Extract from Bob Gay’s piece ‘Policy Blunders and Currencies’
Long-term Implications for the Real economy:
I envision at least three serious long-term consequences of current policy blunders for the US economy. First, at some point, public deficits will crowd out the nascent recovery in private investment – perhaps not this year but by 2019 the burden of financing public debt will begin to interfere with private financing, especially if the private sector is expected to finance public infrastructure projects. Over a longer horizon, the burden of debt will shift to the younger generation whose earnings prospects already are below those of their parents. Second, public debt, trade restrictions and income inequality all impair potential growth. Third, and most worrisome, unsustainable debt cycles always end in tears, especially when the requisite monetisation of public debt begins to creep into inflation expectations. We may be many years from that ominous outcome, but financial markets will reflect that inevitability long before it becomes a reality.
Net Foreign Liabilities and Financial Stress:
Countries with robust net foreign asset positions can make mistakes and still manage to recover their mojo. The reason these long-term consequences are a serious concern today is that the United States has increasingly become dependent on foreign capital inflows. The net foreign asset position of the US, which has deteriorated more than 20 percentage points since the onset of the global financial crisis. At 40% of GDP, US net liabilities are getting close to the tipping point for elevated risk for financial crises. Unsustainable domestic debt will exacerbate that foreign dependence.
Until recently, financial markets seem to have been disconnected from these realities of the real economy and in denial about impending policy blunders. Unfortunately, they cannot be ignored much longer. Signs of mispriced financial assets are mounting. In the world of credit, the quality of new issues is declining, which in itself is a tell-tale end-cycle phenomenon, while risk premiums continue to narrow. Credit indicators have particular significance because as some point commercial banks will cut back their lending as credit quality declines. When credit becomes less available, regardless of cost, business cycles end.
The time has come to upgrade the credit quality of investment portfolios and to focus on the currencies of creditor countries. I expect the currencies of China and some less-indebted EM countries to appreciate along with the yen and euro. The US dollar could be the loser. It may be premature to predict the demise of the US dollar’s pre-eminence in global financial transactions, but one does sense that we now are coasting down the backside of the currency’s pre-eminence as a store of value and safe haven in times of stress.