Debtor's Prison

Greetings fellow inmates,

Much of our recent discussion has focused on the seemingly inevitable collapse of the US-debt-backed global financial system.   In continuation of that theme, today we will explore a specific aspect of this problem: the likelihood of a US default.   Many argue, quite fiercely, that a US default is technically impossible since it is the issuer of the world’s reserve currency.  In other words, the US will always be able to pay its debt in dollars because it can always print more of them to do so.   While this technicality is certainly correct, it is too narrow to really broach the nature of the problem.   For that reason, we will explore some different measures and indicators of a country’s ability to fulfil its debt obligations, when applied to the US.    As a starting point, we will use a benchmark developed by Judy herself, dr. Alan Greenspan, known as the Guidotti-Greenspan Rule (G-G Rule).

In short, the G-G Rule postulates that countries must hold liquid reserves, whatever that means, in a 1:1 ratio to short-term external debt.   In other words, a country must have enough reserves to fulfil all its obligations for a period of one year even in the case of a complete cessation of all influx of capital; reserves must cover 100% of short-term debt.   The rule makes sense, as it implies that a country must hold enough savings to be self-sufficient for at least one year.  The G-G rule has had some success in predicting sovereign defaults and currency crises, allegedly.  In the various interpretations of the G-G Rule in the literature, the terms reserves, liquid reserves and hard currency reserves are used interchangeably, while external debt is used interchangeably with foreign debt and simply debt.   As always, as stated in the About Us section, we believe that the first step to any problem is to properly define all variables and concepts.   This belief is rooted not only in the logical and rational necessity of it, but also our own observations and experience on the plethora of problems that arise simply due to faulty, vacuous, ambiguous and often deceptive definitions.  Our conviction in this is so strong that we would more likely label ourselves DEFINITIONISTS, as opposed to Judy, who is an ECONOMIST.  

Before we get to the nitty-gritty, let’s look at the current Numbers.    As of 10.31.09, the US Treasury owed about $1.8tr in T-bills, which are debts that must be repaid within the next 12 months.  You can download the latest monthly statement on US debt from the Treasury itself, and we advise you to check it regularly, it is, after all, one of the most important "scoreboards" of which to keep track as we stay tuned to the BIG SHOW.   These $1.8tr in reserves roughly matches the projected deficit for the upcoming year of $1.8tr.   Added together, they amount to little more than $3.5tr that must be financed within the next year.    Given the US’s fiscal and current account deficits, it is clear that this money must be borrowed since they are grossly spending more than the take in.   Therefore, it is evident that the US’s ability to fulfil its short-term debt obligations relies on its ability to take on more short-term obligations.  

Let’s focus again on the definitions.   The total $1.8tr in T-Bills represents the total US government short-term debt.   Of that, $600bln T-Bills are owned by foreigners, thus representing the total US government short-term external debt.   Though a more thorough treatment would require inclusion of private total short-term debt and reserves, we will limit our discussion to government debt since the data is more readily available and succinctly presented.    The US short-term external debt has tripled since the end 2007, when it was at $200bln.   This can be partly explained by the global fight to safety, which prompted investors to move money into the “safest” asset, mainly US T-Bills.   We believe this increase in short-term external debt is also the result of investors across the world, including foreign nations, shortening the maturity of their US debt holdings by letting long-term securities expire and rolling them forward into the short-end of the curve.     This tripling of short-term external debt should have been accompanied, according to the G-G rule, by a tripling of US reserves.   Let’s look at how that has fared.

The table below shows the official reserve assets of the US, as reported by Uncle Benny.

While official reserve assets grew dramatically in the first half of 2009, from $77bln in 2008 to $135bln in Q2 2009, it is not the requisite tripling.  The increase was mostly due to a huge increase in the US holdings of IMF Special Drawing Rights (SDR), which jumped from $9.3bln to $58bln in the first six months of 09.   We do not know as of now the reason for this, perhaps they were issued some more?  Perhaps some behind-the-scenes pre-emptive US bailout by the IMF?  Another peculiarity of the data is that gold stock is priced at $42.22 per troy oz, instead of its market value of about $1,200/oz.   If we use the market value instead, then total reserves rise to about $435bln in Q2 2009.    If we count the value of the oil in the Strategic Oil Reserve, then the total value of US reserves comes to about $500bln.  

Therefore, using these narrow indicators as inputs to the G-G Rule, we find that the US has about a 1:3.6 ratio of official reserves to short-term debt, or roughly only 27% coverage.    Meanwhile, it has a 1:1.2 ratio of official reserves to short-term external debt, or roughly 83% coverage.   On both counts, the US fails the G-G Rule.   While the latter ratio might seem to be reasonably close to this rule-of-thumb, it still fails.    Many believe this rule to be of limited value when applied to the issuer of the reserve currency.   However, as we said at the onset, this seems like a sensible rule given the rational underlying principle of having reserves at least equal to short-term liabilities.   Moreover, at this point in the discussion, definitions once again become important.

