Will the U.S. Economy Go Bankrupt?

The flow of funds data released a while ago by the Federal Reserve summarizes the purported recovery of this year in a succinct, and striking fashion. During the first quarter of this year, domestic financial debt in the U.S. grew by around 4 percent in annualized terms, while both the household and corporate sector obligations shrank. The growth in debt was entirely the result of massive government spending on both the state and federal levels. Both the speed of expansion in government debt, and the speed of contraction on the private sector exceed the levels of the previous recession in 2001 by a large margin.

So the question is, will this massive government intervention allow the private sector the breathing space it needs in order to shrink its balance sheet, regain its health and resume its role as the driver of economic growth? The answer would be yes, in the absence of any unpredictable shocks external to the economic picture.

We do know that the deleveraging in the consumer and corporate sectors is a healthy, and expectable development which will eventually allow the economy to stand on its feet again. The problem is that the deleveraging process will take many years to be completed, making the claims about an incipient bull market untimely.

Reducing debt to a reasonable level, while increasing the amount of household savings, is a process that will take a long time to be completed. Meanwhile, dollar bears and doomsayers argue that the U.S. lacks the resilience to maintain its status as the superpower of the world as this process takes place, with the dollar being the main victim of the collapse, and as some argue, hyperinflation being the result.

Fortunately for the U.S. the symbiotic relationship between China and the United States, Japan’s dependency on American security guarantees in the face of its nationalistic and surging neighbor to the east, the fragmented nature of the Arab World, the reliance of the tiny oil rich sheikhdoms on American protection all ensure that the U.S. is still the most powerful nation in the world not only militarily, and economically, but diplomatically as well. Unless the American leadership itself makes a conscious decision that the debt burden is impossible to manage without monetization, and that domestic dynamism is insufficient to take us out of the present debacle, there is hardly any evidence that the U.S. will be forced into debasing the dollar in response to market pressures. And there is every indication that the political leadership of the nation still considers the devaluation option an extreme, and at this stage unnecessary choice.

Contrary to what is often assumed by analysts and commentators, it was Mr. Bernanke himself who initiated the 2008 upsurge in the dollar by making repeated references to its importance for the Federal Reserve as a central bank, and finally bringing rate cuts to a halt, in spite of exceptionally difficult circumstances, in April 30th, 2008.

In sum, the government is happy with a slowly depreciating or stagnant dollar, but it is also against any sharp acceleration in the downtrend (if it indeed exists). Indeed, given how dependent the global system is on stability and confidence, a dollar collapse would be the most counterproductive outcome at this stage. It is hard to argue that the government knows what it is doing, but it certainly isn’t trying to save the U.S. economy by burning the U.S. currency.

We believe that the dollar is unlikely to suffer any major collapse anytime soon. It is without doubt that the American economy is suffering from massive imbalances and inefficiencies, but as long as the rest of the world has no perceptible benefit in a destroyed standard of trade, and possesses nothing to replace it, the dollar death scenario will create new problems, without solving any of the outstanding issues.

Comments

[Prudent Man...:]

It is insolvent which is why it has to monetize debt. What does that "discount"?

Aug 17 03:10 PM

[Dave Wrixon:]

It is this kind of arrogance that could turn a severe collapse into a complete wipe out. There is no choice but to let the dollar devalue and any other outcome would ensure the destruction of the US economy, except that you probably don't have any say in the course of events but are in any case hostage to the market.

Aug 17 04:24 PM

[whidbey:]

Very insightful, but likely wrong. The costs of supporting a reserve currency are largely hidden, but the truth is, few are interested in the job. So the USD will labor on serving no one well.

The only thing that can salvage the dollar is some Congressional religion regarding the US budget. That could happen sometime in the next few years as Obama attempts to hold on for another term. I know, it is desperate, but not unthinkable.

You have to believe 12 impossible things before breakfast, but we did that last fall during the man's election, so it could happen again.

Aug 17 04:51 PM

[Roger Knights:]

"its nationalistic and surging neighbor to the east."

