The Japanese made an unusual suggestion the other day that was largely ignored in the American press.
Japanese economists, increasingly concerned that the United States might seek to pay its enormous and growing debt obligations in a weakened US dollar, are looking to the possibility of US Treasuries being issued in yen.
As the yen strengthens, the effective value of debt held in dollars will decline, a fate that yen-denominated Treasuries would escape.
This idea isn't new. President Carter issued bonds denominated in German Marks and Swiss Francs when the dollar's value was in doubt during the high inflation of the late 70's. Now there are new questions being raised about the dollar, but this time the concern isn't inflation - its default.
In the past few months, the US dollar has strengthened against other major currencies, with the notable exception of the yen, even as the country has been at the epicenter of the deepening financial crisis. That dollar strength is not expected to last.
"There is no wonder the dollar will weaken," said Eisuke Sakakibara, Japan's former top currency official and now a professor at Waseda University. "The dollar now looks strong for a technical reason. The money the US financial firms had invested in the world is being repatriated into the homeland, causing dollar-buying. But once this conversion into the dollars is done, the currency will head south," Sakakibara said at a forum in Tokyo on Sunday.
"The US will be forced to issue foreign currency-denominated US Treasures in its hour of need," said Mizuno. "The US cannot finance its deficit by itself. The US financial system cannot survive without foreign investors. We will see 'Obama Bonds' in the future."
To see how this works, check out this chart. Notice how the bankruptcies of major financial institutions have actually strengthened the dollar, rather than weakened it.
While this may seem incongruent at face value, it actually makes some sense. The defaults are forcing borrowers to raise cash to cover their over-exposed positions. That means selling their winning bets to pay the margin on their losing bets.
Their winning bets were often commodities (such as the falling oil price) and investments in developing nations. Their losing bets were Wall Street financial institutions and American real estate.
However, this is a temporary phenomena that is already beginning to end. According to Bank of America, repatriation of dollars has slowed from $6.4 Billion a day to $200 Million a day. Once the repatriation of dollars ends BofA expects a significant fall in the dollar's value.
A strict reading of interest rate differentials would imply the potential for a further 10% fall in the USD Index during the weeks ahead, about three times the 3.5% correction in place from the October 28 recovery high.
With that in mind it should not come as a surprise that global demand for gold is at an all-time high. Foreign investors have to put their savings somewhere, because they certainly aren't buying dollar-assets. Look at this chart of foreign buying of dollar-based securities below.
Uncle Sam's Credit Line Running Out
America's economy is dominated by consumer spending, which is approximately 70% of he GDP. Compare that to China, where consumer spending is less than 40% of GDP. China makes things. We consume things. China saves. We spend.
It's the ant versus the grasshopper all over again, and winter is coming.
The budget deficit for just October was $237.2 Billion. That's more than half of last year's record budget deficit in just one month. Since America's savings rate is about zero, we simply cannot fund this deficit spending ourselves.
Meanwhile, the Federal Reserve has cut interest rates to just 1%, with more cuts coming. If you were a foreign investor how eager would you be to buy our debt that produces almost no yield?
Which brings up the big problem - how are we going to fund our ostentatious lifestyles with a banana republic economy?
It's this problem that has caused economists to speak the unspeakable - a government default.
How much more can the US taxpayer take? It sounds insane, but the liabilities being taken on by the Fed and the US Treasury are now so enormous that the government itself could default. No?
Check out the chart showing the recent spikes in the US 10-year credit default swap. In other words, the market is now pricing-in the genuine possibility that the US will struggle to pay-back some of its long-term T-bills.
If the government can't borrow the money from foreigners to pay for its massive deficit spending (estimated at $1.5-$2 Trillion or the coming year) then it will have no choice but to monetize the debt. That means the Fed will create money out of thin air in order to purchase the treasuries. It costs nothing to do this, but it also means setting up a hyperinflationary scenario as foreigner investors will flee the dollar.
The attraction of investors to the short end of the Treasury market is "juxtaposed with the massive oversupply and inflationary expectations of the longer end," he writes.
Backshall is not alone in this dire assessment. Scott Minerd, the chief investment officer for fixed income at Guggenheim Partners, a Los Angeles money manager, estimates that total Treasury borrowing for fiscal 2009 will total $1.5 trillion-$2 trillion. That was based on $700 billion for TARP, a $500 billion-$750 billion "cyclical deficit," an additional $500 billion stimulus program and some uncertain amount for the Federal Deposit Insurance Corp.
Minerd doubts that private savings in the U.S. and foreign purchases of Treasury debt will be sufficient to meet those government cash requirements. That leaves the Fed to take up the slack; that is, monetization of the debt.
The idea that the American government will lose its AAA-rating has been mentioned for a couple years now. Of course if the world's reserve currency is no longer trustworthy then is any debt trustworthy? A loss of the AA-rating would be like setting off a neutron bomb on Wall Street. The buildings would remain standing, but everything else would be destroyed.
If you look at currency reserves around the world, it looks like the reserve currency is losing its attraction.
The end of dollar hegemony is approaching and everyone knows it. They just aren't sure what will replace it.
Just before flying to America this weekend, French President Nicolas Sarkozy announced his position: “‘The dollar, which at the end of World War II was the only world currency, can no longer claim to be the sole world currency ... What was true in 1945 can no longer be true today.’” Stating this fact was not a matter of ‘courage,’ but ‘good sense.’”
This day has been coming since America went off the gold standard in 1971 and dared the rest of the world to do something about it. The rest of the world blinked.
Now, 37 years later, the rest of the world still doesn't know what to do about it. Thus you can bet that there won't be a replacement for the dollar-standard until the entire dysfunctional economic system collapses. That's why betting on other currencies might not be the best solution to survive the end of the dollar empire.