This is a really solid article.It’s critical to understand that the USA is presently in a very precarious fiscal situation. The national debt has more than doubled in the last 10 years, but so far, there don’t seem to have been any horrific consequences. Could it be that all this talk about the national debt isn’t such a big deal after all?
The critical point to understand is that while the national debt has more than doubled, the U.S. Government’s cost of borrowing hasn’t increased at all. The reason is that interest rates are less than half what they were 10 years ago. Half the interest on twice as much principal equals the same monthly payment, so to speak. This is exactly the same trap that subprime mortgage borrowers fell into. First, money is borrowed at an artificially low interest rate. But eventually, the interest rate increases, and the cost of borrowing skyrockets. The USA is already running an unprecedented and unsustainable $1 trillion+ annual budget deficit. All it would take to double the already unsustainable deficit is for interest rates to rise to their historical norms.
This all comes back to exorbitant privilege. The only reason interest rates are so low is that the Federal Reserve is intentionally suppressing them to unprecedented low levels in an attempt to combat deflation and resuscitate the economy. The only reason the Fed has the ability to do this is that foreign lenders have an artificial need to hold dollar reserves because the USD is the global reserve currency. They would never accept such low interest rates otherwise. Loss of reserve currency status means loss of exorbitant privilege, and that in turn means the Fed would lose control of interest rates. The Fed might respond by printing even more dollars out of thin air to buy treasury bonds, but in absence of reserve currency status, doing that would cause a collapse of the dollar’s value against other currencies, making all the imported goods we now depend on unaffordable.
In summary, the U.S. Government has repeated the exact same mistake that got all those subprime mortgage borrowers into so much trouble. They are borrowing more money than they can afford to pay back, depending solely on “teaser rates” that won’t last. The U.S. Government’s average maturity of outstanding treasury debt is now barely more than 5 years. This is analogous to cash-out refinancing a 30-year fixed mortgage, replacing it with a much higher principal balance in a 3-year ARM that offers an initial teaser rate. At first, you get to borrow way more money for the same monthly payment. But eventually the rate is adjusted, and the borrower is unable to make the higher payments.
The Janszen Scenario
When it comes to evaluating the risk of a U.S. sovereign debt and currency crisis, most mainstream economists dismiss the possibility out of hand, citing the brilliant wisdom that “the authorities would never let such a thing happen”. These are the same people who were steadfastly convinced that housing prices would never crash in the United States because they never had before, and that Peak Oil is a myth because the shale gas boom solves everything (provided you don’t actually do the math).
At the opposite extreme are the bloggers on the Internet whom I refer to as the Hyperinflation Doom Squad. Their narrative generally goes something like this: Suddenly, when you least expect it, foreigners will wise up and realize that the U.S. national debt cannot be repaid in real terms, and then there will be a panic that results in a crash of the U.S. Treasury market, hyperinflation of the U.S. dollar, and declaration of martial law. This group almost always cites the hyperinflations of Zimbabwe and Argentina as “proof” of what’s going to happen in the USA any day now, but never so much as acknowledges the profound differences in circumstances between the USA and those countries. These folks deserve a little credit for having the right basic idea, but their analysis of what could actually happen simply isn’t credible when examined in detail.
Little-known economist Eric Janszen stands out as an exception. Janszen is the only credible macroeconomic analyst I’m aware of who realistically acknowledges just how real and serious the threat of a U.S.sovereign debt crisis truly is. But his analysis of that risk is based on credible, level-headed thinking complemented by solid references to legitimate economic theory such as Triffin’s Dilemma. Unlike the Doom Squad, Janszen does not rely on specious comparisons of the USA to small, systemically insignificant countries whose past financial crises have little in common with the situation the USA faces. Instead, Janszen offers refreshingly sound, well constructed arguments. Many of the concepts discussed in this article reflect Janszen’s work.
Janszen also happens to be the same guy who coined the phrase Peak Cheap Oil back in 2006, drawing an important distinction between the geological phenomenon of Hubbert’s Peak and the economic phenomenon which begins well before the actual peak, due to increasing marginal cost of production resulting from ever-increasing extraction technology complexity.
“But there’s no sign of inflation…” (Hint: It’s coming)
Janszen has put quite a bit of work into modeling what a U.S.bond and currency crisis would look like. He initially called this KaPoom Theory, because history shows that brief periods of marked deflation (the ‘Ka’) usually precede epic inflations (the ‘Poom’). He recently renamed this body of work The Janszen Scenario. Briefly summarized, Janszen’s view is that the U.S. has reached the point where excessive borrowing and fiscal irresponsibility will eventually cause a catastrophic currency and bond crisis. He believes that all that’s needed at this point is a proximal trigger, or catalyst, to bring about such an outcome. He thinks there are several potential triggers that could bring such a crisis about, and chief among the possibilities is the next Peak Cheap Oil price spike.
