“The United States is the most powerful country in the world”
No, the US military has nothing to do with this statement. What is it then, that makes the USA so powerful? The answer is our currency – the US dollar. For a long time, precious metals were what was used as currency. The entire concept of exchanging consumables for something that has no practical use sounds nonsensical on its face and the barter system makes a lot of sense, however, the convenience of storing something non perishable that you can use later to get what you need can only be supported by everyone agreeing on what that non perishable item (currency) is. Back in the day, Gold was that item and was agreed upon as currency.
As a young kid growing up in India, I asked my dad why we purchased gold every now and then instead of just having money in the bank. This was when banks were only open during the day time and there were no ATMs or credit cards. Appreciative of my curiosity, he explained that gold was the only thing that you could invariably find a buyer for if you had an urgent need for cash. Even at that age, I realized the underlying meaning of that statement was that everyone agreed that gold was valuable – all the time.
When the first paper currency was printed in 1861, something had to be done to assign it value. The gold standard act of 1900 assigned a value of $20.67 to an ounce of gold. Suddenly everything that could be valued in gold, could also be valued in US dollars. The thing to remember though is that gold could be mined and so every time gold deposits were found, the values fluctuated. So the Federal Reserve was created in 1913 to stabilize the values. In other words, to stabilize prices. This responsibility lives with the Fed even today. It is one of the Fed’s two mandates. The other one is setting long term interest rates but we will discuss that another time. It is important to remember though, that the dollar had value due to three reasons –
The US had the largest reserves of gold in the world.
Almost all of the Gold in the US was owned by the treasury because FDR forced all Americans to trade in their gold for US dollars. This gold is supposedly still stored at Fort Knox, although the last president to see inside was FDR himself and the last congressional visit was in 1974.
The world trusted the US to not suddenly change the assigned exchange rate for gold and US dollar for its own benefit
The third point above is the most important because this trust allowed the rest of the world to peg their currencies to the US dollar in terms of defined exchange rates. This meant that the US dollar was tied to the largest reserve of the most ancient tangible thing of value (gold) and everyone else was tied to the US dollar indirectly tying their currencies to gold.
This meant that the US dollar was given a very special place in the economic standing of the world and the Federal Reserve was entrusted with the responsibility to maintain this global economic order.
In 1970s, as US consumer imports were increasing and a lot of US dollars were stockpiling in foreign countries the trust that these countries could just purchase gold from the US by paying dollars started fading. This is when Nixon decoupled the US dollar from its gold standard. The value of gold instantly shot up to $124 from $52 which was where Nixon pegged it at the time of the decoupling indicating the balance of payments deficit that the US had been running for a period of time by importing more than what they exported. In other words, gold was a lot more valuable to the world than what the US thought it was. The US dollar was a little less valuable.
Now every country printed their own money and the modern currency conversion rate was born.
If a country imports more than it exports (US falls in this category), it needs to either –
Procure its currency back from the country it has a trade deficit with by selling them an IOU (A government bond), which is what the treasury bond does for the United States.
Print more of its money to pay for these goods to countries that are doing the exact opposite (Germany, China), hence devaluing its currency exponentially in the process (This could also cause hyper-inflation and is dangerous).
Trade works in two different arrangements for the US at the moment – China and Others
US consumer gets paid and purchases goods from China and pays in US dollars
Chinese business with US dollars will purchase Chinese RMB (ideally in the open market driving up the value of the RMB against the dollar, but instead of allowing that to happen making Chinese exports more expensive in the process, China just pays a fixed exchange rate to its businesses and buys the US dollars to keep the RMB cheap)
China (now in possession of US dollars) will purchase US treasury bonds giving these dollars back to the US as a loan (which the US will have to pay back with interest). Over time, they just use these interest payments to buy more treasuries turning it into a snowball and indefinitely leaving the US indebted to China.
Others (Mexico, Japan, Canada, Germany)
US consumer gets paid and purchases a BMW and pays in US dollars
BMW needs to pay its employees so it will need to convert these US dollars into Euros. It will go out on the open foreign exchange market and bid for Euros increasing demand for Euros and supply of US dollars. Hence the exchange rate of the Euro against the US dollar increases (dollar is devalued)
The entity that purchased the US dollars in exchange for Euros is now in possession of US dollars that it can now utilize to loan to the US government by purchasing a treasury bond.
The primary difference in both instances is twofold –
Since the US imports a lot more from China than it exports, Over time, China will accumulate a lot of US treasury bonds (US debt) that some day needs to be paid. This is true of every other major US trading partner – Japan, Germany, Canada and Mexico but at multitudes of higher degree with China
Since the Euros have to be purchased on the open market, the exchange rate impacts between the Euro and dollar make future exports to the US more expensive and hence less attractive. This is the self correcting nature of global, open market currency trade. Alternatively, someone in possession of US dollars may just use them to buy something from the US creating a perfect trade and currency balance between the US and that country.
However, all these countries are perfectly happy to sell their products to the United States and purchase US treasury bonds in return for the moment because their savings far outpace their consumption and they trust that the United States Treasury bond is still the safest investment in the world. US consumption helps their economies continue to benefit and more importantly they still believe that the US dollar is valuable even though it is no longer pegged to anything tangible (gold).
