Global Crisis

RESPONSE: A "stealthy default" may punish foreign creditors

Posted on Thursday, February 17, 2011

IT'S abundantly clear that America's fiscal arithmetic simply does not add up. The implication is a continued increase in its government debt-to-GDP ratio over the medium term. But will this lead to crisis? And, if so, what kind of crisis?
One option is to "do a Japan" which, despite all its difficulties, has almost miraculously managed to live with persistent increases in government debt while enjoying an extraordinarily low cost of borrowing. Japan, however, is special. Its creditors are almost entirely Japanese, suggesting that both creditors and debtors have a strong "national interest" in resolving any fiscal difficulties. And Japan's stagnation—associated with persistent corporate sector de-leveraging—has released savings which the government has been able to tap into very cheaply.
The US is hardly in the same position. Its creditors are increasingly foreign, not domestic, and it has a paucity of savings. Politically, it would surely struggle to cope with ongoing Japan-style stagnation associated with continued de-leveraging. Under these circumstances, the escape route will be a "stealthy default".
The Treasury Department isn't in the business of delivering an outright default, but monetary trickery can nevertheless shift the burden from US debtors to foreign creditors. The best way to do this is to print money, not so much to raise domestic inflation (that would hit domestic creditors, including many in the baby boomer generation who vote in elections) but, instead, to devalue the dollar. Because foreign creditors have mostly lent to the US in dollars, the renminbi or rouble value of their US investments would then be worth a lot less.
Admittedly, faced with this risk, bond yields might still rise. Much then depends on whether the Federal Reserve would then extend its unconventional stimulus programmes in a bid to keep yields at low levels. If it does so, the risk of a major dollar collapse will surely increase.
The Chinese, Russians and other don't vote in US elections. When political expediency dominates economic reality, foreign creditors become an easy target: because they are, the risks of a financial crisis will escalate, ultimately undermining the dollar's reserve currency status.

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