Tuesday, September 16, 2014
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Debt and America’s Decline

MILAN – Italians and other Europeans have serious problems addressing their own national debts, public and private, so it may seem immodest for a European to discuss America’s growing and grave debt problem. But the fiscal realities on both sides of the Atlantic nowadays are very similar, and only lingering trust in the promise of America keeps alive the expectation among some Europeans that some grand American coup de théâtrewill resolve the country’s dire debt situation.

Of course, many Americans recognize the scale of the country’s debt burden. Admiral Mike Mullen, Chairman of the Joint Chiefs of Staff and thus America’s highest ranking military officer, recently said, “The greatest danger to American security comes from the national debt.” Four Americans out of ten agree with him, whereas less than three in ten deem terrorism or Iran more dangerous.

America’s Great Power status has always been tied to its level of debt. Indeed, it was the absence of debt that marked the United States’ emergence as a world power between 1914 and 1917. The US went from owing $3 billion (mostly to Great Britain) to being a net creditor for about the same amount, thanks to $6 billion in war credits given to the Western Allies. A further $3 billion in credits for European post-war reconstruction cemented America’s status as the world’s premier creditor nation, with its surplus equal to roughly 8% of GNP at the time.

This shift meant that the US had essentially replaced Britain as the heart of the world’s financial and monetary system. Previously, thanks to the gold standard and Britain’s political stability, the City of London had been the world’s key source of capital and financial guarantees for more than a century.

The new era began suddenly in January 1915, when, after a few months of deep uncertainty, gold started to be shipped to New York in increasing quantities. A few months earlier, the veteran Boston financier Henry Lee Higginson had sketched in a letter to President Woodrow Wilson what America’s new strategy should be. “This is our chance to take first place,” he wrote. America’s financial house had to be put in order, all debts repaid, and, as London had done for a long time, confidence had to be maintained, which meant guaranteeing the dollar’s convertibility into gold.

Alone among the world’s great nations, the US did manage to guarantee dollar convertibility throughout the Great War. With peace, the dollar and Wall Street became the dominant force on the world’s financial landscape. The financial-market rules established after 1933 by President Franklin Roosevelt’s New Deal enabled the dollar to replace the British pound at the center of the international system.

America’s role as the world’s banker went unchallenged for the next 40 years ago, until President Richard Nixon decoupled the dollar from gold. Yet, even without the gold standard, America’s economic might, together with the recycling of petrodollars, kept the dollar on top.

Indeed, the US remained the world’s premier creditor nation until 1986-1987, when it became a debtor nation again. In the two decades that followed, America’s debt usually was around $3 trillion, rising or falling with the exchange rate of the dollar.

Starting in 1990, the US began to import more and more capital, particularly from Asia. In the 2000’s, China became the prime source of debt financing, and Americans were happy, because it enabled the US Federal Reserve to keep interest rates low.

There were some who foresaw danger. The Swedish economist Axel Leijonhufvud foresaw asset-price inflation – houses in particular – and a worsening of credit quality. Financial innovation soon made that prediction come true. It is enough to remember that in 2008 there were only 12 public companies in the world with AAA credit ratings, but more than 60,000 – mostly American – triple-A structured financial products. The US, the world’s banker, had mutated into the world’s hedge fund.

With that change, the banker’s traditional imperative to maintain fidelity and trust – to “keep faith,” as Higginson put it – was forgotten. And it is in America’s public debt that the debris of its financial system’s broken promises are collected, just as Italy’s massive public debt reflects its past national prodigality.

The figures for the US are staggering. Public debt includes not only the federal government’s current $13.2 trillion, but another $3 trillion owed by America’s states, counties, and cities. In addition, there is the $3.9 trillion in debt owed by America’s government-backed housing-finance agencies (Fannie Mae, Freddie Mac, and others), which currently underwrite more than 90% of all US mortgages. As a result, America’s public debt has reached roughly 140% of GDP.

The US Congress is well aware of what these numbers portend, but its members have chosen to avert their eyes. Indeed, the president is no longer required to provide the usual five-year forecast of the country’s fiscal position. A one-year perspective is now deemed sufficient.

So, where does that leave the world economy? There is no newly emerging Great Power that can assume responsibility for global finance, as there was in 1914. Back then, Wall Street was ready for the job. Someday, Shanghai and Hong Kong might be ready, but that possibility is of little help now.

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