THE BEAR'S LAIR Where is the safe haven?
By Martin Hutchinson
As the US$1.19 trillion forecast 2009 US budget deficit combines with the
forthcoming $825 billion (and counting) stimulus package, observers seem
convinced that for some mystical reason US Treasuries are a "safe haven" -
endlessly attractive to Asian and Middle Eastern central banks and therefore
able to yield considerably less than the expected rate of inflation over their
life. But what if this irrational investment preference ceases to hold?
US government bonds have not always been the world's safest investments, to say
the least. The phrase "not worth a Continental" encapsulates the inflationary
finance that was used to win the Revolutionary War, while US state bonds were
notorious in the 19th century City of London after Pennsylvania
defaulted in 1841. Even during the Civil War, there were moments when the
Confederate credit appeared more solid than Union credit - after all, absent
the threat of military invasion, the Confederacy was a stable agrarian economy
with several reliable cash crops.
The US rise to global credit supremacy occurred after World War I. At that
point, the US was the world's principal creditor nation, having sold military
equipment to Britain and France, both of whom consequentially had large US "war
debts" matched by theoretical assets in the form of reparations payments from
Germany. Once the United States had messed up world trade with its 1930
Smoot-Hawley Tariff, neither Britain nor France could afford to repay the US
without intolerable hardship, while the arrival of the Third Reich ended any
hope of balancing reparations payments from Germany.
First, France defaulted on its payments to both Britain and the United States,
then Britain defaulted on its US obligations in 1934. British bankers like to
bask in the supposition that the country has not defaulted since the Great Stop
of the Exchequer in 1672; the unfortunate 1934 episode has been consigned to
oblivion. Other British obligations continued to be paid (and then underwent
creeping default through government-induced inflation after World War II) but
the 1934 episode was nevertheless a genuine default.
If a country as rich and successful as Britain could default in 1934 (in a
period when economically it was doing much better than the United States,
having superior economic management), then there's no such thing as a "safe
haven" in a deep enough downturn. Britain has not defaulted again (though it
came perilously close to doing so in 1976) and the US has never come close, but
there is in principle no reason why a US default could not happen.
There are two reasons why the US is likely to appear a much less safe haven by
the end of 2010: monetary policy and fiscal policy. The current disasters may
have come as a complete surprise to the Great Depression expert and Federal
Reserve chairman Ben Bernanke, but they would not have surprised a greatly
superior monetary manager a century before the Great Depression, Robert
Jenkinson, Lord Liverpool, Britain's prime minister 1812-27.
Liverpool took over a country with a national debt of 270% of GDP - and figured
out how to get the debt down to a manageable level. "There is no surer source
of commercial distress," said Liverpool in April 1820, "than the creation and
extension of fictitious capital; and of an appearance of prosperous trade
without the reality, which is the inevitable consequence of a paper currency."
No better description of the Bush/Bernanke bubble could have been written -
"fictitious capital" sums up the whole mania. Now by reducing interest rates
far below zero in real terms, by doubling the monetary base and by blowing up
the Fed's balance sheet to three times its normal size, Bernanke has rendered
capital even more fictitious - and the United States will shortly reap the
appropriate reward in an uncontrollable upsurge in inflation.
Just as Bernanke's monetary policy has been unprecedentedly expansionary, so
too has the Bush/Obama fiscal policy. A federal deficit of 8.3% of GDP is in
itself record-breaking in peacetime; 10% of GDP, the likely final number, is
close to double the previous peacetime record and around the level at which
Britain flirted with default in 1975-76.
US public debt will rocket upwards as did Japanese public debt in the 1990s.
Concern over its overall level need not be excessive in the short term, but
baby-boomer retirements will make the Medicare and Social Security positions
much more difficult after 2015, and we are rapidly approaching that period.
The effects of combined monetary and fiscal profligacy will be manifest in the
bond market. If inflation is rising towards double digits and government
financing needs are $1.5 trillion annually, it seems impossible to imagine that
investors will be willing to accept less than perhaps an 8% yield on US
government debt. However, to get to an 8% yield basis from its current 3%, the
long-term bond market must inflict on its investors a catastrophic loss, about
57% of principal on a 30-year bond; a mere 34% of principal on a 10-year bond.
