Friday, October 3, 2008

How terrible is the US financial crisis?

How terrible is the US financial crisis? SUMIT MAJUMDAR

If East and West Asia start unloading US Treasury bonds every day, their price will plummet, as will ultimately the dollar value. The sellers will, no doubt, take losses as their assets lose worth, but they might recover a fair portion of them. What will happen to the US? The scenario is simply too frightful to contemplate, says SUMIT MAJUMDAR.



The patterns of globalisation that have emerged over the past 25 years are marked by three critical characteristics. The first is that capital has free mobility, and can move around the world today in nanoseconds, if need be. Even if that speed was merely milliseconds a decade ago, or a second 20 years ago, it has meant that you never know who owes you or who you owe money to.

The second is that this trend was accelerated by the strategies of the investment banks and financial exchanges that had the necessary financial clout to implement the technologies that made this contingency possible.

This contingency required that the spread of technology and financial systems within firms was rapid, and of the highest quality, so that the gains from such deployment were readily realised.

It was the investment banks of the US that had the original foresight to make this happen, followed by the investment banks from countries such as Japan, Germany, France, and, latterly, the political units of the Persian Gulf.

The growth of financial technologies that created trading platforms to trade equities, corporate bonds and sovereign treasury bonds, among the large variety of financial assets that exist, has meant that the whole world is a participant of the trauma of the US investment banks.

As the investment banks of the US go down like dominoes, there will be distributed suffering since the shares and bonds of these entities are now well and truly distributed with investors, in varying quantities of course, across the globe.

Greed-is-good mantra

The third contingency is actually fatal for the US, and technology has a part to play in this phenomenon. As the “greed is good” mantra has taken root in the US, after the start of the Reagan era, now almost 30 years ago, consumption has been the be-all and end-all of contemporary society.

Whether a person is six, 16 or 66, to live means to live for today because tomorrow never comes. That, no doubt, has been extremely good for the providers of goods and services, who have found the US markets for all conceivable items, extremely lucrative.

But who funds these consumption patterns? And the tomorrow of yesterday has arrived today! The US savings rate has been negative, compared to the 40 per cent plus savings rate of China and the 30 per cent rate of India, and the US public is leveraged to the hilt for the next four generations. So is the US government.

The continuing size of federal deficits has ensured the national debt of the US runs close to over ten trillion dollars ($10,000,000,000,000). At an aggregate macro-economic level that, of course, means that the total debt of the US is not only gargantuan, but that this debt is owed mainly to those nice foreigners who have so willingly been providing goods and services on credit for now over a generation because the domestic lending capacity of the US public vanished ages ago. But who are those nice foreigners?

Estimates vary, but what is a billion here and there when trillions are at stake? East Asia, including countries such as China, Japan, South Korea, Taiwan, plus all of the others, might hold about $3-5 trillion of the US national debt. Then, there are the nice gentlemen of West Asia! Saudi Arabia and the Gulf States, such as Dubai, Abu Dhabi and Sharjah, to name a few, might collectively hold $2 to 4 trillion of this debt as well. Thus, the US may owe at least half and quite possibly over three-fourths of its debt to East Asia and West Asia.

Consequences of Debt Recall

What next? If East Asia and West Asia decide to pull the plug on the US and start unloading their holding of US Treasury bonds every day, using the wonderful technologies that the US investment banks had so thoughtfully provided them with to do so, the price of these bonds will plummet as oversupply occurs. As more and more dollar denominated bonds are unloaded into the global financial system the dollar value will simply plummet.

The East and West Asian countries will take losses as their assets lose their worth, but they might recover a not unreasonable portion of these assets. What happens to the US? The scenario is simply too frightful to contemplate.

The US economy lives on imports. As the dollar depreciates, imports will become more and more expensive for those living in the US.

As imports become more and more expensive, day by day, inflation will ratchet upwards, on a continuing and never-ending trajectory. This will, of course, immediately dampen consumer spending and effective demand in the US will simply dry up.

In an economy with a negative savings rate, the rise in inflation will put all investment projects on hold as these can only be financed by debt. As savings rate become ever more negative, demand for consumer credit will rise.

Coupled with the demand for investment credit, the demand for lent funds is also going to rise, but this time there are no lenders other than at extraordinarily exorbitant rates.

The cost of these borrowed funds, then, will add to the inflationary spiral. The US economy will become ill and may go on life-support. The upshot is significant declines in living standards as there no lenders in the world willing to lend to the US.

The magnitude of this crisis will be the Latin American + East Asian + Russian crises of the 1980s and 1990s magnified a thousand times! It will be the end of the world financial order as we know it. What is the IMF doing about it?

Collateral and its Consequences

What about collateral? Is a US Treasury Bill not an instrument of sovereign debt that the government of the day will honour? And if it cannot do so, does the lender not have recourse to the assets that back the instrument? Thus, East Asia and West Asia can demand the assets of the US in repayment of their obligations.

Over half of the US is mortgaged to them! In old India, there was the spectre of the Kabuliwala, or the Pathan moneylender from Kabul, who would go lending money on and on until the client was well and truly skewered. Then the Kabuliwala would come and call and demand the loan back. Failing that, he would settle for his client’s land and property. Are East Asia and West Asia the US’ Kabuliwalas?

In the colonial regimes of old, if a man, let us call him Pongo, had debts, and these debts in colonial times were unsecured — mostly arising out of losses at cards, horses or because the local bibi and her accomplices had been excessively egregious — a chap, say Carstairs, would visit Pongo one evening.

After a drink, Carstairs would take his leave, leaving behind a loaded revolver with just a single bullet in it. The good chap and gentleman that Pongo was, he would be a prey to good form and immediately get the hint.

What is to be done today? Can the US get its house in order in a short time? Are there other lenders who might lend to the companies and the government of the US? Does the world have a Carstairs to visit with the US’ Pongo? Or will the Kabuliwala call?

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