The great issue in Washington that divides Republican and Democrats is whether we can go on running deficits and piling up the national debt without some day reaching a point of reckoning.
Democrats adhere to the Keynesian/Paul Krugman school, which says that “deficits don’t matter,” “we owe it to ourselves,” and that printing money is the best and fairest way to stimulate the economy. (Actually, this viewpoint is adopted by whichever party happens to be in power. The Republicans argued the same thing when they controlled the government during the Bush and Reagan years.)
The Republicans and other green-eyeshade types argue that out-of-control deficit spending can’t go on. It’s like a household budget. Any country that runs up a negative account balance will eventually hit bankruptcy. If it tries to inflate its way out of debt, people will start to doubt the value of money and the currency will collapse. Savings will be wiped out and the nation will become penurious.
So far the neo-Keynesians seem to be winning. Federal Reserve Chairman Ben Bernanke has been pursuing his policy of “quantitative easing” (which just means printing more dollars) for five years without producing any negative consequences. Inflation has remained low and the dollar has actually strengthened against some currencies, particularly the Euro as European countries sink into their own financial crises. True, we have now run up a national debt of approximately 100 percent of GDP, which is exactly where Greece was when things started to fall apart. But as everyone observes, no one really thinks the United States is as vulnerable as a little country 11 million people that lives on olives and tourism.
Then there is the example of Japan. The Japanese have had a national debt of 200 percent of GDP for nearly a decade. True, their economy has been in the doldrums for almost two decades and no one talks about the Japanese overtaking the American economy anymore. But once again the Japanese experience seems to confirm that “deficits don’t matter.” You can run up a huge national debt without suffering any immediate consequences.
Two things happened in London last week, however, that indicate there might be a flaw to this argument after all. There won’t be any consequences next week or the week after, but in the long run they may point to the place where America’s house of cards — or paper dollars — could eventually collapse. As Kenneth Rogoff, co-author of This Time It’s Different, says, “Any country that sits with a historically large debt for too long is taking a chance that some out-of-the-box event will shake up markets and raise interest rates to the point where funding becomes very painful. Wars and unexpected catastrophes do happen and the historical transformations that follow can occur.”
So here’s what happened in London:
- The British, faced with declining natural gas production in the North Sea and reluctant to embrace fracking, are facing power blackouts this winter. So they have decided to go with nuclear. They have quickly discovered, however, that America no longer has a nuclear industry and France, the one European country that has embraced nuclear, is bogged down in bureaucracy and political opposition. So they have turned to the country where nuclear construction and technology are making rapid progress — China. Last week Chancellor of the Exchequer George Osborne announced he would allow Chinese nuclear companies to invest in British reactor projects and eventually take ownership of them.
- Almost simultaneously, the Exchequer announced that Britain will allow Chinese banks to set up branches for wholesale banking in London. The decision is part of an effort to steal a mark on Frankfurt and Paris to become the hub of trading in the Yuan, the Chinese currency, in Europe. Having Chinese banks operating in London will allow direct trading between the Yuan and the British pound, instead of going by way of the dollar as things are done now.
The significance of these two events is hard to convey without sounding alarmed, but I will give it a try. First the nuclear part. At the end of the day, as the saying goes, the world is going to have little choice except to go nuclear. China and India are already proving that, even if you’re not particularly concerned about global warming, running an industrial nation on coal produces insufferable air pollution. China just passed the United States on total electricity generated and China and India combined will probably have to produce ten times more if they are to lift their populations out of poverty — which their people desperately want. We may be able to divert ourselves into natural gas for awhile, even though it is a huge waste. (Gas would be much better utilized as methanol to run our cars.) But in the end, the world is going to move to nuclear power — there is no other way.
All this will create enormous economic opportunities. Countries that can build nuclear infrastructure are going to grow rich. The Koreans have landed a $20 billion contract to build four reactors in the United Arab Emirates and that is just the beginning. The Hinckley Point Reactor in Britain — the one the Chinese are investing in — is estimated at $22 billion. There are 70 reactors under construction right now, mostly in Russia and Asia. The builders include Russia, China, Korea and Japan,— which is still selling its technology abroad even though public opinion is opposing it at home. France was in the lead for awhile but has fallen victim to the general sclerosis of European institutions. At the Olkiluoto project in Finland, the Finnish environmental bureaucracy has taken months to sign off on approvals that were supposed to be done in days and the project is now five years behind schedule with completion still out of sight. Before she was forced out of her job, Anne Lauvergeon, former CEO of France’s Areva, was complaining that the Chinese were able to build French-designed reactors faster and cheaper than the French could themselves.