It is self-evident that the G-G rule implies that reserves can be used to pay for debt – if not, then it is truly vacuous, much like the sunken-in chest of one of its progenitors.   Then, the question is whether the official US reserves, in their current form, could be used to pay for the maturing T-Bills in case the world at large stops buying more of them.   Close to 60%, or $300bln, of the reserves are in gold.   We think it’s highly unlikely that Uncle Benny would give up that gold – after all there is nothing Wizards of the Black Arts love more than gold.  Ostensibly, the IMF SDRs (or roughly 15% of total reserves) could be used to pay for some of that external debt.   In effect, this would amount to little more than a digital debiting and crediting of individual country’s accounts at the IMF.   This of course is a clear example of a supranational entity serving as the enforcer of debt amongst smaller sovereigns a theme we have begun discussing in Transitioning to a Global Credit Regime Part I.  This might prove shallow comfort for US creditors, since the SDRs are nothing but a basket of currencies heavily weighed by the USD.   The roughly 10% of reserves held as foreign currency is arguably the most liquid component, which, in the case of a cessation of foreign capital to the US, would presumably appreciate substantially (depending of course on magnitude and duration of this cessation).    It seems then that official reserves may actually have limited scope as debt tender, which would lower the G-G ratio even more.   It is beyond the scope of the G-G Rule and of this post to quantify the willingness of a given country to use up their reserves to fulfil debt obligations, so we would rather be conservative and assume that every single ounce of gold could be sold.   In this case, the US would have about $300bln of gold ready to pay for $1.8tr of outstanding short-term debt, or roughly 16.666%.   The other 83% of people would have to be PAID-IN-KIND; receiving a new IOU from Uncle Sam.   

Given some of the narrowness of the G-G Rule, we decided to look at another indicator, which at first might seem peripheral, but illustrates some key points.  The following chart shows the ratio of USD currency in circulation to nominal US GDP, which we will call the currency cover, data courtesy of Uncle Benny and Co.  You can download all the data and charts here.  

We can take away a few notable points from the data.  After FDR ended the gold standard in 1933, the ratio of currency to GDP increased by 87% over the following 13 years.   In other words, over the course of 13 years, the fractional amount of total GDP that was covered by currency nearly doubled.  Bear in mind that this is different than a simple doubling of the total amount of currency in circulation (CIC) (since in that time period, CIC quadrupled).   Rather, it is the amount of currency necessary to grease the wheels of an economy of a given size and growth rate.  Since GDP is a measure of output, which is itself a measure of the amount of transactions, the currency cover is the amount of currency needed to ensure/collaterize those transactions.   Alternatively then, in the period between 1933 and 1945, the economy became twice as dependent on physical currency.   Of course, there are several reasons for this, most notably the end of the gold standard and WWII – and we will post about this in much more detail later on.  After 1945, this ratio dropped significantly by 67 % to its low in the mid-1980s, when the currency cover was only 4%, as opposed to its 1945 high of 12%.   This could be explained by the transition to a more digitized and globalized economy.   While we intend to post in the near future on the history of the actual currency location, our intuition tells us that in the past few decades we have seen a monotonic increase in the percentage of dollars in circulation that are held outside the US. For now, the relevant point is that physical dollars have become less necessary as collateral for transactions due to an increased collaterization based purely on credit, brought forth by a system of digital crediting and debiting.  

The relevance of this trend to this discussion lies in the US’s economy rate of growth as compared to the physical currency rate of growth.   While of course, “physical” is a term that we use lightly here since Federal Reserve Notes are actually financial assets with no intrinsic value, but they are nevertheless material, as opposed to digital.   The increased digitalization of the US economy exacerbates this trend towards an asymptotically vanishing RESERVE BASE that US creditors can legitimately claim.    The G-G rule evidences the inadequacy of US official reserves to cover short-term debts; even these official reserves could be largely illiquid (if we assume Uncle Benny will be unwilling to part with his pot of gold) or simply be an alternative form of debt (SDRs).  Then what can US creditors CLAIM?   Definitely not a chunk of the current economy, which is pervasively running deficits on all counts.   A claim on the future economy is, of course, nothing but more debt.    Then maybe, US creditors could claim physical commodities in US soil?  Perhaps, though you can easily imagine how thorny that would be.   What about claiming some intellectual capital in the form of patents and technological know-how?  Political influence, military might?  Now, things are getting interesting. Have your tanks on stand-by!

Ultimately, can the world at large expect payment from the US?  Of course not!   Even in the past, this scenario was also self-evident.   As we have often argued recently, the only reason this system seemed tenable for decades was the faith that the US will ALWAYS be able to roll over their debts.   One of the most prevalent and ingrained cognitive biases in human behaviour is the belief that things will not change even when the entirety of universal history proves that everything changes.  We are as certain as can be that this current US-backed global financial system will come to an end.   The risk US creditors are taking is enormous since there is no way to exactly predict when the crisis of faith will explode.  They have begun shortening the maturity of their holdings for this very reason, as a form to reduce risk of non-payment.   Eventually, this process will reach critical mass and the death-tsunami-avalanche many of us have been expecting will come in full force.  Hapless creditors left holding the BROWN, SMELLY bag will wonder, why o why didn’t I ASK myself, to what exactly does this paper entitle me?   Well, nothing Beverly, Judy has been trying to tell you that for years!  Do NOT lend your hard-earned money to Uncle Sam!

May your capital be safe and your investments prosperous,

MAAA