The US has more outstanding treasury bonds than any other country in the world by a long shot. Which is another way of saying we have more debt than the entire world. However, that is misleading since we also have the highest GDP in the world. GDP by the way stands for Gross Domestic Product and basically indicates the amount of goods and services a country produces. So the correctly adjusted way would be looking at debt in terms of GDP which is the debt to GDP ratio. By this metric, the US ranks 11th in the world out of 173 countries with a ratio of 107%.
There is no question then that we should be working to pay down this debt and we all know that the way to do that is to spend less, make more and ideally, both. However, that is not the path we are on. As a matter of fact, we are doing the exact opposite. For the US to make more money, it needs to increase taxes. For the US to spend less, it would need to decrease government spending by cutting benefits and social safety nets. Both of these things are unlikely to win anyone elections so are very unlikely decisions to be made.
So then, the only option is for citizens to reduce import consumption but that would mean paying far more for just about every consumer product since it is this currency manipulation that has kept products so cheap for so long. However, if we stop purchasing imported products from China on principle, China has no incentive continue to manipulate its currency exchange rate to stay low and keep buying and holding treasury bonds. So what happens if they decide to dump these on the global open markets? At that point, the US has two options
Print a lot of money to buy back all these treasury bonds but as we’ve discussed earlier that would risk devaluation and hyper inflation, so not quite an option
Increase interest rates on treasuries the US issues so that no-one else would buy the treasuries China has to sell. This would cause a tremendous economic slowdown in the US since investors would transition from stocks to high yield safe investments like these treasury bonds.
Either way, it is not a good outcome for the United States. Honestly, there are no good outcomes here but as long as the world trusts the US treasury, Federal Reserve and the overall economic governance, what has been happening for several years seems sustainable. Basically, continued trade and sound governance could be the answer. You could also increase taxes on the highest echelon to raise more capital and reduce the budget deficits so less new treasury securities need to be issued but that would somewhat compromise the capitalist fundamentals the country was built on so that is a whole other discussion.
All of this background brings me to my final point. COVID-19. This has been a once in a lifetime phenomenon and the impacts of it have comparisons to the Great Depression. It is no surprise then that many governments around the world have taken drastic measures to deal with the potential impacts of this outbreak. While some financial effects of a pandemic of this magnitude are inevitable, some leaders have had to put in far less economic reinforcement than the United States. Countries like New Zealand, Australia and Germany acted quickly and decisively to shut down their economies before things got out of control and as a result, things never did get out of control. New Zealand has now gone multiple days without a single case and my friends there tell me that life is pretty much back to normal. They put safety net programs in place and made them accessible quickly and effectively preventing panic and hysteria driven unemployment spikes. They are now reopening the economies slowly and the amount of new capital creation from their governments was nothing compared to what is being done in the US.
The US Federal Reserve in conjunction with the Treasury has pledged to do whatever it takes to keep the economy propped up. The federal reserve is now purchasing far riskier corporate bonds for the first time of its history to inject money into cash strapped businesses. According to CNBC, about 2 million jobs are currently supported by ‘Zombie’ companies that were hardly surviving prior to the pandemic and now are receiving a cash infusion with the Fed giving out loans and buying bonds. While it may keep these businesses afloat for a little while, what happens when they go bankrupt and the Fed cannot recover their dues even after liquidating their assets? Basically, the capital that the Fed created to sustain the economy just vanishes. If that is what will eventually happen, wouldn’t it be easier to just let those businesses liquidate their assets now and the Fed use their funds to pay their employees unemployment benefits directly? They will be required to pay them unemployment when these companies fail to survive anyway, but that will be more money the Fed will need to create or borrow. If the Fed decides to borrow, the US goes further into debt. If the Fed prints more, they will devalue the US dollar and cause inflation.
I am not against government bailouts but the Fed needs to be selective. There has to be a repayment plan and strategy in place prior to giving out the loan or buying these corporate bonds. My bank verifies I have a plan to make payments before giving me a mortgage, so why wouldn’t the government before loaning money to businesses? Especially when this is the first time it is loaning money at this scale.
A lot of CEOs prior to this crisis spent a lot of their profits buying back stocks. It is the easiest shortcut to increasing the one metric that makes every investor and board member (read as the bosses of the CEO) happy. And who doesn’t want to make their bosses happy? Especially when it means big bonuses. However, just like any personal finance expert will tell you, there needs to be a rainy day fund. A lot of executives were so optimistic about the economy, that they didn’t think it was necessary to have a sizable rainy day fund. As soon as the coronavirus hit, they were forced to make tough decisions to lay off employees, causing the massive spike in unemployment. Why are we now letting these executives who marginalized the financial well being of their organizations to borrow money which could have catastrophic consequences to the reputation of the United States globally?
If the United States Federal Reserve prints money to create capital to address problems exacerbated by its own ignorance, they are diluting not only the value of the US dollar, but they are also diluting the trust, the rest of the world has placed in it by constantly purchasing US debt and even issuing their own debt in the US currency.
We would be remiss to take the power the world has willingly provided the United States due to its short but powerful history of capitalism, innovation and the pursuit of the American Dream. While the American dream is alive and well today, if we are to leave the dream alive for our children, we better make sure we understand the long term consequences of the actions of our leaders. The United States is the most powerful country in the world and it is all of our responsibility to keep it that way.