Vivek Kaul
Governments typically spend more than they earn. This difference is referred to as the fiscal deficit. The government of the United States (US) is no different on this front. It has been running fiscal deficits greater than a trillion dollars every year since 2009. It makes up for this deficit by borrowing. It borrows money by selling bonds on which it pays interest.
Currently, the US government has sold bonds close to $16.69 trillion. Of this, around $4.8 trillion worth of bonds have been bought by agencies of the US government which primarily run pension funds and retirement funds. The American households own around $1.2 trillion or around 7.2% of the total outstanding bonds of $16.69 trillion.
This is not surprising given that the savings rate in America has averaged at around 4.6% of the disposable income over the last 10 years. In July 2005, it had fallen to as low as 2% of disposable income. It has since recovered and since the beginning of 2013, it has averaged at 4.4% of the disposable income. The moral of the story is that the average American doesn’t save enough to be able to lend to his government.
So who are the other lenders to the US government? As I explained in detail yesterday the Federal Reserve of United States, the American central bank, is a major lender to the government. Currently it holds bonds worth $2.086 trillion or around 12.5% of the total outstanding bonds of $16.69 trillion.
This lending has gone up by 434% over the last five years. On September 17, 2008, two days after the investment bank Lehman Brothers went bankrupt, the Federal Reserve held US government bonds worth around $479.84 billion. As stated earlier currently it holds bonds worth $2.086 trillion.
The Federal Reserve doesn’t have any money of its own. It basically prints money and uses that money to buy government bonds. This money printing adds to the money supply. This excess money can ultimately lead to high inflation with excess money chasing the same amount of goods and services.
Hence, the Federal Reserve printing money to buy US government bonds is something that cannot continue forever. In fact, Ben Bernanke, had indicated in May-June 2013, that the Federal Reserve will go slow on money printing in the months to come. Since then, he has gone back on what he had said and indicated that the money printing will continue for the time being.
But even with that change in position, the US government cannot continue to rely on the Federal Reserve to finance a significant part of its fiscal deficit by buying its bonds. As I mentioned yesterday, between 2009 and 2012, the US government ran a fiscal deficit of $5.09 trillion. During the same period the Federal Reserve’s holdings of US government bonds went up from $475.92 billion (as on December 31, 2008) to $1.67 trillion (as on January 2, 2013). This increase, amounts to roughly $1.2 trillion. This amounts to around 23.6% of the total fiscal deficit of $5.09 trillion.
So the question is who will the US government have to ultimately borrow from? The answer is other countries.
As of the end of July 2013, foreign countries held a total of $5.59 trillion of US government bonds. Of this China was at the top, having invested $1.28 trillion. Japan came in a close second, with $1.14 trillion. How has this holding changed over the years? As of September 2008, the month in which the current financial crisis started with the investment bank Lehman Brothers going bust, the foreign countries held US government bonds of $2.8 trillion. Hence, between September 2008 and July 2013, their holdings have doubled (from $2.8 trillion to $5.59 trillion).
Given this, what it clearly tells us is that the foreign countries have helped by the US government run its trillion dollar fiscal deficits by buying its bonds.
Let us look at this data a little more closely. As of the end of December 2008, the foreign countries held US government bonds of $3.07 trillion. By December 2012, this had gone up to $5.57 trillion. This meant that during the period foreign government bought bonds worth $2.5 trillion. During the period the US government ran up a fiscal deficit of $5.09 trillion. The foreign governments financed around 49% of this, by buying bonds worth $2.5 trillion($2.5 trillion expressed as a % of $5.09 trillion).
During this period, some of the bonds that foreign countries had bought would have matured. The US government spends more than what it earns. Hence, it does not have the money to repay the maturing bonds from what it earns. Given this, it needs to sell new bonds in order to repay maturing bonds. A part of these new bonds being sold over the last five years have been bought by the Federal Reserve. The Federal Reserve has done this by printing money.
