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26 March 2005

What are they trying to accomplish?

Two prominent economists, Nouriel Roubini (NYU) and Brad Setser (Oxford) have recently made considerable waves in macroeconomic circles with their paper "Will the Bretton Woods 2 Regime Unravel Soon? The Risk of a Hard Landing in 2005-2006"
[First draft online at:
http://www.stern.nyu.edu/globalmacro/BW2-Unraveling-Roubini-Setser.pdf ]

This is by far the most comprehensive analysis of the global financial system currently in operation that I've seen, known as "Bretton Woods 2". This system is based upon the United States being allowed to operate massive trade deficits (as well as fiscal deficits) which are then covered by the purchasing of U.S. debt by foreigners, especially the East Asian central banks (esp. the Bank of Japan & the People's Bank of China). Essentially these foreign central banks purchase U.S. debt in order to prevent their local currencies from appreciating against the dollar (i.e. they artificially inflate the dollar to keep it higher than their own currency) in order to fuel their export based economies. That is, as long as the dollar remains higher than the yen or the yuan, Japan and China can export to the United States at an advantage, thereby fueling their own growth.

All said, such a system would only be sustainable if the United States adopted a responsible trade and fiscal spending policy. However, the neo-cons have determined - with some truth - that essentially the world community, and especially the East Asians, are forced into buying U.S. debt in order to maintain their economic solvency, that is, in order to keep their existing dollar assets (which serves as their foreign currency reserve) from losing value, they have to perpetually buy more dollar assets. Therefore the Bush administration has considered this something of carte blanche to throw fiscal responsibility to the wind, after all, no matter how grossly irresponsible they opt to behave, the world community will be forced to pick up the bill in order to keep their own economies strong.

However this is not sustainable for a number of reasons, but the most important of these is that the government's policy of grossly irresponsible spending (severely complicated by the continued occupation of Iraq and Bush's tax cuts for the wealthy) means that the dollar will continue to lose value, making the purchasing of U.S. dollar-denominated debt a losing investment. Quite simply, with interest rates at their current level, no major U.S. investment will provide a real return against the devaluation of the dollar. And, of course, should they remedy this by increasing interest rates, then the U.S. debt bubble runs the risk of bursting leading to a major "adjustment" or revaluation of the dollar.

Anyway, this system would only be sustainable if the leading economic powers decided to evenly distribute the U.S. debt load, but this is not likely to happen because - as noted above - due to our domestic spending policies the dollar is bound to continue losing value, meaning the dollar is simply not a good investment (i.e. why would anyone invest in an asset that is certain to lose value?). The alternative is, of course, what economists refer to as an "adjustment" - "The basic outlines of a hard landing are easy to envision: a sharp fall in the value of the US dollar, a rapid increase in US long-term interest rates and a sharp fall in the price of a range of risk assets including equities and housing. The asset price adjustment would lead to a severe slowdown in the US, and the fall in US imports associated with the US slowdown and the dollar's fall would lead to a global severe economic slowdown, if not an outright recession."

In their paper, Roubini and Setser cite a number of "potential triggers" that could result in the collapse of the current (Bretton Woods 2) system, i.e. foreign investors either stop buying U.S. debt or begin dumping existing U.S. debt holdings, sparking a sell off. What I found really odd is that the it seems to me that the current administration is specifically trying to trigger this. They're rich and their holdings are offshore so they won't be hurt, but anyone trapped in a purely dollar-based economy will be screwed, further such a crisis would justify a Republican shut-down of almost ALL government social services (Social Security, Medicaid, Medicare, welfare, &c.) while the "war on terrorism" would justify redirecting all existing financial resources into military/security projects. Perhaps this is what they are trying to do.

Anyway, among the "potential triggers" identified by Roubini and Setser are:

> "Congress makes the Bush Administration's tax cuts permanent but balks at deep cuts in FY 2006 discretionary spending * or the bond market starts to recognize that it is impossible to substantially reduce the deficit simply by limiting growth in non-defense discretionary spending."

The tax cuts are completely incompatible with the current perceived interests of the country, to quote: "Bush's tax cuts have reduced the federal government's revenues from 20% of GDP in 01 to a bit above 16% of GDP, even as spending rose from 18.5% of GDP to almost 20% of GDP (CBO data). The 2004 budget deficit would have been even larger if the average interest rate on marketable debt had not fallen from 6% to 3.5%, reducing the federal government's (net) debt servicing costs from 2.1% to 1.4% of GDP even as debt held by the public rose from 35% to 41% of GDP." And yet, Bush & gang are fighting hard specifically for these cuts to be made permanent despite the inevitable reaction that this will cause on the bond market - they want it to happen.

> "The Bush Administration proposes and Congress passes a costly scheme for partial privatization of Social Security. Doubters are won over by smaller benefit cuts and larger private accounts, leading the markets to anticipate sharply higher consolidated budget deficits after 2009 and a surge in the supply of Treasuries."

This one is self-evident, and yet Bush & gang are pressing hard to make it happen despite the inevitable reaction among those currently financing the U.S. - they want it to happen.

> "The monthly trade data continues to belie hopes most recently expressed by Federal Reserve Chairman Greenspan -- that the lagged impact of the dollar's fall in 2002 and 2003 has been sufficient to at least moderate the expansion of the US trade deficits. Oil stays relatively high, and non-oil import volumes continue to grow rapidly, pushing the monthly trade deficit toward $65 billion ($780 billion annualized) and the current account deficit toward $850 billion."

The administration simply needs to do nothing, i.e. take no counter-measures, to ensure that this is will continue as it has been.

Of course there are many other potential triggers - some included in the paper cited above and others not mentioned there - such as a move by Venezuela or Iran to sell oil in currencies other than dollars (or "in-kind" barter, which Venezuela has already started doing). Either option would allow countries to acquire oil without using dollars, thereby lower the demand for dollars elsewhere. So, of course the current U.S. campaign of provocation against Iran (and Venezuela) is utterly and completely detrimental to our financial interests.

So, the very simple question is, what are they doing? Are they TRYING to "adjust" the economy to the detriment of all Americans that do not have extensive non-US dollar assets?

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