So the task or producing the world’s industrial infrastructure is rapidly shifting from West to East. So will the cutting edge of innovation. Bill Gates sat in the lobby of the Nuclear Regulatory Commission in Beltsville, Maryland, for a year (figuratively) before finally realizing the task of getting the bureaucrats to look at his Traveling Wave reactor was hopeless. So he took his invention to China. The design, which burns continuously for 50 years, consuming its own waste in the process, is now being developed by the Chinese National Nuclear Corporation.
That’s one thing. Now what about this banking business? Well, the Chinese here are striking at our Achilles’ heel — the role of the dollar as the world’s reserve currency. Let’s go back to Ben Bernanke’s “qualitative easing” and the argument that the national debt doesn’t matter because “we owe it to ourselves.” The fact is we don’t owe it to ourselves anymore. Fully one-third of our debt is owned by foreigners. China and Japan are the largest stakeholders, each owning 7 percent. If we just owed this money to American investors, we could just stiff them the way the government stiffed bondholders at GM and Chrysler — or the way savers are currently being stiffed by the Fed’s zero interest rates. There is nothing anyone could do except move their money abroad. (This is apparently already happening, since the U.S. is experiencing a negative investment capital outflow.)
But the real danger lies in the dollar’s role as the world’s reserve currency. This is the legacy of our hugely productive economy during and after World War II when we played the role of world leadership. “At the Bretton Woods Conference of 1944, the major western powers turned over responsibility for maintaining a stable world currency to the United States,” says Lewis Lehrman, the long-time advocate of the gold standard. “Unfortunately, it’s a responsibility that we haven’t fulfilled.”
Until 1971, the dollar was pegged to gold at $35 an ounce. But with inflation raging and gold flying out of Fort Knox, President Nixon renounced the exchange rate and said that the dollar would float against other currencies. “Since 1971 we’ve been living in an era of inconvertible paper currency,” says Lehrman. Gold now sells at $1300 an ounce, a 2000 percent depreciation since 1971.
So what “quantitative easing” really means is that we are dumping out domestic profligacy on the rest of the world. We go on running up debt and printing dollars and the rest of the world is forced to take them because, based on its former stability, the dollar still serves as the international means of exchange in 60 percent of world trade. There are now more $100 bills circulating abroad than at home. It’s the kind of situation that will go on until someone successfully challenges the dollar’s role as the world currency.
That challenge will almost certainly come from China.
As holders of $1.1 trillion in American debt, the Chinese are the principal victims of our inflationary policies. So far, however, there’s not much they can do about it. In 2009, as the American economy was collapsing, Chinese Prime Minister Wen Jiabao warned “We have lent a huge mount of money to the US. Of course, we are concerned about the safety of our assets. To be honest, I am definitely a little worried.” The Chinese can’t rock the boat too hard, however, without endangering their own assets. As the great swindler Billie Sol Estes once said, “When you owe someone $1000, you’re in debt. When you owe them $1 million, you’ve got yourself a partner.”
What the Chinese have been doing, however, is quietly building a financial infrastructure that would allow them and the rest of the world to free themselves from dependency on the dollar. They have suggested substituting promissory notes from the International Monetary Fund in world trade and struck deals with Russia and the OPEC nations to trade outside the dollar. They have established direct exchange of the yuan with Hong Kong, Taiwan and Singapore. Last spring Australia agreed to make its currencies directly convertible with the yuan and has since shifted 5 percent of its reserve holdings into yuan instead of dollars. The Chinese are negotiating a similar arrangement with New Zealand. And now they will be moving into London and the European market as well.
All this may seem very distant but it represents an historical shift that could come about very quickly. “We hear arguments that China has a long was to go before they could become a major international reserve currency but let’s not kid ourselves. The process is already underway and a lot further down the road than most people think,” says Stuart Oakley, head of foreign exchange trading at Nomura, a global investment bank in Singapore. Michael Pento, president of Pento Portfolio Strategies, who writes frequently for Huffington Post, adds: "The No. 1 security issue we have as a nation is the preservation of the U.S. dollar as the world's reserve currency. It's a thousand times more important than a nuclear bomb being tested by North Korea. Yet we are doing everything to abuse that status."
At any one time, up to 35 percent of the dollar’s value comes from its role in international trade. This is what differentiates us from Japan, which may have twice our national debt but does not have the same exposure in international markets. If the dollar were to be toppled from its role as the world’s reserve currency, it would set off a run on the dollar in which every American could lose up to a third of his net worth.
At that point, people might start paying attention to what the Tea Party is saying.