Hawaii?

Aug 17 05:25 PM

[Roger Knights:]

"its nationalistic and surging neighbor to the east."

Hawaii?

Aug 17 05:25 PM

[The Geoffster:]

The only currency worth owning in these uncertain times is gold.

Aug 17 06:46 PM

[Fitz919:]

People were leveraged, Financial institutions were leveraged, and now the Fed and the Treasury are seriously leveraged, which means "we the people" are leveraged again. And by the way...the FDIC isn't leveraged....it's virtually broke. 77 banks have failed so far this year, and just last Friday the FDIC said it will have to pay out 3.7 Billion just for the failures on Friday.

It's time to sing kum-bah-yah, and pass the koolaid, this party is over.

Aug 17 07:10 PM

[j-dub:]

psst.....................
It's already pretty much BK.
How long it'll stay that way is up to Obama pumping his spending brakes and to some extent, the American people.

(It's amazing what a phony stock market rally can do to trick the mind)

Aug 17 09:10 PM

[conceptwizard:]

The next wave is likely to involve a worldwide dollar panic. Using ballpark figures, we can say that there are about $4 to $5 trillion sloshing around the world in the form of hot money, US Treasury securities, Euro dollars, and various forms of zeno-dollars. Japan has about a trillion, China almost $2 trillion, and so forth. It is naturally very unwise for a developing country like China to hold so many dollars rather than using them to purchase needed infrastructure and capital goods, and the Chinese leaders are now very uncomfortable with their own foolish decision, which was of course taken under heavy US pressure. But the point is that this $4.5 trillion overhang is by its very nature exceedingly unstable. Every country that holds large sums of dollars or US Treasury bonds is nervously eyeing every other such country to see if they show signs of bolting for the exit. Up to now, so far as we know, no large holder of dollars has attempted to reduce its exposure to the battered greenback by dumping these dollars on the international market. If anyone did so, it would cause a true universal financial panic which would create chaos and mayhem not just in the United States and Great Britain, but in the vast areas of the rest of the world as well. This is concretely how hyperinflation could now very well arise: if one or more US creditor nations attempts to abruptly lighten up on dollars, the value of the US currency could undergo a catastrophic collapse, and that would spell runaway hyperinflation on the US domestic front.

Aug 17 09:14 PM

[Tony Petroski:]

"Fortunately for the U.S. the symbiotic relationship between China and the United States, Japan’s dependency on American security guarantees in the face of its nationalistic and surging neighbor to the east, the fragmented nature of the Arab World, the reliance of the tiny oil rich sheikhdoms on American protection all ensure that the U.S. is still the most powerful nation in the world not only militarily, and economically, but diplomatically as well. "

Forex Traders: I'm breathless. I agree with you (guys?) but for different reasons.

"the government is happy with a slowly depreciating or stagnant dollar..."

Clean up the prose. "The government" can't be happy with anything. It's an entity made up of people pursuing their happiness.

Aug 17 10:55 PM

[Moon Kil Woong:]

I don't think the dollar will go to zero anytime soon simply because people will start demanding very high rates on US Treasuries long before that happens making it impossible for the Federal Government to keep on spending like a drunk person with a rich man's platinum card and impossible for the Fed to engage in productive QE. If the Fed's QE turns dollar to dollar into inflation it simply is not worth engaging in.

Thus the argument that the war is really about perception takes place. As long as cause doesn't immediately translate into effect, the government can simply lie about engaging in causes that help today when they know the effect will slap you back in a few more months or years. Be in tax cuts, QE, or government spending. It's all bad if the government and its citizens can't pay for it and can't efford the inflation and currency depreciation that comes attached to it.

Aug 18 02:55 AM

[PainfullyAware:]

Not much left to "Squeeze" out of the populous. Servicing The Debt Will Not Be Possible By The Citizens In The Future. We Are On The Wrong Side Of The Laffer Curve And Accelerating.

When The Bill Comes Due There Are Going To Be A Lot Of Angry People.

Aug 18 04:08 AM