Monday, September 28, 2009

Sprott September Comment: Safe Harbour No More

The US dollar (USD) is the world’s “reserve currency”. This status is arguably the greatest privilege enjoyed by the US as an economic entity. Most people don’t appreciate its significance. As the world’s reserve currency, the USD is used by other countries across the globe to back up their own respective paper currencies. In some cases, it’s as basic as a country stockpiling US dollars in their central bank vaults. When asked what supports their Pesos, Rubles, or Yen, the powers that be simply point to their pile of US dollars as proof of value. Upon reflection, it’s quite obvious how tenuous it is to back up one’s currency with a pile of paper issued by another country, but this is exactly how the world of international currency has worked for decades. And it has worked quite well…until now.

Despite falling 36% since 2001 (as measured by the US Dollar Index (DXY)), it is only recently that the US dollar’s ‘world reserve currency’ status has been seriously questioned. The media pundits haven’t spent much time discussing this of course, but during the week of September 8th to 11th, the DXY actually fell to new 2009 lows every single day that week. Over the last six months there has also been a substantial increase in anti-US dollar rhetoric from China, Japan, Russia, France, Brazil, and even the United Nations. Reading between the lines, it appears the US dollar hegemony has finally broken, and what happens next will have major consequences for the global economy.

Because there is little hope of paying for their unfunded liabilities through current tax revenues, the Social Security and Medicare promises will undoubtedly require new bond issues. You probably don’t need a calculator to realize that the US can never cover the debt costs on $118 trillion. Even if the US Government were to spend 100% of their tax revenues on debt payments, the absolute maximum they could rationally borrow today couldn’t exceed $64.2 trillion ($2.157 trillion ÷ 3.36%). What is glaringly obvious is that the United States’ penchant for increasing its ‘promises to spend’ is directly threatening the future viability of the USD. While US politicians brazenly approve future spending promises they forget the real costs those promises imply – and there is no feasible way we can see those promises being paid for under foreseeable economic conditions.

So how will this US debt crisis ultimately resolve itself? Let’s consider the options. It would appear from our analysis that the spending ‘promises’ are the crux of the problem now facing the US Government. If there isn’t enough new capital in the current environment to fund new Treasury bill issues (as we argued in “The Solution... is the Problem”), then there certainly isn’t enough capital to pay for the US’s unfunded future obligations. The choices, therefore, are bleak:

1. Default on Medicare promises. (Unlikely given the current debate in Washington to expand medical coverage.)

2. Default on Social Security promises. (Unlikely given the increasing average age of the voting public.)

3. Put forward a credible plan to balance the budget. (Unlikely given the most recent budget projections.)

4. Default on outstanding debt. (Unthinkable)

None of these options are feasible for the US Government. So they realistically only have one option left – to print their way out of their debt crisis.