and even the future of the euro.

According to monetarist logic, financial assistance to EMU member countries that have persistently violated the terms of their participation in the union would impair the credibility of the whole monetary framework of the EMU. By its construction, the EMU is a "no transfers" union of sovereign states. Transferring taxpayer money from sovereign member states that diligently obey EMU rules to those that regularly violate them would create antagonism towards the EMU based in Brussels and between euro area countries. For the people in the eurozone, such antagonism would undermine a necessary but still fragile sense of super-national identification with the larger aim of pan-European integration.

Financial crisis made in the USA
Yet while the current financial crisis facing the EMU was not caused by any external shock in the form a natural disaster, it has been undeniably caused by an external shock created by and originated from United States. As Nobel laureate economist Joseph Stiglitz, an American, rightly observes, the global financial crisis comes with a "Made in the USA" label. The allegedly irresponsible member states of the EMU got into financial trouble merely by acting according to the brave new rules of the neo-liberal no-holds-barred games promoted globally by US market fundamentalists and supported by easy money monetary stance of the US Federal Reserve. Destabilizing instruments of financial market innovation has been the main US export since the end of the Cold War.

The end of the Cold War removed the geopolitical gravity of a united Europe driven by a garrison mentality against communism. With the fall of the Berlin War, Europe's unification gravity came increasingly against an immovable socioeconomic wall. Necessity for doctrinal political survival was preempted by a doctrinal quest for
economic growth. Yet the gap of national differences is too wide to prevent a centrifugal fracture of the virtual union in the absence of an external enemy threat. Further, the European Union has since the Cold War transformed itself from a grateful ally of the US against a threatening USSR to a potential challenger of US global economic dominance.

Germany, the magnet that has held the EU together and generated most of its dynamic growth, is now driven by domestic politics that push for a return to nationalistic insulation against the European disease of social welfare inadequately sustained by economic productivity. German public opinion is moving toward separating the disciplined nation state from nebulous European common interests.

German taxpayers are not prepared to take on the role of unconditional underwriter of credit for the EU's problematic, free-spending member economies. The potential pain of a failure of the European Union for the stronger member economies such as Germany and France is now balanced by the pain of maintaining an unwieldy union of wayward members. European Union politics is now dominated by tactical nationalist maneuvers at the expense of strategic goals towards full union.

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