The Next Banana Republic
On June 10, in the note entitled “The Cobbler’s Children Go Unshod,” I extensively discussed the enormous problems caused by the fiscal irresponsibility of the outgoing U.S. presidential administration. The situation has deteriorated notably in just six months.
At that time, I was tempted to title the posting “The Next Banana Republic is More North than You Would Imagine,” but I was convinced that it would not be diplomatic. Six months later, I am sure that a similar title could not offend anyone. The fiscal monetary authorities of that country have recognized -I should say, with certain trepidation- their serious errors, typical of a banana republic.
To illustrate the situation, I used an article Bloomberg published on November 3, in which the author estimated that the U.S. fiscal deficit would reach US$1 trillion in 2009. In the 2008 fiscal year, it reached the unprecedented figure of US$455 billion.
In 2001, George W. Bush received public finances with a US$127 billion surplus. Barack Obama, meanwhile, will receive a government that posts the worst fiscal deficit in history.
Given such a scenario, the government has to issue growing amounts of debt because it has no alternative. In total, during 2007, US$134 billion were issued in public debt, which mushroomed to a record US$760 billion during the 2008 fiscal year. It is estimated that in 2009 the Treasury Department will have to issue US$2 trillion in new bonds, but this figure could be much higher.
Since the supply of bonds will be immense, if the monetary authorities ((the FED) do not intervene, the prices of these instruments will decline (due to the Law of Supply and Demand), which will automatically boost their yields. But if interest rates rise, the recession will intensify. So in order to keep the rates lower, the FED will purchase large quantities of debt issued by the government, printing money non-stop. In the 1980s the treasury ministers of any banana republic would call this “liquefying liabilities,” today's economists elegantly label it “monetizing debt.”
The Paradox of Panic
The paradox is that today, 30-year bonds are trading at close to their highest level in years. They are only paying a nominal 3%, that is, before deducting inflation from the yield. In the words of Warren Buffet, they are “expropriation bonds,” but people are in a state of panic and are seeking security.
On December 9, three-month Treasury Bills offered a negative nominal yield, paying 99 cents for each dollar invested in them on maturity. Investors are so desperate to find “security” that they are willing to pay the government for the privilege of possessing the instruments that it issues.
At a time in which bank and auto industry rescue packages, rebates and fiscal stimuli, and huge public work projects must be paid, this capacity to issue debt without cost (or with a negative cost), feels quite good for the federal government.
But investors are not idiots (in the long term). When the panic is over, they will realize how little a currency is worth when supported by an economy in chaos. This will lead to a depreciation of the dollar against other hard currencies. The United States will eventually have to liquidate its debt, and to do so, the frugal economies of Asia and the Middle East will be able to buy increasingly more assets in that country and the Americans will have to save much more. It is not in anyone’s interest, and less so in the case of Mexico, for the United States to become “The Next Banana Republic.”
For the good of the world economy; we hope that the United States will soon reverse course.