How Peak Oil could cause a Bond and Currency Crisis
There are several ways that an oil price spike could trigger a U.S.bond and currency crisis. Energy is an input cost to almost everything else in the economy, so higher oil prices are very inflationary. The Fed would be hard pressed to continue denying the adverse consequences of quantitative easing in a high inflation environment, and that alone could be the spark that leads to higher treasury yields. The resulting higher cost of borrowing to finance the national debt and fiscal deficit would be devastating to the United States.
A self-reinforcing vicious cycle could easily begin in reaction to oil price-induced inflation alone. But we must also consider how an oil price shock could lead to loss of USD reserve currency status, and therefore, loss of U.S.exorbitant privilege. In the 1970s, the USA represented 80% of the global oil market. Today we represent 20%, and demand growth is projected to come primarily from emerging economies. In other words, the rationale for oil producers to keep pricing their product in dollars has seriously deteriorated since the ‘70s. The more the global price of oil goes up, the more the U.S. will source oil from Canadian tar sands and other non-OPEC sources. That means less and less incentive for the OPEC nations to continue pricing their oil in dollars for all their non-U.S. customers.
Iran and Turkey have already begun transacting oil sales in gold rather than dollars. What if the other oil exporting nations wake up one morning and conclude “Hey, why are we selling our oil for dollars that might some day not be worth anything more than the paper they’re printed on?” Oil represents a huge percentage of international trade, so if oil stopped trading in dollars, that alone would be reason for most nations to reduce the very large dollar reserves they now hold. They would start selling their U.S. treasury bonds, and that could start the vicious cycle of higher interest rates and exploding borrowing costs for the U.S. Government. The precise details are hard to predict. The point is, the system is already precarious and vulnerable, and an oil price shock could easily detonate the time bomb that’s already been ticking away for more than two decades.
Rambo to the Rescue?
Let’s not forget that the USA enjoys virtually unchallenged global military hegemony. China is working hard to build out its “blue water navy”, including strategic ballistic missile nuclear submarine capability. But the USA is still top dog on the global power stage, and if the USA was willing to use its nuclear weapons, it could easily defeat any country on earth, except perhaps China and Russia.
While the use of nuclear weapons in an offensive capacity might seem unthinkable today, the USA has yet to endure significant economic hardship. $15/gallon gasoline from the next Peak Cheap Oil price shock coupled with 15% treasury yields and a government operating in crisis mode just to hold off systemic financial collapse in the face of rampant inflation would change the mood considerably.
All the USA has to do in order to secure an unlimited supply of $50/bbl imported oil is to threaten to nuke any country refusing to sell oil to the U.S. for that price. Unthinkable today, but in times of national crisis, morals are often the first thing to be forgotten. We like to tell ourselves that we would never allow economic hardship to cause us to lose our morals. But just look at the YouTube videos of riots at Wal-Mart over nothing more than contention over a limited supply of boxer shorts marked down 20% for Black Friday. What we’ll do in a true crisis that threatens our very way of life is anyone’s guess.
If faced with the choice between a Soviet-style economic collapse and abusing its military power, the USA just might resort to tactics previously thought unimaginable. Exactly what those tactics might be and how it would play out are unknowable. The point is, this is a very complex problem, and a wide array of factors including military capability will play a role in determining the ultimate outcome.
I certainly don’t mean to predict such an apocalyptic outcome. All I’m really trying to say is that the military hegemony of the USA will almost certainly play into the equation. Even if there is no actual military conflict, the ability of the U.S. to defeat almost any opponent will play into the negotiations, if nothing else.
Conclusions
The current incarnation of the International Monetary System, in which the USA enjoys the exorbitant privilege of borrowing practically for free, and is therefore able to pursue reckless fiscal policy with immunity from the adverse consequences that non-reserve currency issuing nations would experience by doing so, cannot continue indefinitely. Therefore, it will not continue indefinitely. How and when it will end is hard to say, especially considering the fact that it’s already persisted for 42 years after it stopped making sense. The system will continue to operate until some catalyst or trigger event brings about catastrophic change.
The next Peak Cheap Oil price spike is not the only possible catalyst to bring about a U.S. bond and currency crisis, but it’s the most likely candidate I’m aware of. I don’t believe that U.S. energy independence is possible, but if it were, the end of oil imports from the Middle East would also be the catalyst to end exorbitant privilege and bring about a U.S.bond and currency crisis. To summarize, the music hasn’t stopped quite yet, but when it does, this will end very, very badly. I’m pretty sure we’re on the last song, but I don’t know how long it has left to play.
I'm sure at some point America will face a major economic crisis as the current Pax Americana system of the dollar reserve currency ends and the T-bond bubble implodes.
Its interesting to read Greers articles and his own thoughts on how America's military hegemony is more myth than reality and even a medium sized military power using smart methods could defeat the Achilles heal of the US military, its aircraft carriers fleet.
This, along with a Peak Cheap Oil crisis could also affect why countries ditching the dollar.
Regarding the nuclear threat, I doubt the US would go down this route because China and Russia would take it very badly.