Even the People's Bank of China will cease to regard as a safe haven an
investment that loses half of its principal in less than two years (apart from
any loss through decline of the dollar against the yuan). However much Asian
and Middle Eastern sovereign investors may admire Barack Obama, they have a
responsibility to their own people not to throw money away in this fashion.
That's even before they start worrying about the credit risk, the possibility
of the United States actually defaulting on its uncontrollably increasing debt.
Hence they will look for an alternative safe haven, where their money might
have some better chance of preservation. This may already be beginning;
international capital flows into the United States were a mere $1.5 billion in
October (against a payments deficit of $50 billion to $60 billion per month)
and a negative $21.7 billion in November.
OK, so where else is there? Britain? Don't make me laugh - it's possibly the
one country at present in even more fiscal and general economic trouble than
the United States, though its monetary policy is a touch more sensible. Canada?
Well-balanced economy, good credit, soundly managed, provided the current
government can keep its job, which doesn't look certain. Modest political risk
- but Quebec independence looks less likely than it did 20 years ago. However,
Canada's public debt is only $390 billion, so even if it represents a truly
safe haven, it is much too small for the likes of Japan and China's over $1
trillion each in reserves.
The safe haven is certainly not Spain or Italy. As The Economist helpfully
reminded us last week, Spain's economic and fiscal chaos has been caused by the
cyclical collapse of a real estate bubble, whereas Italy's has been achieved
the hard way, through sheer long-term mismanagement. In a deep recession, both
countries are vulnerable. France is a better bet; the European Central Bank
will keep inflation reasonably low, and the fiscal position is tolerable.
France has even managed to make a little progress on its structural economic
problems. With public debt of $1.5 trillion there's enough to invest in, though
debt (65% of GDP) is somewhat high and public spending (54% of GDP before
recession hit) is uncomfortably high. Still, it's a possibility.
What about Asia? Japan has public debt of 180% of GDP, so, impressive though
its economy is, it can hardly be regarded as a safe haven - on fiscal policy it
is something of a dreadful warning to the United States rather than an example.
In any case, 10-year bond yields of 1.3% don't leave much room for things to go
wrong. China, if you believe the official figures, is an admirable economic
example, but can a country that still prevents its citizens from investing
overseas be regarded as a safe haven? South Korea is another admirable economy
- but alas too small, with only $250 billion of public debt. Singapore -
splendid place, superbly run, an example to us all - but only $150 billion of
The rest of the world? Russia looked attractive for a few years, but can hardly
now be regarded as a haven of any kind. Brazil is a lot safer than it used to
be, but you don't get to be a safe haven with a BBB credit rating. Australia
lost its superior management a year ago and now appears to be in the usual
And then there's Germany. Fiscally very sound - budget deficit of only 2% of
GDP in 2009, even in a deep recession and after a modest stimulus plan. The
British approach to stimulus was described by Germany's Finance Minister Peer
Steinbruck as "crass Keynesianism", which is in my view something of an insult
to his late lordship, who was subtler than many of his followers.
Monetarily part of the euro zone, and the principal force behind the European
Central Bank's monetary caution - eurozone M3 money supply has increased only
7.8% in the last year, a pretty modest rate given the onset of recession and
the banking crisis. A large balance of payments surplus, labor costs below
those of 10 years ago, competitiveness continually increasing against its
European neighbors. Germany's public spending at 44% of GDP is lower than
Britain's; public debt is a moderate 65% of GDP in spite of huge 1990s
expenditures to re-integrate East Germany. Germany's total public debt is $2.2
trillion, so the market is more or less big enough to absorb a substantial
percentage of even the largest central bank's investment. Finally, the country
did not have a housing boom in the 2000s; house prices recently were lower than
a decade ago.
US policymakers have operated for years on the theory that there was no
alternative to the United States as a safe haven for sovereign wealth
investment. Germany in particular, has not been taken seriously since the
1980s. However, Germany after 2000 solved its economic problems, whereas the
United States went on a spending spree.
The safe haven is about to move, and American taxpayers and savers will pay the
price of that move in higher borrowing costs and lower equity prices for
decades to come.
Martin Hutchinson is the author of Great Conservatives (Academica
Press, 2005) - details can be found at www.greatconservatives.com.
(Republished with permission from PrudentBear.com.
Copyright 2005-09 David W Tice & Associates.)