US Debt And The Financial Crisis

Written by admin on July 29th, 2011

Let’s start with the sources. By the middle of the XX century the U.S. had about 70% of the world gold reserves. The Bretton Woods Monetary Management System was set up in July 1944 and primarily resulted in recognition of the U.S. dollar as the world currency, while the fixed relationship of dollar to gold was set up as per ounce of gold. The countries participating in international economic relations could freely exchange dollars for gold at a fixed rate, and their currencies were pegged to the dollar. Such a system could function smoothly until the U.S. had enough gold reserves. However, by 60s the dollar reserves of countries’ central banks caught up with the U.S. gold reserves. As a result, when one or another country tried to exchange dollars for gold, the U.S. first exchanged and then restricted the exchange and devalued the dollar against gold. By early 70’s while the major world’s gold reserves were concentrated in Europe, problems with international payments raised as gold production could not keep up with the rapid growth of international trade. The U.S. lost their dominant position in the financial world, which, among other things, was complicated by the country’s balance of payments deficit.

As a result the Bretton Woods system proved to be inadequate. A new system of international settlements was established in 1973, the Jamaican Monetary System operating today. Since then, the currencies have not been tied to the U.S. dollar and the dollar has not been pegged to gold. Instead, the IMF introduced a new international reserve asset, the Special Drawing Rights (SDR). In addition to the SDR, the reserves could be held in gold, U.S. dollars, JPY, GBP, SHF, FRF and DM.

Today we can observe that despite the refusal to use the U.S. dollar as the main world reserve currency, about 85% of world’s foreign currency exchange transactions involve the U.S. dollars. Besides, more than half of the international reserves of countries’ central banks are held in dollars. Thus the dollar, although not secured by gold, has kept the status of the world reserve currency, for the following reasons: will of the U.S. government; the infrastructure created for dollar trade and risks hedging; the size of the U.S. economy (almost a quarter of the world economy). A choice of a currency for international transactions is a question of confidence: America had been trusted prior to the crisis.

Why does the international community question the U.S. economy? Let’s consider these complex reasons. Today globalization has spurred the rapid development of the international economic relations. Exports of the U.S. goods and services in 2010 were .83 trillion USD, import – .33 trillion and a similar pattern has been observed for a long time. However, trade deficit by itself is not a primer reason of concern of international investors.

A trade deficit (the excess of imports over exports) can be tolerated and last for an indefinite time provided that a country attracts enough investments and borrowings to compensate it; the country did not lose confidence; there is no capital outflow in form of withdrawals made by foreign investors or investors’ reluctance to lend. In this concern, the 2010 balance of payments data show the U.S. situation as stable: the country receives enough credits and foreign investments to compensate the trade deficit.

Moreover, the capital inflow to the U.S. is strong enough to keep gold reserves. For instance, as per U.S. Treasury report of February 11, 2011, U.S. reserve assets were 2.9 trillion. The U.S. model of international relations presumes high volumes of imports and consumption while creating a favorable investment climate. Such a model will exist as long as there is confidence in the country. The components of government policy in this model of “confidence” are currency stability, favorable foreign investments legislation, moderate taxation, transparency of economy, etc.

Let us consider the second aspect of confidence in the country, its domestic fiscal policy. In 2010, the U.S. budget revenues were .2 trillion, the expenses were .48 trillion, and the budget deficit was .28 trillion. Since the 1970, a budget surplus was recorded only 4 times, during 1998-2001, while during all the other years America had a chronicle short money supply.

Finally, we’ve come down to detect the main cause of anxiety of foreign investors, the U.S. enormous external debt. The website usdebtclock.org was purposely created to keep track of debt and to provide related statistics. By January 31, 2011 the U.S. Federal Government debt was .1 billion. Considering the debt structure, around 33% was held by foreign states while the rest was internal residents’ debt. The ratio Debt /GDP was 96.5%. Historically, this ratio reached its maximum in 1946, when it was 121.2% of GDP. If to look at the debt statistics, the U.S. debt had grown more for the period of ten years from 2000, than for the period of 60 years from 1940 to 2000 inclusively.