Hence, the US government has paid for a part of its maturing bonds by simply printing dollars. This is similar to running a Ponzi scheme, where the government is paying off old bonds by issuing new bonds. A Ponzi scheme is essentially a financial fraud where the money that is due to older investors is repaid by raising fresh money from newer investors. The scheme keeps running till the money brought in by the new investors is greater than the money that needs to repaid to older investors. The moment this reverses, the scheme collapses.
Despite this, foreign countries have been more than happy to buy US government bonds. As we saw a little earlier in this piece, they have doubled their holding of US government bonds between September 2008 and July 2013. In short, foreign countries along with the Federal Reserve have helped the US government to keep running its Ponzi scheme.
Why is that the case? The United States with nearly 25% of the world GDP is the biggest economy in the world. By virtue of that it is also the world’s biggest market where China, Japan and countries from South East Asia and South America, sell their goods and earn dollars in the process.
The way things have been evolved, the US imports and countries like China, Japan, Saudi Arabia etc earn dollars in the process. These dollars can either be kept in the vaults of central banks of these countries or be invested somewhere.
Hence, over the years, these dollars have made their way to be invested in US government bonds, deemed to be the safest financial security in the world. With so much money chasing them, the US government, has been able to offer low rates of interest on them.
This has helped keep overall interest rates low as well. It has allowed American citizens to borrow money at low interest rates and spend it on consuming imported goods. So the Americans could buy cars from Japan, apparel and electronics from China and countries in South East Asia and oil from Saudi Arabia. And so the cycle worked. The US shopped, China and other countries earned, they invested back in the US, the US borrowed, the US spent, China and the other countries earned again and lent money again.
The way this entire arrangement evolved had the structure of a Ponzi scheme. China and other countries invested money in various kinds of American financial securities including government bonds. This has helped keep interest rates low in the US. This helped Americans consume more. The money found its way back into China (like a return on a Ponzi scheme), and was invested again in various kinds of American financial securities, helping keep interest rates low and the consumption going. Like in a Ponzi scheme, the dollars earned by China and other countries has kept coming back to the US.
Hence, foreign countries have an incentive in keeping this Ponzi scheme going. Earlier, it was important for them to keep buying US government bonds to keep interest rates low and help American consume more. It was also important to keep buying these bonds to ensure that the US government had enough money to repay them. Now it has reached a stage, where the US government is repaying them by simply printing dollars.
But even with this foreign countries are likely to continue lending money to the US government by buying its bonds. Sanjiv Sanyal, global strategist, Deutsche Bank Market Research makes this point in a recent report titled Bretton Woods III and the Global Savings Glut.
As he writes “The basic idea is that, when people are young, they have little savings and may even need to borrow in order to spend on consumption and/or build assets. However, as they grow older, their net savings rise as they build up a stock of wealth that is later run down in very old age. The same dynamic can be said to broadly hold for countries as they experience demographic transitions although there are nuances that vary according to cultural context and fiscal incentives of individual countries.”
Basically what this means is that as a country ages (with the average age of its population rising) it tends to save more. Sanyal expects many developing countries to age at a very fast pace over the next two decades. As he writes “The link is even clearer if one considers the pace of aging by comparing the current median age with the expected median age in 2030. For instance, Japan will then have a median age of 51.6 years while China will go from being significantly younger than the US in 2010 to becoming significantly older after two decades. The aging of South Korea is even faster.” He expects these countries to have a median age of 40 by 2030.
Given this, it is likely that as countries age, they will keep generating excess savings. A lot of this money is likely to find its way into the United States, feels Sanyal. As he writes “we know that lenders do not just care about high returns but about policy risk, property rights, corporate governance and the overall ability/willingness to the borrower to return the money. Thus, aging current-account surplus countries may prefer to park their funds in safer countries even though returns are higher in certain emerging markets.”
And this will help the American government to continue borrowing. It will also keep interest rates low and help Americans keep their excess consumption going. “The next round of global economic expansion may require the US to revert to its role as the ultimate sink of global demand,” writes Sanyal.
And so the Great American Ponzi scheme might just continue for a while.
The article originally appeared on www.firstpost.com on October 18, 2013
(Vivek Kaul is a writer. He tweets @kaul_vivek)