Monday, November 15, 2010

Who really pays for all the money that the U.S. is borrowing?

When Canada's national debt reached unsustainable heights, interest rates increased and the Canadian dollar fell to 0.6 dollar U.S. while earlier in the 1980s it was nearly on par with the U.S. Also, taxes were increased, which resulted in more inflation, which in turn resulted in higher interest rates, which then resulted in yet a higher Canadian budget deficit. This nasty cycle of ever increasing debt could only be stopped one way and Ralph Klein showed the way. The federal Liberals also reduced spending under the keen eyes of Paul Martin.

Well, really, how did Paul Martin and his Buddy Jean Chretien reduce Canada's budget deficits? Eh, they reduced the transfer payments to the provinces and so the provinces were really forced to do the dirty work. Oh, there was also the cold war that had come to an end, thanks to Paul Martin and the Liberals? Yeah right, but as a result we could reduce Canada's military expenses dramatically.
Hmm... it was Paul Volcker who drove interest rates up so high that the economy came crashing down in the early 1980s, as a result inflation began to fall and so the 3 decades of interest rate decline started, culminating in today's near zero interest. Of course, failing interest rates also helped reduce Canada's budget deficits and in the end we even got annual surpluses.

Also, the energy crises of the 1970s and the oil prices contributed to that decade's escalating inflation. Prices finally peaked around 1982 and their subsequent fall combined with the much hated NEP resulted in the collapse of Alberta's oil industry and declining commodity prices for the next 20 years. The disappearing fear of oil and gas shortages in the 1980-1998 period; the benefits of energy conservation starting in the late 1970s under Jimmy Carter; the benefits of deregulation and tax cuts under Ronald Reagan; the rise of cheap labour powered manufacturing in the emerging economies of China and SE Asia as well as globalisation overall; it all resulted in a booming world economy and enormous productivity gains. This was even further enhanced by a fiercely competitive oversized baby-boomer labour force and the high tech revolution's productivity gains.

Those were the real factors that brought down the government deficits of Canada. It was more serendipity than being Liberal or Conservative. No matter how hard Michael Wilson and Brian Mulroney tried, their deficits kept escalating and in spite of Paul Martin and Jean Chretien's reluctance to really cut social spending and to decentralize the government, they were dragged along in the above described maelstrom that resulted in Canada's debt reduction. Not all was luck; there were some good policies or better policies. Canadian Banking policies by many considered too conservative for normal economic conditions, made our banking system in 2007 and 2008 the envy of the world. However in previous decades it was City Group, JP Morgan, Salomon Brothers, Bank of Hongkong, ING and Deutsche Bank that were the leaders of the financial world. Blinded by their own good fortunes these institutions in their ever more voracious search for profits then became the focus of the U.S. and world's financial crisis of 2007-2008. Canada's banks conservatism was temporarily justified. But will that also be the case in the decades to come? Will the old banking establishment arise again from the ashes and retake their former leadership, albeit (hopefully) a bit less smug?

If you don't believe how serendipitous our national debt reduction was just remember that at the end of Bill Clinton's presidency, even the U.S. had achieved a budget surplus. So were many other countries! Of course, around that time the world economy was booming and demand for commodities started to escalate. In Alberta, the provincial government had created a pro-business tax and royalty system that worked well and set the stage for a booming economy along with the rising commodity prices. And after a long series of budget spending cuts at the expense of education, healthcare and the poor, money rolled into government's coffers during the 2000-2008 period like a tsunami – both on a provincial as well as on a federal level. There was so much money pouring in, we were wondering whether Alberta should cut income taxes to zero! $400 per capita government gifts(?) and no Alberta Healthcare premiums! Wow those were the times.

The times are changing again! After 9-11, after fighting wars in Afghanistan and Iraq; after combating the financial excesses of the late 1990s and early 2000s, following gross financial mismanagement by its financial institutions, the U.S. economy and that of many other countries finally collapsed. Just like the extreme affluence was not due to the brilliance of CEOs and bankers, neither was the collapse of the U.S. and European banking system their fault entirely. We all played a role in this; who in their right mind takes out a mortgage without having the means to make the payments no matter how the real estate prices rise?

