The decisions of the Super Committee are likely to have more far-reaching implications than are currently envisioned, as the deliberations have been cast only in political terms by the media. There are, however, significant long-term economic implications.
As we have seen over the past couple of weeks in Europe, contagion can spread like wildfire. The bond yield spreads to U.S. Treasuries or German Bunds on all European peripheral country debt, and even on the debt of AAA rated (at this writing) France, have widened significantly and are displaying huge volatility depending on the day’s headlines.
Luckily for the U.S., the dollar is still the world’s reserve currency and, in a world of fiat currencies, shows up as the least risky because of its worldwide liquidity and its unabashed penchant to use its money printing press in a financial crisis. So, despite the imbalances clearly present in the U.S. today (see U.S. Debt Crisis: What’s the End Game? ), there still exists a “flight to the lowest perceived risk” (formerly known as “flight to quality”), when crisis and uncertainty rear their ugly heads.
Benefits of Reserve Currency Status
The rapid spread of the contagion in Europe should be a wake-up call to U.S. policy makers, especially the Super Committee. Any stumble or failure to propose something significant in the form of deficit reduction could further jeopardize the dollar’s reserve currency status and bring the day of reckoning perilously closer. The Nov. 14 edition of Barron’s (Enter the Yuan) set forth five benefits of reserve currency status:
- Investor willingness to hold your currency and paper;
- The ability to print money to purchase foreign assets — without paying any interest;
- Easy issuance of debt and worldwide acceptance;
- Deeper financial markets ultimately benefiting your financial institutions;
- Conducting trade in your currency which avoids exchange rate risk and benefits your exporters.
Think of what could happen to the U.S. without reserve currency status. Like what has already happened in the European periphery countries, interest rates would rise. This will occur even if the U.S. shares reserve currency status, which is the most likely initial scenario. I (see Wow-II! That’s A Lot of Interest!) and other prominent economists have estimated the cost of debt in the U.S. if rates rise. Some possible scenarios are truly frightening in that the cost of the debt relative to the federal budget and GDP could put the U.S.’s debt burden on par with or higher than that of Greece, Italy and the other countries involved in Europe’s debt crisis.
For sure, as I opined in the above referenced blog on Dec. 1, 2010, “[g]iven the structural nature of the deficit and the difficulty of slowing or reversing defense costs or the costs of ‘social’ categories, even small upward changes in interest rates … will exacerbate the deficit and economic growth issues.” Thus, preserving reserve currency status, just for the lower interest rates that accompany it, is critical.
Recession Implications, QEs and the Financial System
While recent data suggest that a U.S. recession is not imminent, some leading edge economists and even the San Francisco Fed believe that the inevitable recession in Europe in 2012, a slowing growth rate in Asia and China, and fiscal austerity at the state and local levels could tip the U.S. into recession. The San Francisco Fed says this probability is above 50%. A renewed recession will certainly cause the Fed to embark upon additional QEs, and the Administration and Congress will react by increasing the deficit (after all, it is an election year!). This will further erode the world’s confidence in the dollar as the world’s reserve currency.
The U.S. financial system was not “fixed” by TARP or Dodd-Frank. MF Global has shown that some of these institutions still have insanely high levels of leverage and are more than willing to make “all in” bets. An implosion in European financial institutions may negatively impact both the mid-sized and the Too Big to Fail institutions and cause further credit tightening. Under such circumstances, I can envision another TARP-like response from the Treasury and Fed with more money printing and secret lending further eroding the dollar’s status as the world’s reserve currency.
One has to wonder why China hasn’t come to Europe’s aid given that China exports as much or more to Europe as it does to the U.S. The answer could be that China has a long-term plan to vault the Renminbi (RMB or Yuan) toward reserve currency status. The benefits are numerous as outlined above. Already McDonalds, Caterpillar, Unilever, UBS, Volkswagen and the World Bank have issued bonds denominated in RMB in the Hong Kong market. It is no secret that China wants its emerging market trading partners to settle merchandise trades in RMB and wants a financial center on par with New York and London on its mainland. So, a flailing Euro and QEs in the U.S. advance the RMB as a potential reserve currency.
The importance of the Super Committee recommendations for the dollar’s status in the world and the special privileges, liquidity, and low borrowing rates that accompany that status cannot be overemphasized. Failure to make significant progress will only hasten the day when there won’t be a “King Dollar.” The end result will be higher borrowing rates, lower economic growth, a continuation of depressed economic conditions, and a further lowering of the U.S.’s standard of living.
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Robert Barone and Joshua Barone are Principals and Investment Advisor Representatives of Universal Value Advisors, LLC, Reno, NV, an SEC Registered Investment Advisor. Statistics and other information have been compiled from various sources. Universal Value Advisors believes the facts and information to be accurate and credible but makes no guarantee to the complete accuracy of this information. Universal Value Advisors, LLC is a registered investment adviser with the Securities and Exchange Commission of the United States. A more detailed description of the company, its management and practices are contained in its “Firm Brochure”, (Form ADV, Part 2A). A copy of this Brochure may be received by contacting the company at: 9222 Prototype Drive, Reno, NV 89521, Phone (775) 284-7778.
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