US: Too big to fail

THE US ECONOMY is staging a recovery. Economic forecasts are around the 2% level for 2012. This compares with the UK and many eurozone economies, which have entered a double-dip recession. Economies are faced with a ruefully ironic predicament: bond market pressures are forcing them to implement fiscal austerity; debt piles must be paid down and fiscal contractionary measures are part of the process. At the same time, their economies have been dealt a demand side shock and a contraction of credit supply. Expansionary policies are needed to correct these effects, but it is extremely difficult to find a balance between contractionary and expansionary policy. America seems to have escaped this predicament. It unapologetically enforced aggressive easing policy with no repercussions from bond markets. The result is ultra low bond yields and an economy on the mend.

It is easy to draw comparisons and suggest the UK should abandon austerity for an indulgent, easy economic policy. But we would be overlooking a huge economic buffer for the US economy – the US dollar is the global reserve currency and dollar-denominated assets, global safe havens. A global reserve currency necessitates running persistent current account deficits. And the US has obliged running a deficit every year since 1982 but one. The global economy needs America to spend more than it saves to provide it with a liquid pool of safe haven assets. If the US Treasury market failed to provide such abundant and liquid debt, the world would be saddled with a lack of safe assets and worldwide credit supply would be hit.

In perverse market mentality, not only do we encourage the US to spend more than it earns, we fund it. In a kind of “reverse aid”, demand for foreign exchange reserves forces developing countries to transfer resources to the US. This facilitates financing the US balance of payments deficit. The US receives this financing at very attractive rates, as being the world’s global reserve asset means US bond yields stay low. The US actually makes a net interest income as the US treasury rates are often depressed lower than the inflation rate.

A global reserve asset is obviously an enviable position but it is not easily replicated. In 2009, US interest rates were rising. China was one of the main critics of US assets as global safe havens. A building stock of debt undermined the safety of US assets. The easy monetary policy that the US ran to offset the effects of the Global Financial Crisis, was devaluing US dollar-denominated assets. As a result, the Eurozone experienced an unprecedented increase in net bond inflow. Foreigners were buying up sovereign bonds of Euro area countries. The Euro was a likely predecessor to the US dollar as a global reserve asset. The Euro is the second most liquid currency, behind USD. What is more, the central bank was founded on the primary principal of maintaining inflation, with its founding treaty preventing Quantitative Easing. Euro area bonds were viewed as a better alternative to US Treasuries that were seen as too prone to devaluing. Money piled in the Europe’s debt markets, but imbalances began to show.

The eurozone is not one single indiscriminate bond market – individual national debt markets do not make the liquidity or the ability for investors to easily enter and exit. Individual bond markets showed up weaknesses in the system as large debt burdens built up on single member states. Had the total debt been supported by the entire economy of the Eurozone, the situation would have been sustainable. The bond market infrastructure wasn’t there and the debt markets crumbled. Yields rocketed and locked nations out of funding markets meaning they had to turn to international aid.

US capital markets have powerful advantages over foreign alternatives, with high liquidity, size and transparency. Convention also supports the position of the US dollar as a global reserve asset. Nearly all commodities are priced and settled in USD, leaving emerging nations with large dollar reserves. Many countries manage their currencies against USD and the liabilities of many nations are dollar denominated. America’s prominent position as providing military protection and international aid supports its position. The possibility of the Renminbi becoming the next global reserve currency are hindered by China’s closed financial account, high saving rates of its citizens and its relatively small bond market. Disregarding the arguments for and against the Renminbi as the next global reserve currency, internationalisation of the currency and the expansion of its bond market will undoubtedly take a long time.

A global reserve currency is not as easy a status to sustain. The underdeveloped structure of the EMU could not handle the influx of capital. If the current crisis forces unification of eurozone bond markets, the Euro could be a contender to the US dollar. But it will take a long time for the eurozone to hold the kind of market confidence required. A global reserve currency also sets a precedent for its citizens to spend more than they save and inevitably leads to an economy that is overweight on consumer demand. This is an economy that is imbalanced and susceptible to internal demand shocks.

There is no immediate need for America to pay down its debt. In fact, America should complete its recovery before it begins to tackle its over-leveraged public sector. This should be a medium to long-term policy that is attuned to the current business cycle. However, America being too big to fail doesn’t guarantee immunity. America should act in a defensive mode, begin to stabilise and steadily pay down its debt while promoting expansion of its manufacturing sector and exports. This will protect the US from a shock to consumer demand, pressure in bond markets or a threat to its status as the global reserve currency. Whatever the benefits of being the world reserve asset, it makes it easy for an economy to become over dependent on consumer demand and this must be balanced out.

Eimear Daly is a market analyst at Schneider Foreign Exchange

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