Is US the next Greece? Watch out for a dollar debacle

In what could only be described as a move “from the frying pan to the fire”, one of the consequences of the European crisis has been the increased demand for the Greenback. We have witnessed the dollar index strengthening to 82-plus, with a corresponding decline in commodities like gold and oil.

Most currencies also declined in this period—the Aussie and Canadian dollars declined from 1.1-plus levels to parity or less and we have had similar percentage declines with other currencies as well. To that extent, the decline in the exchange rates of the INR (Indian rupee) vis-à-vis the USD was not entirely based on fundamentals and we should witness a return to sub-50 levels over the course of this year.Reuters

Not that I have great faith in the Indian economic team and their ability to understand the nature of reforms that are required to move us forward, let alone implement them. Just that the US policies are much worse—both on the fiscal as well as the monetary front — and in a relative sense, we are indeed better off.

That said, lest the readers or the policymakers conclude that the current account deficit (CAD) would improve because of the strengthening rupee, I would have to point out that commodities (in particular gold and oil) would strengthen far more in percentage terms than the rupee.

On a fundamental basis, the US economy is probably in a much worse situation than evenGreece, let alone the eurozone. Readers must remember that the US government uses cash-accounting to report its fiscal deficit at $1.3 trillion. Using GAAP accounting, which is a far more indicative and reliable measure than cash-based accounting, the deficit is well in excess of $5 trillion (Source: shadowstats.com) and growing.

So we are looking at a deficit-to-GDP ratio that is well in excess of 30 percent as compared to the eurozone deficit of 7 percent.

Looking at the debt and the net present value (NPVs) of unfunded liabilities of the US, the situation gets much worse. According to even the GAO (Government Accountability Office) statistics, we are looking at a Federal debt of about $80 trillion and, using more realistic assumptions about growth and inflation, other estimates of this debt, such as the one by Prof Laurence Kotlikoff, total well in excess of $200 trillion (putting the debt-to-GDP ratio at a mind-boggling 1,200 percenr or more). Even at the lower end of these estimates, these numbers are just way outside the realm of anything that can be realistically serviced.

The only question is what would be the mechanism of default on these obligations. The US Fed has made is abundantly clear that inflation would the chosen route. After all, the epithet of “helicopter Ben” (Fed chief Ben Bernanke) is not without reason.

But let’s leave the above arguments aside for the moment. The current US national debt is about $15.8 trillion and even at historically normal 5-6 percent interest rates, the outgo in interest payments alone would total about $1 trillion and we would be looking at a Greek-style implosion in the US economy.

Or, in other words, the zero percent interest rates maintained by the US Fed is the ventilator support that is keeping this zombie economy afloat. The US Fed has been able to indulge in this rather reckless extravaganza of zero percent interest rates due to a scenario of not overtly exploding consumer prices. But how long can these increases in base money growth continue without triggering an exploding consumer price scenario? And if all the deficits are true, where are the bond vigilantes?  I might as well reply with “Who is John Galt?”.

The Twist in the Tale

So what exactly is the US Fed trying to achieve by Operation Twist “OT”?. Ostensibly, this was a way for businesses and mortgages to finance their long-term plans at low rate  but given the historically low rates prevailing pre-OT, nobody should be under any illusion that a marginal decline is going to significantly alter private investment plans. As usual, we have to look at the effects on various participants to find out the real reasons beyond the explicitly stated ones.

As the treasury is the largest issuer of long-term debt that is being snapped up by the US Fed, the OT can be rightfully seen as a pre-crisis bailout of the Treasury by the US Fed. But how long can this swapping be done? At some point, the Fed will run out of short-term securities to indulge in OT. And despite the swapping over the last one-year, an estimated 70 percent of the $15 trillion debt held by the treasury is short-term in nature.

Given that the Fed has about $500 billion of short-term treasury securities remaining that would mature in less than five years and the treasury holds debt of nearly 20 times that size in short-term debt, it does not take much to conclude that OT cannot continue in its present form for an extended period of time.

Thus, when interest rates climb, as they eventually will, the treasury would stand exposed. That’s when the Fed would be forced to monetise all the debt in the act of buying treasury securities. Bonds, especially the long-term ones, today represent a triple-threat as an investment class – a declining value due to higher interest rates; lower unit purchasing power due to currency debasement; and ofcourse, the explicit default that is inevitable given the size of the debt.

When this bond bubble will exactly burst is anybody’s call, but one would have to be really polyannish to make a case for status quo beyond 2013-14.