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The Growth and Sustainability of Sovereign Debt

In October 1959, Yale professor Robert Triffin informed the U.S. Congress' Joint Economic Committee that the Bretton Woods system was doomed. The current monetary system could not survive, he explained, because of the inherent imbalances it incentivized. The fatal flaw - which would became known as the “Triffin Dilemma” - was that as the reserve currency of the world, there was consistent strong demand for U.S. dollars to facilitate global trade. Therefore, the dollar would be overvalued relative to other currencies. This overvaluing, he explained, would cause persistent trade deficits. Moreover, the ability of the United States to purchase imports in its own currency meant that the nation could not face a balance of payments crisis and was able to partially export it’s inflation to the rest of the globe. This feature of the Bretton Woods system was famously characterized as an “exorbitant privilege” by French finance minister Valéry Giscard d’Estaing.

If this persisted, Triffin argued, eventually the supply of dollars would increase and the account balance of the country would deteriorate enough that the world would lose confidence in the dollar. Under the Bretton Woods system the dollar was pegged to gold at $35 an ounce. Triffin argued that the country would be unable to hold the peg if confidence was lost and nations insisted on converting their dollars to gold. He argued that "A fundamental reform of the international monetary system has long been overdue. Its necessity and urgency are further highlighted today by the imminent threat to the once mighty U.S. dollar."

Largely ignored at that time, his warning became famous only when in 1971, as he had predicted, the Bretton Woods system collapsed. The United States had printed a substantial amount of dollars since the end of World War II. The Marshall Plan, the Korean War, the Vietnam War, and Lyndon B. Johnson’s Great Society anti-poverty programs had been subsidized in part by taking advantage of the U.S. dollar’s status as the global reserve currency.

By 1971 the ratio of dollars in foreign hands to gold in Fort Knox had declined precipitously. On August 15th, 1971, President Richard Nixon addressed the nation in a prime time televised speech where he announced that the dollar would no longer be convertible to gold and that a ten percent import surcharge - a tariff on all foreign goods - would be imposed in order to address the trade deficit.

The collapse of the Bretton Woods monetary system lead to turmoil in the U.S. economy. By 1974 inflation, set off by the Nixon Shocks, was soaring - while the stock market was crashing. The US economy was in a downward spiral and the dollar’s future was uncertain. To end the crisis, Nixon sent William Simon, the newly appointed U.S. Treasury secretary, to Saudi Arabia. He would make a deal with the Saudis that would help stabilize the US economy and help maintain the dollar’s status and the global reserve currency. Forty years after the secret agreement Bloomberg reported on the details of the arrangement:

“The basic framework was strikingly simple. The U.S. would buy oil from Saudi Arabia and provide the kingdom military aid and equipment. In return, the Saudis would plow billions of their petrodollar revenue back into Treasuries and finance America’s spending.”

By 1977, Saudi Arabia had accumulated about 20 percent of all Treasuries held abroad. Under this petrodollar arrangement the dollar keep its place as the reserve currency of the world. But in the post-Bretton Woods era all currencies which had been pegged to the dollar were now free-floating, Nations were free to increase the amount of their currencies without regard to any pegs. The dollar itself was also free-floating - severed from the peg to gold which it had been (loosely) holding. The effect was immediate and sustained inflation by all nations.

The United States also began increasing the supply of dollars - but as the reserve currency, and without the mechanism of the gold standard to balance imports and exports, the dollar only became increasingly overvalued relative to other currencies. Leading to a larger and larger trade deficit.

In addition to trade imbalances, one major impact of the free-floating monetary system was to incentivize increasing sovereign debt. Before free-floating currencies, higher interest would have prevented nations from increasing their debt so substantially. In this new system, the risk of default is perceived to be vastly less. Nations do not face a hard limit to debt issued in their own currency. Worldwide, debt has increased dramatically since this new system began in 1971. And this increase in government debt has not been merely an American phenomenon. Globally debt has risen dramatically in the last fifty years.

The reasons for this accumulation of debt are varied. But debt is projected to surge across the developed world for one common reason. The demographic shift from young to old means that spending on aging populations will rise as growth is projected to slow.

Fiscal Crisis

While debt has risen around the globe, nations in the developed world have not suffered economic hardship as a consequence of the debt. To the contrary, increasing the debt has allowed social benefits to increase without raising taxes.

The issue with the debt is that the trend is unsustainable. The problem with debt is that, as CBO states about the American debt, it “increase[s] the likelihood of a fiscal crisis, an occurrence in which investors become unwilling to finance a government’s borrowing unless they are compensated with very high interest rates."

Centrals banks have powerful tool to keep interest rates low, and the have used them extensively, to do just that. And this has prevented a fiscal crisis. However, the demographic headwinds will now be against them.

The rapid aging of the world will both massively increase government's expenses, and potentially raise the real interest rates. Already nations such as Japan are running out of eligible bonds to purchase in continue their quantitative easing programs to keep interest rates low.

Even with low interest rates, In roughly a decade the United States is projected to be spending more on interest on the debt than on the entire military budget. The Government Accountability Office (GAO) says that “the nation’s unsustainable fiscal path is not just something that we are predicting for the future - it is happening now.” In much of the developed world the population collapse is more extreme and the debt burden already higher. Japan spends twenty-five percent of it’s tax revenue paying interest on its debt. Ireland spends twenty percent. Italy, Portugal, and France are not far behind paying over fifteen percent

In 2017, Zhou Xiaochuan, governor of the People’s Bank of China (PBoC) at the time warned of a possible “Minsky Moment” saying:

"If we are too optimistic when things go smoothly, tensions build up, which could lead to a sharp correction, what we call a ‘Minsky moment’. That’s what we should particularly defend against."

The financial times reporting on these remarks said that:

"This might sound unexceptional. But it is about as close as someone in Mr Zhou’s position can come to yelling “fire” in a crowded theatre. To quote Robert Hockett, an expert on China at Cornell Law School: “It’s calculated to inspire panic. It’s almost an incantation to panic — especially in China.”

A Minsky Moment is at abrupt collapse in values of assets which have been propped up with debt. No one can say when a Minsky Moment could occur - but it is inevitable if debt continues to increase.Yet, there is no political will to raise taxes or to cut entitlements anywhere in the developed world. Even now, in the midst of record long recovery and before the retirement of the Baby Boomers, we have record deficits.

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