Feature Stories | Mar 13 2009
By Greg Peel
Let’s start with a few definitions, kept simple because these things become awfully complicated.
When politicians bang on relentlessly about surpluses and deficits they are referring to the fiscal budget. The fiscal budget is basically the difference between how much the government has collected in taxes and how much it has spent in providing public infrastructure and services like roads, hospitals, schools, welfare et cetera. Australia built up a huge fiscal surplus over the last decade because the mining boom was ensuring a wealth of taxes but the Howard government did not see spending on infrastructure or services as anything important. Instead it preferred to stay in power by cutting income tax.
The bad news is the glory days are now over, so not only are we left with crumbling and inadequate infrastructure we no longer have a mining boom either, hence no excess tax bonanza. The Rudd government is now spending money hand over fist to stimulate the economy, both through cash handouts and infrastructure investment, which will send the fiscal budget rapidly into deficit. This simply means Australia will be borrowing money now instead of saving money, and we will do that by issuing government bonds.
The previous government will now tell you what a wonderful thing it is that a huge surplus was built up, such that borrowings from here can be kept to a minimum. The opposite is true in the US, where currently Obama is adding trillions upon trillions of further borrowings to existing extensive borrowings. If one wanted to really cynical one could say how fortunate it was the previous government put big houses and big TVs before hospital beds, for instance, otherwise the Rudd government wouldn’t now have anything to pour money into to provide jobs and keep the economy stable.
But the fact that the Howard government built up a huge fiscal surplus belies the fact that Australians still borrowed more than they earned, and have done so for some time. Australia is a big country with only a small population, so while we have no manufacturing industry of note we do have lots of land, upon which grow lots of valuable foodstuffs and below which lie lots of valuable rocks – more than the handful of us could ever need.
The food part has not been great of late given the drought, but China loves our rocks. So we sent our rocks to China (and Japan, and Korea) and they came back in form of TVs and fridges and all manner of other nice “things”. The problem is, our love of “things” ran well ahead of our capacity to get enough rocks out of the ground fast enough (see lack of infrastructure spending above, along with lack of private investment) and hence we ended up importing more than we exported, in dollar terms. We were already borrowing money from the rest of the world, despite our domestic surplus.
We were only just beginning to turn that equation around last year when we posted 300% price increases for iron ore and coal, for example, before our world fell apart.
The difference between what we export and what we import is our “balance of trade”. Add to that the difference between interest payments that flow out of Australia to foreign investors, and flow into Australia from offshore investment, and you arrive at the “current account”. If a country’s current account is in deficit, it means that country is spending more than it earns. A current account surplus means income exceeds spending.
So when you hear politicians talking about “the deficit” they are most likley talking about the fiscal (or domestic) deficit, unless they are specifically talking about the “current account deficit” which relates to our ledger position in the global market place.
Add the current account to the “capital account” and you arrive at the “balance of payments”. While the current account adds the trade balance and interest payment balance, the capital account takes care of actual investment in this country by foreigners net of Australian investment offshore. (That which pays the aforementioned interest or dividends).
The capital account confuses the issue somewhat, for if there were no cross border investment then a country’s current account would simply be the difference between what it buys and what it sells.
Before the GFC
China is a country with an enormous population of people who are only just now starting to buy fridges and cars and so forth. Most of the fridges China had been manufacturing like there was no tomorrow were destined for the rest of the world. Hence China had been registering huge revenues from exports and as such was building a huge current account surplus. Japan is economically mature, but it too has been a highly successful manufacturer and exporter in the past decade or more and thus also had a large surplus. Korea has been similar on a smaller scale.
Indeed, in recent times one could say the East was the producer and the West the consumer, although this gets complicated in that Germany and other European countries have been running surpluses while other EU members have been running big deficits. But let’s just stick to East and West. If you assume that the East has always exported its manufactured products at a margin over the raw materials (rocks) it imports, then the East has been making all the money. The West has simply been spending money it doesn’t have.
And if you like, there’s the GFC in a nutshell. The uber-bears had been warning us for a decade that Western debt growth was out of control it would all end in tears. The West was building huge deficits to the East’s huge surpluses (and you can include Middle Eastern oil producers in that equation) and the world was becoming severely “imbalanced”. Such global imbalance was indeed a bubble that must one day burst.
And now it has.
Under normal circumstances, global imbalances are kept in control by exchange rates.
Assume there are two companies with steady earnings flows in the same industry but one is loaded up with cash and the other is loaded up with debt. Which one would you pay the higher share price for?
So now substitute two countries for the two companies, and which currency would you value the highest? Bear in mind that currencies are only backed by a country’s economy (they are a government IOU).
