“We might hope to see the finances of the Union as clear and intelligible as a merchant’s books, so that every member of Congress, and every person of any mind in the Union should be able to comprehend them, to investigate abuses, and consequently to control them.” Thomas Jefferson, 1802
This quote has gotten a lot of play over the past couple years, its even on the treasury’s website, but can it really be taken seriously? Abuse is the norm, and getting control of spending seems to be a distant memory.
Yesterday, US Treasury Secretary Janet Yellen called for "extraordinary measures" to continue paying the government's bills as the US has once again reached its debt limit. Since 1960, Congress has acted 78 separate times to permanently raise, temporarily extend, or revise the definition of the debt limit, raising important questions about the country's financial management.
If they’re this irresponsible who would continue to loan them money at this point?
To start lets cover some basics, the national debt refers to the total amount of money that the federal government has borrowed to cover expenses over time. When the government's spending exceeds its revenue in a given fiscal year, a budget deficit occurs. To fund this deficit, the government borrows money by issuing marketable securities, such as Treasury bonds, bills, notes, floating rate notes, and Treasury inflation-protected securities (TIPS). The national debt is the accumulation of this borrowing, along with the interest owed to investors who purchased these securities.
The primary market for US Treasury securities is the auction market, where the government issues new debt securities through a competitive bidding process. The Treasury Department conducts regular auctions for various types of Treasury securities, such as Treasury bills, notes, and bonds. These auctions are typically held on a regular schedule, and investors, including individuals, financial institutions, and foreign governments, can participate by submitting competitive bids for the securities. Once the auction is completed, the securities are sold to the highest bidders at the auction's winning yield. The securities are then traded in the secondary market where investors buy and sell the securities among themselves.
The largest buyers of US Treasury securities are typically the Federal Reserve, foreign central banks and governments, and domestic financial institutions such as commercial banks, mutual funds, and pension funds.
The various buyers of treasuries do so for a wide variety of reasons, for many, US treasuries are considered one of the safest investments because they’re, “backed by the full faith and credit of the US government”. They are also highly liquid meaning there are almost always buyers and sellers for them so if you need to enter or exit a position you can do so quickly. They also offer a small yield that is commonly referred to as the, “risk-free rate of return”. The market considers this to be risk free because they think there is virtually no chance of the U.S. government defaulting on its obligations.
Now that we have the basics on US debt covered, what is the likely outcome if they continue to borrow with no end in sight?
The US is in a unique position because it has the world reserve currency. Meaning it is widely used internationally as a medium of exchange, a store of value, and a unit of account. The US dollar is by far the most desired and utilized currency in the world as seen in the chart below from the US federal Reserve.
Because of this the near-term challenges to the U.S. dollar's dominance as a world reserve currency appear limited, but nothing is invincible, and nothing lasts forever. A quick look at the history of world reserve currencies shows an interesting pattern. Roughly every 100 years the world reserve currency changes, understanding this pattern can help to predict where the US dollar may be headed.
Portugal - The Portuguese Real was a silver coin of uniform weight. It could not be printed so was seen as scarce and able to preserve purchasing power of those who used it. Portugal was conquered by Spain in 1530 leading to the creation of the Iberian Union and the death of the Real.
Spain - Spain adopted the same standard Portugal was on and continued with a pure silver coin. However in order to finance the Thirty Years’ War Spain began to debase the currency by adding in other metals to allow them to mint more coins. The value of their currency tanked and they were defeated by the Dutch.
Netherlands - The rise of the Dutch East India Company led to the Guilder gaining dominance until the Anglo-Dutch wars between the Netherlands and Britain. Unable to produce more silver to finance the wars, the Guilder was debased until it lost its position to the French Franc.
France - The Franc started out as a silver coin which was replaced by paper bonds to finance France’s involvement in the American Revolution and the extravagant spending of the monarchs. Naturally they issued more paper than they had silver to pay back leading to the French revolution and the rise of Napoleon. Following his rise a new bank was created and a gold coin with a uniform weight was issued.
