Nevertheless, I’ve been waiting to see whether and when another shoe might drop. Specifically, I’ve worried about the creditworthiness of national governments, including our own. After investors shorted AIG stock and the US government bailed AIG out, investors began shorting the US dollar – signaling that they expected a run on the dollar. This is something I’ve long worried might result from large US deficits. A run on the dollar would be catastrophic for both the US and world economies.
Instead, the dollar rose against other currencies, at least in the short run. Investors worried about the state of the world moved their money to where they believed it safest – US Treasuries. Since then, as investors have regained confidence, the dollar has declined steadily against other major currencies, but not at a rate likely to trigger a run.
We now may be seeing the beginnings of a real sovereign debt crisis. The Greek government has been unable to bring its finances under control; its creditworthiness is in serious question. Spain, Portugal, and Ireland also have immediate debt problems. Portugal is having trouble refinancing its short-term debt. Even the biggest players are not immune. Two months ago, Moody’s declared UK and US debt “resilient,” reserving its highest rating, “resistant,” for French and German government debt. The Bank of England is no longer trying to stimulate the British economy with further UK government debt purchases. President Obama has proposed a selective discretionary spending freeze.
What does all this mean?
If the European economies were not linked through a common currency, the problems of a few less-well-off European governments would probably not be of major concern. After all, we weathered similar problems in Iceland and Hungary without incident in 2008.
But the problems of some Euro Community nations now inevitably affect others. Greece’s problems have triggered a slide in the Euro against the dollar, a renewed flight to the dollar, and a decline in the yield on US Treasuries. Normally, this would trigger a rise in stock values, but the equity markets don’t like what’s going at all, so they’re falling as well.
While fans of the US dollar might be tempted to celebrate any fall in the Euro (the Euro passed the US dollar as the world’s largest currency in October 2009), distrust of sovereign debt is unlikely to bode well for anyone. This growing distrust cannot help but be reinforced by the US Administration’s recent proposed budget, which projects trillion-dollar deficits into the indefinite future. Economist Alan Auerbach projects that within about ten years, US national debt will reach levels that historically have tended to trigger major economic and political shifts. His projections do not necessarily mean we have ten years to solve the problem; rational expectations theory tells us that if we really believe a crisis will hit then, we'll likely precipitate it earlier.
(Grover Norquist is presumably celebrating. He’s the anti-government activist who famously said that he wanted to reduce the US government “to the size where I can drag it into the bathroom and drown it in the bathtub.” He may soon get his way.)What is the nervous investor to do? Buy German bonds? Maybe. But if Germany remains financially cautious it won’t issue enough bonds to meet world demand. And if the world economy falls into a tailspin, even the finances of the German government are likely to be adversely affected.
The real danger is that investors will go into a “hide it in the mattress” mode. I don’t mean literally. One possible scenario, if investors stop viewing government debt as safe, is world-wide hyperinflation. If the US cannot refinance its short-term debt (an ominously large percentage of its debt is now short-term), it will be forced either to stop operating or to finance its operations by printing money. The former is unlikely to be politically or economically acceptable. The latter may trigger inflation at levels that we’ve never seen –- ever -- in this country.
So the “mattress” has to be real assets – not currency. What assets? Perhaps land (not mortgage-financed) and companies that produce essential goods (food, clothing, shelter) and are not heavily leveraged. Gold was once the safe haven of choice, but Russia has the capacity to produce as much as it needs to finance its spending; if it does so, gold will decline in value as well.
Unfortunately, if investors go into a "hide it in the mattress" mode, the rest of the world economy will be starved for credit, and we’ll be back to yet another -- but much worse -- credit crisis. Only this time, governments will not be able to borrow to bail us out.
Please do not panic. I am not predicting any of the foregoing. I am merely worrying. But I’m now sufficiently worried that I feel it appropriate to worry out loud.