An Indian Civilizational Perspective

Where is the US of A going??

fed-meeting.jpgThis at present is a million dollar question. And the beauty is that everyone seems to have an answer, yet nobody knows what’s happening, including the ‘gurus’ – the economists and the Feds.
Sample this – an extract from the statement (paraphrased) from the latest meeting (on August 10) of the Federal Open Market Committee, the body that sets the interest rates in the USA:
1. Information received since the Federal Open Market Committee met in June indicates that the pace of recovery in output and employment has slowed in recent months.

2. Household spending is increasing gradually, but remains constrained by high unemployment, modest income growth, lower housing wealth, and tight credit.

3. Business spending on equipment and software is rising; however, investment in nonresidential structures continues to be weak and employers remain reluctant to add to payrolls.

4. Housing starts remain at a depressed level.

5. Bank lending has continued to contract (data released on August 6 shows that consumer credit decreased at an annual rate of 3-1/4% in the quarter April – June).

And here is the solution offered by the Fed:
1. The Committee will maintain the target range for the federal funds rate at 0 to 1/4%….for an extended period.

2. …The Committee will keep constant the Federal Reserve’s holdings of securities at their current level by reinvesting principal payments from agency debt and agency mortgage-backed securities in longer-term Treasury securities.1 The Committee will continue to roll over the Federal Reserve’s holdings of Treasury securities as they mature.
In simpler words, what it means is that the Federal Reserve will continue to finance the fiscal deficit run by the US Government. So what’s wrong with that?? That’s like writing a blank cheque in favour of the US Government. And when the Fed runs out of money (most of which is also recently printed), what will it do – print more stuff of it. Print money and poof!!!! you get rich. As has been widely remarked, what got the US into this mess is debt and the policymakers are attempting to remedy the situation by taking on more debt.
Keynesians such as Paul Krugman have come out vociferously in support of the fiscal stimulus program (and thereby higher debt levels) that the US Government is running. In fact, they have advocated even a greater stimulus for the economy. Keynesian theory is great on paper but is rarely implemented in the true spirit, as envisaged by Keynes in his pathbreaking book published in 1936 – save during good times and spend during bad times, thereby balancing the budget over a business cycle. The US government, however, has not saved any money since the Carter Administration (except for a brief period during Clinton’s era). But it has added one hell of a lot of financial commitments since then – be it the pensions payable to the baby boomers, or the recent healthcare reform bill.
And most of this debt is unfunded. Based on what I read from a highly respectable and a reliable source on the internet (so I did not bother to check for its accuracy), the present value of future unfunded obligations has been estimated by Lawrence Kotlikoff, a well-known professor of economics at Boston University, at a whopping $202 trillion.
So how is that gap going to be funded? Kotlikoff refers to an IMF study showing the US would have to double taxes, raising an amount equal to 14% of GDP every year from now on. Every year that the gap is not closed, the additional amount is added to the “principal,” making that much more to be paid in the future.
So, with no ‘recovery’ (oh sorry, reduced pace of recovery), high unemployment and huge debts, where is the US going?? Back to square 1 – nobody knows!!!!!
Here are some solutions available to the US:
1. Raise taxes
2. Reduce Government spending
3. Borrow more money and spend more
4. Print more money
The first two seem unlikely, since that will nip the fledgling ‘recovery’ in the bud. More so, with unemployment (officially) at close to 10%, these 2 options are politically not palatable. It’s the 3rd and the 4th, which look more likely.
Bizarre as it may seem, the US Treasury securities are still viewed as the safest asset on this planet. US sovereign debt is still rated AAA. Of course, Dagong, a rating agency in China, has downgraded that rating to AA. Also, with no other currency offering the liquidity that the Dollar offers, it is still the most widely accepted currency in the world. Therefore, countries are still willing to stash Dollars. These Dollars then go back to the US and earn these countries a paltry 2.68% on a 10 year paper (as on August 12, 2010). Sooner or later, countries around the world are going to realize that the US government does not have the resources to pay off its debts. Interest rates will start creeping up and bring the consumption engine of the US to a halt. And when the US cannot repay its debts, what will it do – now here is where we come to the 4th option – yes print more currency. Probably, that may happen much earlier, when Ben Bernanke, seeing no recovery, may decide to drop greenbacks from a helicopter.
And what will all this lead to – the Dollar will become almost worthless, perhaps completely worthless. There are examples galore before us – the present day Zimbabwe or the Weimar Republic of the 1920s.
One may label all this as doomsday mongering. Well, all I know is that conventional knowledge holds, always. With all its innovation in finance, see where the US has gone. The law of supply in economics says that you increase the supply (other things remaining the same), the price goes down. Ultimately, that may be good for the economy, for it will make its exports cheaper and will increase employment. However, the problem is that the US today hardly manufactures anything. So this adjustment process is going to be quite painful.
But sitting here in India, I am of course not complaining. The next few years will see wealth moving to this part of the world and I am all set to bask in the glory.

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