In theory, the country with the cash should see its exchange rate appreciate against the country with the debt. Then those manufactured goods would become more expensive while the rocks would not create as much income. The debtor country would just have to stop spending until the imbalance was corrected.
The US had reached the greatest current account deficit known to mankind just before the wheels fell off. Thus in theory, the US dollar should have depreciated against the yen, euro and renminbi (America’s three biggest creditors were Japan, Germany and China) and those currencies therefore appreciated against the dollar and the imbalance would have begun to reduce. If only it were that simple.
If the US was borrowing money, it had to borrow it from somewhere. Imagine if YOU had lent the Americans money. When they came back the next year and instead of paying that money back they asked for more, and did this every year, would YOU lend them more money? I didn’t think so. But Japan, Germany and China did.
The cashed up nations were also creditor nations – they lent the Americans money to buy their goods. Then when the Americans wanted more goods they just lent more money, never asking for any back. They did this by buying US bonds. The countries with the cash needed somewhere to put that cash so as to earn interest and beat inflation, and so they chose the “safest” bank of all – the US Treasury, keeper of the world’s reserve currency (by its own decree).
While the US dollar did indeed weaken as the US current account deficit grew, it did not weaken to any point truly representative of the debt Americans had built up because the creditors kept buying US bonds. The creditors knew that if they stopped lending money to Americans, Americans would stop buying goods, and the creditors would stop making lots of nice money and, in China’s case, never emerge from a Communist-enforced pre-Industrial Revolution society.
Can you see the potential problem here? But wait, it gets worse.
The US dollar would also have been lower against the German currency if the German currency was mark and not the euro. The euro roped an economically efficient and successful Germany in with basket case economies such as Spain’s, thus undermining the euro’s value. The US dollar would have been lower against the yen if Japan had not still been stuck in its decade of deflation, brought about by the bursting of the Japanese stock and property bubble in 1989. Japan was running zero interest rates, encouraging the world to borrow in yen (sell yen) and buy whatever it pleased, such US dollar-denominated CDOs which were AAA-rated but paid high returns. The US dollar would have been lower against the renminbi if China did not maintain a currency peg against the US dollar.
The latter was the most telling, as it meant Chinese goods would remain forever cheap for Americans (at least until Chinese wages and conditions came into line with US wages and conditions) and Americans could forever afford to buy them. What could stop the ever growing imbalance between China’s reserves and America’s debt?
A little thing called the GFC.
When the US current account deficit began to blow out, one might have expected creditor nations to stop lending the US anymore money. But they didn’t. Had they stopped, the yield on US bonds should have risen dramatically, indicating increased lending risk. But it didn’t. Instead, the US Federal Reserve was able to respond to the tech-wreck and 9/11 by lowering interest rates, making US money very cheap. But still the creditor nations kept buying low-yielding US bonds. Americans just had more money than they knew what to do with. They had to spend it on something.
I know! What about a bigger house?
And so the US housing bubble was born, spawned by and spawning such things as CDOs which became the butterfly wings. The tsunami eventually followed.
After the GFC
Because of the GFC, Americans have stopped spending (as have Australians). Hence they have stopped buying lots of imported goods. Economists expected this to happen, and thus expected that the exporter nations such as Japan and China would see a fall in demand for their exports. They assumed that Japan would see about a 5% fall in exports and China about a 1% fall in the month of February last.
Instead they both fell about 25%.
Economists across the globe have been absolutely dumfounded this week. Exports from Asia have not just slowed as one might expect, they have absolutely and utterly crashed. So much so in Japan that for the first time in 13 years, Japan has a current account deficit. And so much so that for the first time since China exploded onto the export scene, it would appear that China is also heading towards deficit.
[Economists at ANZ already assume China has a negative balance of payments. This is because all the “hot money” which flowed into China over the last decade – meaning foreigners looking to invest in the China miracle – is now flowing out again. This is the capital account part of the BoP. If the capital account has turned negative and the current account is going backwards then a negative BoP is likely the case. See “China’s Falling Trade Balance Means Stable Yuan” (today).]
Now – one might have guessed having come this far that global imbalances of surpluses and deficits must always nevertheless net out to zero. Each side of the ledger might blow out but the tally will still be square. Let’s just assume that is the case for the moment.
Such an assumption would imply that were the Chinas and Japans of the world heading into deficit, then the Americas and Australias of the world must be heading into surplus. And indeed the current accounts of the latter two are now showing declining deficits, if not quite surpluses yet.