In the long run, is it any hope for the reduction of debt? The structure of the U.S. project budget for 2020 is as follows: expenses on social security, elderly health insurance programs, free medical aid to poor and interest on debt make up .56 billion which is equivalent to 81 % of the total budget revenues (.4 billion). That correlation was 61.4% in 2011. Defense and other government expenditures in 2020 will be financed by government borrowings.

According to the government forecasts for the next 10 years of 2011-2020, the total U.S. budget deficit will reach .6 trillion, meaning that the U.S. debt will reach almost trillion (14.1 + 10.6, existing debt plus planned debt). The GDP forecast for 2020 is trillion. To achieve this level of GDP the economic annual grow rate should be at least 5%. This value seems to be too high for a developed country.

Alternatively, the government budget forecast may underestimate the prospective social expenditures. On January 1st 2011 the first Baby Boomers will reach 65 years old. The ratio of retired workers versus active workers will grow steadily during the next ten to fifteen years, provided that the state demographic policy remains the same. The U.S. has undertaken colossal expenses related to special medical insurance programs for the retired. At the given rates of economic growth, tax structure and projected Social Security expenditures, the budget revenues would show negative dynamics if adjusted for social expenditures. The recommendations in this concern would be as follows: to raise taxes, although it could have a negative effect on the economical growth rate; or reduce the scale of social programs in order to cut social expenditures. In fact, the latter would be a challenge for most politicians. Need to note, that the issues discussed have not been resolved up to the present date. It seems that the projected medical insurance reform shall be seeking for related budget cuts first, instead of increasing the availability of medical services to Americans.

It is suggested, that the country’s debt can be analyzed better if to look at the Debt/GDP ratio, rather than consider debt separately. For instance, Debt/GDP ratio in Greece is 176.8%, in Portugal – 231.2%, in England – 428.8% and in Japan is over 200% for 2011 (source: CNBC). What is a proper benchmark for a secure level of debt? The ratio Debt/GDP in Germany and England is considerably higher compared to the ratio Debt/GDP of the U.S. Nevertheless, these countries continue to grow. Certainly, it is a matter of confidence. Nor Germany neither England act as global warrants or serve 85% of world currency transactions.

Comparing to Japan’s Debt/GDP ratio which is two times higher than the U.S. equivalent, it is notable that about 95% of Japan’s debt is owed to the country residents: local banks, households, pension and insurance funds, industrial enterprises. This defines a very low risk of foreign capital outflows. The U.S. situation is different, as 33% of debt is financed by foreign countries; China holds about 8.2%, Japan 6.3%, GB 1.9% and Russia about 1%.

To keep its international confidence, the U.S. as a global currency warrant should not accumulate debt. The U.S. is approaching the 100% Debt/GDP ratio. This situation has a negative psychological effect, bringing anxiety in the world. Moreover, as it has been already stated, the world community is concerned not only about the debt size, but also by its growth rate, which is being unprecedented in the U.S. history. To finance the budget deficit in the future, the U.S. will have to depend on foreign countries, primarily China. This situation may become dangerous due to the risk that China and other countries may eventually stop buying U.S. treasury bonds. This would result in sharp increase of interest rates, lack of means to finance debt and possible cascade of defaults on the U.S. treasury bonds of different issues.

Another reason of anxiety is that even if countries and institutions would continue buying U.S. treasury bonds despite an increased debt, the interest on debt may exceed the levels that the U.S. budget can afford. In the U.S. budget of 2011 the net interest payable is about 6,7% of the total budget expenditures, defense expenditures – 22.7%, social security expenditures (excluding medical programs Medicare Medicaid) – 19.6%. Based on this U.S. budget structure, we conclude that the current debt settlement expenses are not as burdensome as other expenditures. However, while about 0 billion is assigned for interest-on-debt payments in 2011, this amount will increase nearly fourfold to 2 billion in 10 years.

Thus, there is a probability that the U.S. interest rates will grow. Although inflation which influences interest rates

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