Britain - Britain’s victory at the Battle of Waterloo ended France’s world dominance leading to the Pound Sterling becoming the global reserve currency. Its base unit was a pound of silver, this was replaced with gold but was still based on a weight. Bank notes issued by British banks were redeemable in gold leading to what we now call, “The Gold Standard”. In order to finance their military in WWI the UK issued bonds that it hoped its citizens would buy. Only 1/3 of them were purchased so The Bank of England deceived the public by making advances to bank staff so they could purchase the rest of the debt to fund the war efforts. Once this Pandora’s box was opened it didn’t stop, Britain officially left the gold standard in 1931 and was effectively bankrupt as a nation by the end of WWII
US 1933 to present - When Franklin Delanor Roosevelt became President on March 4, 1933, one of his primary goals was to stimulate the economy by raising the price of gold by devaluing the dollar. To achieve this, President Franklin D. Roosevelt issued Executive Order 6102, which required all American citizens to turn in their gold coins and bullion to the Federal Reserve in exchange for $20.67 per ounce in paper dollars. By February 1, 1934, the price of gold had risen to $35 per ounce. In just four months, the dollar had been devalued by an astonishing 70%. Despite the prohibition on American citizens owning gold since 1933, the dollar's value was still fixed, and foreign central banks could still exchange dollars for gold at the US Treasury.
In 1944 the United States entered into the Bretton Woods agreement with twenty nine other nations. Under the Bretton Woods system, countries used dollars to settle international balances and US dollars were convertible to gold at a fixed exchange rate of $35 per ounce. The United States was responsible for maintaining the fixed price of gold and adjusting the supply of dollars to preserve confidence in future gold convertibility. However, persistent US balance-of-payments deficits led to an accumulation of dollars held by foreign countries, which exceeded the US gold stock, indicating that the United States could no longer uphold its commitment to redeem dollars for gold at the official price. As a result, in 1971, President Richard Nixon ended the dollar's convertibility to gold.
Doing this meant that from 1971 on the US dollar no longer has convertibility to gold for any entity. Meaning it has no backing, in other words it costs nothing to produce more dollars. While this hasn’t lead to the collapse of the dollar yet, history shows that a currency’s reserve status is on borrowed time when the cost to borrow (interest) moves to zero.
At what point do people decide they no longer wish to hold their value in something that costs nothing to produce? Better yet, given the history we just reviewed, is there a typical point of no return for a currency?
In a letter to partners, Hirschman Capital found that in the past two centuries, 51 out of 52 countries that reached a sovereign debt level of 130% of GDP ultimately defaulted, either through devaluation, inflation, restructuring, or nominal default, within a range of 0-15 years after reaching that level. By the end of 2022 the US was at 120% Debt to GDP.
While the dollar is not currently facing an immediate threat, there are indications of weakness. Historically, when a reserve currency loses its status, it starts with debasement and is followed by other nations gradually reducing their use of the currency in favor of ones that maintain their purchasing power. This results in the former reserve currency being used in a small fraction of global trade compared to its previous dominance, or it collapses entirely. Examining the currencies used for trade and savings by nations can provide insight into the fait of the dollar in the coming decades.
Post 2008 financial crisis Foreign and international investors purchases of US debt rolled over. That leaves private investors and the Fed to make up the difference. It is highly likely given recent history that the difference will come mostly from the Fed because the interest rates offered on bonds are lower than the rate of inflation. This means investors are likely to seek alternatives to protect their purchasing power. Contrary to popular belief the Fed cannot simply print money to pay off the US government's debt because it would lead to hyperinflation. Instead, the Fed funds its bond purchases by borrowing. The Fed purchases securities from a bank (or securities dealer) and pays for the securities by adding a credit to the bank's reserve (or to the dealer's account) for the amount purchased. The bank has to keep a percentage of these new funds in reserve, but can lend the excess money to another bank in the federal funds market. This increases the amount of money in the banking system and lowers the federal funds rate. This ultimately increases business and consumer spending because banks have more money to lend and interest rates are lowered.
However, if Treasury yields spike due to a debt crisis, the Fed may be trapped as they cannot raise interest rates on deposits without exacerbating the crisis, but if they don't, hyperinflation may occur. This is why the Fed had to raise rates in 2022, if they didn’t their reputation would likely have suffered irreparable damage. The challenge they face now is that by raising interest rates they make the already large US government debt obligations even larger which leads to the US hitting its debt ceilings even faster. They are literally between a deflationary debt unwind rock and a hyperinflationary hard place.
This was extremely well done. What will happen when people no longer believe in the US dollar?
This is very well done, I like the chart referencing past currencies!