Clem Sunter

Is America too big to fail?

2010-10-20 13:40

One of the most important roles of a scenario planner – especially a foxy one – is to play scenarios that are real outliers. In other words, if you consider any range of futures to have a probability distribution which is the shape of the normal Bell curve, a scenario planner should occasionally look at futures perched on the extremities of the curve, ie around several standard deviations from the mean.

The challenge for me to do this came from a very illustrious financial journalist called Martin Wolf. In a recent article in the printed media, he made the following comment: "Some fear that a cessation of Chinese purchases of US government bonds would lead to a collapse. Nothing is less likely, given the massive financial surpluses of the private sectors of the world and the continuing role of the dollar. "

I wanted to quantify "nothing being less likely" so I rang a derivatives trader and asked him what odds he put on an American collapse. He replied: "One in a thousand years." Interesting answer, because that is a minute probability of 0.1%. The collapse of Lehman Brothers was in retrospect rated as a "one in a century" event (or 10 times more likely than the collapse of America). Nevertheless it did happen. Moreover, the last time the world's leading economy went insolvent was during the decline of the Roman Empire at least one and a half millennia ago.

China and Britain have since also lost the No.1 position but, as I recall, they went down without defaulting on a massive quantity of debt owed to the rest of the world. America, on the other hand, seriously owes money offshore. They remind me of a cousin of mine who was once asked by a bank manager” "Are you banking with us or are we banking with you?"

So is it time for another Rome? Is America about to fail and are the odds much shorter than the experts think? One statistic says it all. Total American debt (government, business, consumer) as a ratio of GDP has surpassed the peak of the Great Depression and is now at an all-time high of 4:1. The question is whether this constitutes the same level of vulnerability that the balance sheet of Lehman Brothers possessed at the time of its downfall. Its gearing ratio of loans to equity was 37:1, the highest in the industry.

I think it depends on three factors all of which have to be positive for the US to emerge successfully from the debt trap in which it currently finds itself:

1. While American business and American consumers are busy saving and deleveraging their balance sheets, this does not apply to the US government. The latter has done nothing to curb the budget deficit and is indeed aggravating the problem by quantitative easing (which is a euphemism for printing money you have not earned).  After the mid-term elections, the US President and Congress must begin resolving this problem – like Britain and Ireland. So far I have not heard a single comment from the Democrats or the Republicans that suggests America must take pain to correct the situation. Ironically, there are several Nobel prize-winning economists who advocate further stimulus measures to avoid a double-dip recession. This advice will only add to the debt burden.

2. Towards the end of the Second World War, the US was in a dangerously over borrowed position. But in the late 1940s and 1950s, the US GDP compounded annually at such a high rate in real terms that the ratio of debt to GDP automatically fell to a reasonable level. Can the US repeat this experience given the increased competition from the East? The alternative is to devalue the dollar and allow inflation to take the problem out of play. The difficulty with this approach is that with higher inflation go higher interest rates which is exactly what caused the crash of 2008. The bond bubble would burst spectacularly.

3. The world has to continue to trust America. If America loses that trust, it will no longer have access to the savings of other countries which are crucial to bridging the gap of the government deficit while measures are being implemented to achieve a better balance. You might say that it is in China’s interest to keep America viable. True, but there comes a time when you cut your losses and run. The dollar would then no longer be viewed as a reserve currency.

There you have it. The blackest of "black swan" scenarios is that America fails. I do not believe it is beyond the bounds of possibility as Martin Wolf suggests. Size leads to vanity and vanity leads to insanity. The Titanic sank for this reason and so can America.

By the way, the name of the scenario is "Forked Lightning". The flag to indicate an imminent strike is a jump in US government bond yields to over 5%. Right now, I give it a one in 10 chance; or, in my terminology, I still treat it as a wild card scenario. But it is definitely on my radar screen and defensive strategies such as purchasing put options on bonds should be considered.

Remember, speed of response is what separates the fox from the wolf!

Send your comments to Clem

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