WILD CARD WARNING: Is America too big to fail?

A wild card is a low probability event, which, if it occurs, has dramatic consequences. I believe we now face such a wild card. The idea occurred to me just last week, as I was riding a plane from A to B. Sometimes ideas coalesce for no apparent reason, and as I was reading about the pretty useless cap-and-trade emission system that the U.S. government seems about to pass, a number of different pieces came together to create a sudden insight: that the U.S. government is going to fail, possibly even go bankrupt. This is heresy for someone who studied the financial markets all his adult life: U.S. T-bills have been the world’s primary “risk-free investment.” For this not to be the case implies a financial earthquake of massive proportions.

This is a wild card, instead of a dead certainty, for the same reason that a flu pandemic is a wild card: that there will be a pandemic is an absolute certainty, but nobody knows whether it will start this afternoon, three years from now, or three decades from now. Likewise, the U.S. federal government, unless it makes a Herculean effort to change direction, will fail. What isn’t known is whether it will be this month, or five years hence. It cannot be a long way off, but the precise timing of this biggest-of-all-bankruptcies will come to pass if present trends are unchanged. I really don’t want this to happen, but am very much afraid it will, which is the reason for this warning.

During the financial crisis of 2008, the U.S. government deemed that some banks were “too big to fail,” meaning that if they went bankrupt, they would bring the entire financial system down with them. Therefore, the government concluded, there was no alternative but to pour hundreds of billions of taxpayers’ dollars to rescuing these banks and their incredibly selfish executives, no matter how ideologically or ethically repugnant it might be to do so. And, in my opinion, they were correct, both in their presumption that some banks are too big to fail, and that they had no alternative but to rescue them.

Now, eight months later, we must ask an even tougher question: Is America too big to fail? And who is capable of saving it if necessary?

First, let me explain the reasons why it might fail. Because of the brain-dead management of the U.S. federal government under George W. Bush, the American government went from the biggest surplus in history to the biggest deficit in history, and at precisely the worst time. (Frankly, how Bush could ever consider himself a conservative is beyond me, but that’s another discussion.) The reasons why it was the absolute worst time fall into two categories: those we knew about, and those we didn’t know about ahead of time. Those we knew about were the impending insolvency of Medicare around 2019 – 10 years from now – and the somewhat more distant insolvency of the U.S. Social Security System in 2041. And meanwhile, these two programs cost the federal government more than $1 trillion last year, or about one-third of the entire budget.

America has, for decades, been piling up debts to be paid by later generations, ably aided and egged on by the U.S. Congress, which loved the fact that it could make promises of immediate benefits to voters, especially vote-happy seniors, and leave the tab for someone else to pick up. Moreover, lobbyists and voter interest groups make it very hard for any elected official to resist the temptation to raid our children’s piggy bank, because our children and grandchildren don’t have enough votes to stop us. The result, before last year’s financial crisis, was an unfunded liability that was estimated in a report published by the U.S. Federal Reserve Bank of Kansas City to amount to $65 trillion by 2050. And according to the Government Accounting Office, the non-partisan watchdog of the American government, the only solution would be for the federal government to start getting its financial house in order immediately if not sooner, by making tough choices, cutting spending, trimming benefits, and postponing the age at which voters qualified for benefits.

Clearly, that’s not what Bush did. (Although to his credit, he did try to do something about Social Security. His proposals were wrong-headed, and insufficient, yet the U.S. Congress spiked even that weak-kneed attempt.) Accordingly, even before the crisis, the U.S. government was driving towards a brick wall at 60 miles an hour.

Next was the U.S. trade deficit. America, as a nation, consumes more than it produces, with its trade deficit reaching a record $847 billion a year in 2007. This means that its trading partners, notably but not exclusively China, are selling Americans that much more in goods and services than America is selling to them in return, with foreigners accepting IOUs for the difference. China alone has something approaching $2 trillion in foreign currency, and while there are Euros, Yen, and other currencies in there, most of their reserves are in the form of U.S. treasury bonds and T-bills.

Since Americans consumed more than they produced, this meant, in effect, that they were systematically transferring their past or future wealth to their trading partners in exchange for a more luxurious lifestyle today.

Clearly, neither the build-up of an unsustainable U.S. federal debt because of government deficits, nor the export of America’s wealth to its trading partners can continue forever. Yet, America has the largest economy in history, so it can run up a tab for a long time before this becomes a problem.

Now let’s turn to the issues we didn’t know about before the crisis: the costs of bailing out the banking system from the worst financial crisis since the Great Crash of 1929, and the hopes of forestalling what might become the worst recession/depression since the Great Depression of the 1930s. The Bush government, via the Treasury and the Federal Reserve Bank, decided they had no alternative but to weigh in, throwing money around without regard to long-term consequences. If they hadn’t, they believed the global banking system would likely have come crashing down around all of our ears, and the global economy would have collapsed with a devastating crash that would have thrown tens of millions of people out of work, and done enormous harm to the global economy. And the U.S. government was not alone; virtually all of the world’s major central banks (eventually) went along with the policies for the same reasons, and many of the world’s governments also plunged ahead, trying to spend their way out of recession.