Who is paying for the excessive debts of the U.S. and other governments? Not only the U.S. was involved in the Gulf War, Iraq and Afghanistan! Not only the U.S. provided crazy loans; the Deutsche Bank bought U.S. subprime and other securitized mortgage debt by the bucket full. The Irish banking system went ballistic! And don't tell me that the Chinese did not benefit from U.S. imports and kept on extending debt to the U.S. because it had more money than it could spend!

This was the Zeit Geist and it was a worldwide phenomenon. 2007 – 2009 was the time to pay the piper. So the pendulum is swinging, not necessarily back and forth, but more in yet a different direction. Yes action results in a reaction; but the reaction is not necessarily an opposing one. It is one that tends to move in the direction of least resistance. Somehow history repeats.
Although Canada's government finances seem to be brimming with health; the U.S. and many European countries are bloated with debt. One would think that the U.S. dollar would collapse and so would the Euro, but something strange is happening on the currency front. Look at the graph below which depicts the relative performance of the Canadian Dollar (CAD), the Australian Dollar (AUD), the Japanese Yen (JPY), the British Pound (GBP) and the Euro versus the U.S. dollar from 2001 until today.

Look the CAD and AUD have risen nearly 50 to 80% in value compared to the dollar. That must be the oil-price because everyone knows that these are petrol currencies (see also the price of oil graph below).

Oil production over the last decade barely increased. Some believe conventional oil production has peaked while demand kept on going up. Others don't believe in the Peak Oil theory, however, they must admit that production could not keep up with demand. Of course, now that the financial crises of 2007-2008 has abated and maybe has even passed, exploration funds by many oil companies were severely cut over the last couple of years and if we had already trouble before the financial crisis to meet oil demand, this will probably be even more difficult thereafter. It is not that one can switch on or off the supply of world oil like an electrical switch. With gas drilling down big time as well and with the decline rates of shale gas in the 80 to 90% range while the drilling of new wells probably requires a $8 to $10 per BTU price rather than today's $3-$4 price, we will be in for some nasty shocks.
No wonder that the petrol currencies are doing so well against the U.S. dollar. No big government debt and strong commodity prices. But... hé, if the U.S. dollar is so weakened because of the high U.S. debt created during the financial crises, how come the CAD is now exactly the same as before the financial crisis? Even worse! Look at Japan (yellow curve of the currency graph). It is nearly as high as the petro currencies! Japan has no oil whatsoever and everyone is aware of Japan's deflationary lagging economy! So why is it performing so well? Especially since 2007, it has blown away any other currency!

Worse, the Euro which should be hit by its banking crisis is certainly not a petro currency! Yet its performance over the last decade is not really that bad against the U.S. dollar. Other than last May, from which it is rapidly recovering, the Euro performed nearly as well as the much admired CAD. Even the British Pound, the closest thing in Euro to a petro-currency, was doing OK. But since the debt crises it is the only one of this set of currencies that performed worse than the U.S. The U.S. $ / GBP is now the same as it was ten years ago.

Clearly, the valuation of the dollar is not driven by commodity prices, because then the JPY and Euro would not have kept up with the CAD and AUD petro currencies. Neither has the so-called European debt crisis, other than early this summer, very strongly reflected in the Euro vis-a-vis the petro currencies! And all the Gurus that always look down on stodgy Japan and unionized Europe must have missed the gradual deterioration of the U.S. dollar against world commodity prices as well as against the other currencies. So what is really going on?

Is this the true reflection of the U.S.' ever present trade deficits and it current account deficits? Has the world discounted U.S. debt not only since the financial crisis but from the beginning of the decade – possibly even earlier? Have the Chinese not only pegged their currency to the U.S. dollar to prevent becoming un-competitive but rather to prevent a devaluation of their portion of U.S. debt financing? After all, that his how Canada discounted its debt in the 1980-mid 1990s! Once bitten, twice shy? The Chinese won't let the U.S. get away with shoving their debts onto the back of the Chinese! So, really it is us Canadians, the Japanese, the Aussies and the Europeans that pay for the devalued U.S. debt. Now after having discounted our own debts so heavily a decade earlier, I don't think us Canadians can complain too much about this little scheme. But it is an eye-opener isn't it? Anyone wants some more U.S. treasuries?

I guess their commercial is dead on, when it asks what the U.S. is doing with all the money it saves from buying a Toyota! This is truly a new way of looking at the slogan "Too big to fail"! The only ones not falling for this (yet) are the Chinese – no wonder Geithner and Clinton are red in the face when discussing the Chinese Yuan.

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