This is great news! The GFC is fixing the problem! If Paul Keating were in charge he’d call it the “GFC the world had to have”. The GFC is causing excess debt to be unwound and the runaway train that was the Chinese economy (which even Chinese authorities were worried about) has slowed to a walk. Okay there’s been some pain, and more pain to come. People across the world are losing their jobs, be they in import or export economies. Fortunes have been lost, hardship will prevail. But we are taking the medicine. The regulators are plugging the holes and so once we get through this, life will happily go back to normal.
Except for one small problem.
Imagine if back in about 2006 George Bush had said, “Okay – America is spending too much money”, and had duly passed a law prohibiting Americans from spending any more money than they had to to survive. Americans would have stopped buying imports, the current account deficit would have begun to move back towards square, and the US dollar would have been secure. China would have seen its exports plunge then too, and would not have been happy because its current account surplus would also have fallen back towards square and its economic miracle would have slowed right down, but China’s growth only boomed because America’s spending boomed, and both sides knew that the bubble could not last (it hasn’t).
Had this have happened, America would not have needed to borrow money, and thus not issue more bonds. China would no longer need to lend America money, and thus it would not have bought anymore US bonds, but if America wasn’t issuing any it really would not have mattered. The difference would have been, however, that the American way of life would have become more austere and the Chinese way of life would have had to wait just a bit longer to catch up to America’s.
But it didn’t happen. Instead, the Bush Administration just encouraged more borrowing and more spending, the Federal Reserve kept borrowing costs low, and still China kept buying US bonds. The bubble burst, the GFC began, and now America has seen its current account deficit collapse by catastrophic force and the Chinese surplus likewise. But if that’s the case, then America can now stop issuing bonds.
BUT IT HASN’T.
America is not happy to allow a Great Depression again, even if that’s what the economic doctor ordered. Even if that’s fair retribution. Even if that’s what is really needed to clean up the mess and stop it from happening again. Instead, America is going the other way, even under the Obama administration. It is pretending to take the pain but realistically it is printing trillions of US dollars to feed into the economy to stop it from starving. And because it is printing trillions of dollars it is issuing trillions of dollars worth of more US bonds. It assumes the rest of the world will buy them. It assumes the rest of the world will keep lending America money to get itself out of the problem created by having borrowed too much money from everyone in the first place.
To some extent, its right. America is issuing bonds and the world is buying them, and that is maintaining the dollar’s strength right now. But we have just learnt that Chinese and Japanese export revenues have completely collapsed. Even if China and Japan wanted to, they couldn’t buy more US bonds. Indeed, as their surpluses turn into deficits they will have to sell US bonds. And if no one is there to buy the new US bonds the US is issuing, and existing US bonds are being sold as well, what happens next?
Obama has said he will “do what it takes”, just as his predecessor did. That means he will keep printing money until the problem is solved. While debt continues to be unwound, and while asset prices and commodity prices and prices of goods and services continue to fall (deflation), the printing of more money will not cause inflation. But if no one lends America anymore money and it keeps printing its own, then look out.
I said that all the current account deficits and surpluses of the world must net out to zero, but its not quite as simple as that. Capital accounts cloud the issue for one. It would make sense that US dollar could remain healthy, as it currently is, despite all the money printing, if the rest of the world was in the same boat and also printing money and issuing bonds, which it is. Exchange rates are only relative. If the US dollar remains strong, and American spending keeps falling, then the US current account will go into surplus. But were the US dollar to crash, America would be straight back into deficit without spending another cent.
Hyperinflation has been discussed as a major risk facing the US as it continues to print more and more money. Hyperinflation would occur if the US dollar were to collapse against other currencies as a result of too much money printing without bonds to back it up, just as has occurred in Zimbabwe. But everyone around the world who started out with a current account deficit is now printing money, and everyone who had a current account surplus is now looking at a current account deficit. Can everyone have a deficit together?
If everyone who needs to is issuing bonds, and everyone who used to buy those bonds no longer can, that implies that everyone needs money but no one has any. Last year the US Federal Reserve said it would buy US bonds if it had to. Now the Bank of England has said the same thing, and the European Central Bank is working out ways to do so as well. Where do central banks get their money? From the printing press.
One might assume that for one country to suffer hyperinflation it must do so alone. For hyperinflation implies the collapse of a currency’s value against other currencies. Ergo, the US could not suffer hyperinflation from printing money because everyone else is also printing money and monetizing debt (central banks buying bonds to cover the money being printed, and using printed money to buy them).
If no one has any money, other than that which is printed but not earned, what will a barrel of oil be worth? The rush will be on between every country to offer as many of their own banknotes as they can before the next guy offers more.
And at that point, the whole world will be suffering from hyperinflation.