I have real concerns about the apparent ease with which President Obama has taken to spending money. It is true that he inherited this mess, and probably had no choice but to spend, and it’s also true that he’s only been in power for five months, but he seems to be trying to do everything at once, and ignoring the cost. And while I understand the political imperative to make your major moves early in your mandate, the scope and size of his moves are breath-taking. For the current fiscal year, the total of U.S. federal government spending is projected to be $3.6 trillion, so that the government will have to borrow almost $1.8 trillion to finance its deficit, compared to $1.2 trillion in fiscal 2009, and $0.455 trillion in fiscal 2008. In short, the deficit has almost quadrupled in two years.

That’s the situation as it is today. And the net effect of all of this emergency spending is to bring the brick wall America was racing towards much closer, and to push the pedal to the metal, so now America is racing towards it at 180 miles an hour instead of 60 miles an hour. The only question is: How many years will it take before we go splat?

But while these issues would naturally come home to roost in a matter of years or decades, there’s a more immediate problem: the financial markets look towards future events, and use their best efforts to avoid holding securities that they think will depreciate. Now add to this general observation the immediate reality that the U.S. government must sell an unprecedented amount of bonds and T-bills to finance 46% of U.S. federal spending. But who is going to buy them? With the U.S. already the biggest debtor nation in the world, with its biggest creditor, China, already musing publicly about whether the U.S. government is capable of supporting the debt loads projected, and with market players musing about whether the U.S. government will lose its AAA credit rating, who is going to want to step up and buy more U.S. securities than have ever been sold before? Why would any sane investor want to take that kind of risk? I can’t find any good answers to these questions. Even if they make it through the next year, and find buyers for $1.8 trillion in new debt (in addition to rolling over the existing debts), the Obama administration is projecting deficits, and hence borrowing needs, amounting to some $7 trillion over the next five years or so ­– and those projections are thought to be optimistic. The net result is that whether it happens today, or three years from now, sooner or later America won’t be able to borrow as much as it needs.

And that brings us to the crux of the matter: What happens when that time arrives? I hope to hell I’m wrong, but just for the moment let’s suppose my reasoning is correct. If the American government tries to sell all of this new debt, and doesn’t find enough takers, than the U.S. government won’t have enough money to pay the bills it is so freely running up. Its checks (or cheques) will start to bounce; it will be functionally bankrupt.

If that were to happen, the next logical step would be for the U.S. Federal Reserve Bank to step up and buy the bonds and T-bills itself. It, technically, has the ability to do that, but practically it would mean printing money to cover government IOUs, and an absolutely unprecedented amount of money at that.

But the U.S. dollar doesn’t trade in a vacuum. Printing this amount of money would do two things, both of them bad. First, America’s trading partners would sell U.S. dollars in favor of almost any other currency. (This may be one of the factors driving the Canadian dollar up so quickly in the last few weeks, for example.) And secondly, it would trigger domestic inflation, as greenbacks became worth progressively less and less. Both would move towards the same end: it would trigger a run on the U.S. dollar, pushing it into a downward spiral as currency traders sought to sell, but could find no buyers. The dollar would go into free-fall.

In turn, these events would have three knock-on effects, none of them good. First, it would mean the U.S. government would have to cut its spending drastically, or risk having its checks bounce. This happened to the government of New Zealand in 1984 , and it caused a national crisis there. But America is not New Zealand, and if it cuts its spending, both the American economy and the global economy will get hit hard at a time when both are beginning a fragile recovery. Second, it precipitates another financial panic, worse than the one last year, only this time the biggest rescuer is the one that needs rescuing, which could crash the entire global financial system. And third, the global trading system, which uses U.S. dollars as its principal medium of exchange, slows to a crawl because there is no other currency big enough to replace the greenback. This might mean that global trade would plummet.

What happens after that is anyone’s guess, but it’s hard to paint an encouraging scenario, or even one that’s not wildly pessimistic. So let’s circle back to my opening question: Is America too big to fail? Perhaps, but who is big enough that they could possibly save it? There are only two players even close to having the size for this task: China, and the European Union. Neither of them are big enough. Probably the two of them together aren’t big enough. And it may be that all of the central banks of the world, combined, and backed by their national governments, may not be big enough. Moreover, it would take a degree of cooperation and willingness to accept losses by the rest of the world that, going by past performance, is unlikely in the extreme. So, based on what I can see now, America will probably go bankrupt, and create a panic and even deeper global recession in the process.

Of course, people are endlessly inventive, and it may be that someone will come up with clever solutions that will save the day. For instance, the Federal Reserve could raise interest rates significantly to help make America’s debts more attractive. But that won’t happen unless there is a crisis that trumps domestic politics, because raising interest rates by much would likely throw America back into recession, dragging global growth down with it. So, absent some miracle solution, America is going to crash – I just don’t know when.

Believe me, I hate writing about this, especially since I know that many people will inevitably blame the messenger. So instead, let me turn this into a question: Am I wrong? Is my reasoning incorrect, or are my facts wrong, or my interpretation too pessimistic? Perhaps I have the timing wrong, or am overestimating the scope of the problem. Let me ask, then, does anyone else have a different view? I’m not asking for political views, pro-Democrat, pro-Republican, anti-Democrat or anti-Republican; that is frankly a boring and unimportant sideshow. What I’m interested in is: Is American likely to fail? And if so, what can be done about it?

I’d like to hear your thoughts. Thanks.

© Copyright, IF Research, June 2009.