When I was a child, my father frequently told me I needed to have “an ace in the hole.” Whenever I wanted to drop something or focus my intentions elsewhere, he would dust off the “ace in the hole lecture.” Trust me, it wasn’t a fun one to hear and, brother, did I hear it. In fact, I believe I was married with a child on the way the last time he subjected me to it.
Of course, my father wasn’t exhorting me to cheat at poker. He was talking about having a competitive, or comparative, advantage. That special or unique skill which separates you from others. Essentially, that talent which makes you less replicable in a sea of replicability.
Do you know what your ace is?
While you could argue the U.S. economy has a number of comparative advantages, (i.e. aces), our currency is perhaps the biggest one. Since the dollar is the world’s primary reserve, and therefore the grease which lubricates the global financial system, the demand for it is massive.
According to Reuters, U.S. dollars are involved in over 85% of all foreign exchange (forex) trades. Get this, the (forex) market has a daily turnover in excess of $7.5 trillion.
Doing some quick and basic math, this means some $6.375 trillion (USD) changes hands each trading day. That’s mind-boggling, isn’t it?
For this reason – the global economy’s appetite for our currency – Americans enjoy lower interest rates than they would otherwise. Seriously. How else can a country run a current account deficit of $943.8 billion, as we did in 2022, and its Treasury still borrow at 3.75% for 30-years (as we can on 5/11/2023)?
In truth, there is much for foreign investors to like about the dollar.
- First, there are the guns, tanks and missiles.
- Second is our traditional adherence to the rule of law and strong individual property rights.
- Third is the relative transparency and liquidity of our financial markets.
- Fourth is that the U.S. Treasury can easily cover its debt service with the record $4.9 trillion it collected last year.
That is if we want to service it.
Make no bones about it, Washington doesn’t have a revenue problem. Using the International Monetary Fund‘s (IMF) measure, the money it collected last year would be greater than the entire GDP of either Japan or Germany.
Essentially, the US Treasury is the world’s 3rd largest economy.
So, why are we having all of this discussion about the debt ceiling? Why do we suffer through this political theater so frequently? Why can’t we come close to balancing the books with $4.9 trillion in collections? As John McEnroe famously screamed at the chair umpire at Wimbledon in 1981, “you cannot be serious!”
Obviously, Washington has a spending problem. If not that, it is highly inefficient with the money it has. Perhaps it could be a combination of the two. You think?
Unless you really haven’t been following the news, you know Capitol Hill and the White House are at loggerheads about the current debt ceiling. By many accounts, the Treasury will run out of money to pay its bills by June if our politicians don’t come to an agreement to raise the ceiling. As I type, intransigence is the word of the day in the District.
No one wants to give on the subject. The Republicans will raise the debt ceiling if the Democrats agree to some spending cuts. Frankly, and in my opinion only, both sides have boxed themselves into the corner.
Does Washington need to be a better steward of our money? There can be little argument. Would the necessary cuts to balance the budget be politically unpopular? That is even less of an argument.
This is important for several reasons:
- What happens when the United States doesn’t pay its bills?
- What happens when it runs out of money? To date, no one knows.
- What’s more, what happens to the U.S. dollar if this were to happen?
In a so-called Town Hall meeting on CNN this past Wednesday night, May 10th, Donald Trump said the following:
If you don’t mind, let’s cue the McEnroe clip again: “you cannot be serious!”
Trust me, a default would lead to more than a bad day or a bad week. Given the current fragile state of many bank balance sheets, the U.S. Treasury defaulting on its debt would likely cause a significant financial crisis. The reason being is I can’t imagine interest rates doing anything other than go up in such a scenario.
Obviously, this would further erode asset prices at a time when banks can least afford it.
Then, what happens in the overnight markets which use U.S. Treasuries as collateral? I would imagine overnight rates would skyrocket. Further, what about the 2a-7 money market mutual funds out there? I suspect they would all “break the buck” as the value of their T-Bills evaporates.
But the bigger question is: what happens to our biggest comparative advantage? The strength of the U.S. dollar? The constant global appetite for our currency which enables us to live beyond our means?
Unless the Chinese, Japanese and other large holders of dollar-denominated assets are curious investors, I imagine there would be a substantial run to the exits.
Consider this. The current 2-Year Treasury Note has a 3.875% coupon and matures on 04/30/2025. As I type here at 10:30 am CDT on 5/11/2023, it is essentially trading at par, 3.875%. So, what happens if a default causes a haircut to 90 cents on the dollar? Is that reasonable? If so, the yield would spike to over 9.50%, assuming a settlement date of 5/12/2023. Shoot, even 95 cents on the dollar would take the yield to over 6.60%.
For grins, 90 cents on the dollar for the current 3-month Bill (8/10/2023) would take the yield to – get this – roughly 45%. 95 cents is still a massive 21+%.
Please tell me how that doesn’t cause, let’s say, a bit of a problem in the U.S. financial system? The global financial system and, therefore, the global economy? Poof! Quite literally trillions in capital vanishing in the blink of an eye due to political folderol in Washington.
Who would want our debt after that? After all, if we aren’t willing to pay it back, then we don’t take individual property rights very seriously. If so, we can expect a higher interest rate environment for an extended period of time.
Why?
Countries are no different than individuals in this regard. Those that have bad credit scores (and you don’t get much worse than a D) have to pay more to borrow money.
It really is that simple. We can pretend it isn’t, but we do so to our detriment. Laughingly, I say that from personal experience. After all, I burned more “aces in the hole” than I care to admit. How else can you explain the number of lectures my father gave me? You know, perhaps I should send the old man up to Washington to give them what he gave me all of those years….a good lecture.
What do you think?
John Norris
Chief Economist & Receiver of Lectures
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