Where is Jack Traven?
In the 1994 movie "Speed", Jack Traven played by Keanu Reeves was a young S.W.A.T cop in the Los Angeles police department who had to disarm a bomb on a bus that would detonate if the speed of the bus fell below 50 miles per hour.
In 2009, the $1.4 trillion U.S. budget deficit, 1 with trillions more projected for the next 10 years, is the bomb ticking down. The city bus that Jack Traven maneuvered through traffic and saved from exploding with all the hostages on board has become a metaphor for U.S. spending careening out of control.
In the real life drama of 2009, nearly a century of American economic hegemony is now imperiled as growth prospects in developing countries attract capital fleeing the threat of deflation, inflation and devaluation in the U.S. The bus is rigged with the biggest bomb, and nobody in Washington has the skill, the will or courage to defuse it.
Just as Officer Traven kept the bus speeding at over 50 miles per hour to prevent it from blowing up, China, with its hoard of foreign exchange reserves, keeps up its pace of investing in U.S. debt to satiate the voracious appetite of Obama and the Congress to borrow and spend.
Far from being altruistic, China knows that it must continue to invest in the U.S. in spite of America's worsening balance sheet. The slightest hint of any treasury auction being less than well received could seriously impair China's portfolio of over $800 billion2 in treasury bonds, and billions more in agency debt issued by entities such as Fanny Mae and Freddie Mac.
One open secret about China's economic miracle is the role that currency manipulation has played in modernizing its industries and liberalizing its economy. An artificially depressed yuan coupled with low labor cost allow Chinese goods to gain trade advantage in world markets and make foreign imports less affordable to Chinese consumers. Millions of manufacturing jobs have been created, easing the pains of large scale migration from rural China to the cities.
Chinese surpluses finance U.S. deficits and keep interest rates low for American consumers who can purchase more Chinese imports on credit. Stopping short of labeling China a "currency manipulator", 3 U.S. policy makers take a more nuanced approach to bilateral exchange rate policy with China who has now become the number one creditor to the U.S. Both countries have never been more reliant on each other in the global economy than they are today.
However, this symbiotic relationship is seeing fissures, if not out right fractures along the fault lines of soaring deficits and the falling dollar. Stimulus spending passed by the U.S. Congress has pushed the U.S. budget deficit to almost 10% of its GDP. 4
The bond market is holding up well so far in spite of record borrowing and quantitative easing, a surreptitiously named program under which the Federal Reserve exchanges government debt for currency. Far from being impressed, the foreign exchange market has voted its non-confidence in the U.S. Dollar, which has slipped 15% from its 2009 high.5
Having amassed a large stake in U.S. bonds, China finds itself in the unenviable position of being held hostage to expansionary U.S. fiscal and monetary policies which favour domestic priorities over international obligations. Other than seeking assurances that the U.S. does not embark on policies that could further endanger its investment, China feels powerless to stop the ongoing dollar devaluation, despite the frequent hollow pronouncements from Washington of its "strong dollar" or "sound dollar" policy.
Just like Jack Traven who pondered defusing the bomb while steering the runaway bus at dangerous speeds, China engages in its own high wire act to sustain the record U.S. deficit without jeopardizing its investments. Although some junior Chinese officials have made bellicose statements about dislodging the U.S. Dollar from its primary reserve currency status, the senior echelon of the Communist Party is keenly aware of how vulnerable China's foreign exchange reserves are to the fate of the greenback.
The mistrust is shared. Confronted with the reality that China has emerged as America's largest benefactor, shrill anti-Communist voices echoing from the McCarthy era sound the alarm on Capitol Hill that America may soon become subservient to its paymasters in Beijing. The fear is that, unfounded as it may be, China could one day threaten to unload its vast holdings of U.S. treasury bonds in an act of economic blackmail and send U.S. interest rates skyrocketing.
Notwithstanding the impolitic irony of the largest capitalist economy in the world being funded by a Communist regime, the dilemma facing China is more complex. America is betting on near-zero interest rates and deficit spending to lift its economy out of recession, but so far the results have been record budget deficits, slow domestic growth, and a plunging dollar.
China's hard earned foreign exchange reserves largely denominated in dollars have turned into an albatross for the Middle Kingdom. Any outright action to curb its appetite or reduce its existing holdings of U.S. debt could send the treasury market and the U.S. Dollar into a death spiral. Many vulture funds have already positioned for such an eventuality, and they constantly scour the currency and bond markets for signs of capitulation.
No country would take any action contrary to its self-interests. China faces a dilemma where its instinct for trade advantage may encourage continuous recycling of surpluses to prop up the dollar in the short term, at the risk of long term damage to its reserves. It would be advisable for China to spur domestic consumption, diversify away from accumulating more U.S. debt and instead acquire tangible commodities and foreign resource companies. Yet even such strategic diversification may further erode confidence in the dollar.
In the movie, Jack Traven finally disarmed the bomb and saved the day, after taking his passengers on a harrowing ride. In the aftermath of the financial crisis, billions have been spent on bailouts and billions more planned for current and future entitlement programs. America waits in vain for a heroic character with the requisite intellectual prowess and political acumen to emerge and save the Republic from collapsing under the weight of its debt.
Total U.S. public debt is on an unsustainable growth trend and stands at $120 trillion by some estimates, including $107 trillion in unfunded liabilities to Medicare and Social Security. 6 As the U.S. economy attempts a tenuous recovery, debt reduction is relegated to the back burner.
The financial crisis of 2008/2009 that destroyed wealth on an unprecedented scale unleashed deflationary forces on the economy, witnessed by falling prices in housing, stocks and commodities. However, central bankers and policy makers have countered with reflationary tactics of equally unprecedented fiscal and monetary stimulus measures.
The latest data suggest the U.S. is lagging while many global economies are on the mend. However, expansionary policies may nevertheless stoke inflationary expectations ahead of employment recovery. While the Federal Reserve will have to normalize interest rates sooner or later, the Obama Administration will also have to weigh the benefits of its extravagant initiatives against their costs. Without the political will to rein in spending or raise taxes, the outlook for the U.S. economy will be infinitely more dire than the specter of an exploding bus on an L.A. freeway.
Footnotes
1 Source: Bloomberg http://www.bloomberg.com/apps/news?pid=20601103&sid=aA8lChe4zUQU
2 Source: US Treasury Department http://www.treas.gov/tic/mfh.txt
3 Source: Bloomberg http://www.bloomberg.com/apps/news?pid=20601110&sid=abwfzaq6aJUI
4 Source: WSJ http://online.wsj.com/article/SB10001424052748704429304574467071019099570.html?mod=googlenews_wsj
5 Source: Net Dania Charts - USDX 2009 high 89.62 (Mar) low 75.92 (Sep)
6 Source: National Center for Policy Analysis http://www.ncpa.org/pub/ba662
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