WILD CARD WARNING: Is America too big to fail?

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A wild card is a low probability event, which, if it occurs, has dramatic consequences. I believe we now face such a wild card. The idea occurred to me just last week, as I was riding a plane from A to B. Sometimes ideas coalesce for no apparent reason, and as I was reading about the pretty useless cap-and-trade emission system that the U.S. government seems about to pass, a number of different pieces came together to create a sudden insight: that the U.S. government is going to fail, possibly even go bankrupt. This is heresy for someone who studied the financial markets all his adult life: U.S. T-bills have been the world’s primary “risk-free investment.” For this not to be the case implies a financial earthquake of massive proportions.

This is a wild card, instead of a dead certainty, for the same reason that a flu pandemic is a wild card: that there will be a pandemic is an absolute certainty, but nobody knows whether it will start this afternoon, three years from now, or three decades from now. Likewise, the U.S. federal government, unless it makes a Herculean effort to change direction, will fail. What isn’t known is whether it will be this month, or five years hence. It cannot be a long way off, but the precise timing of this biggest-of-all-bankruptcies will come to pass if present trends are unchanged. I really don’t want this to happen, but am very much afraid it will, which is the reason for this warning.

During the financial crisis of 2008, the U.S. government deemed that some banks were “too big to fail,” meaning that if they went bankrupt, they would bring the entire financial system down with them. Therefore, the government concluded, there was no alternative but to pour hundreds of billions of taxpayers’ dollars to rescuing these banks and their incredibly selfish executives, no matter how ideologically or ethically repugnant it might be to do so. And, in my opinion, they were correct, both in their presumption that some banks are too big to fail, and that they had no alternative but to rescue them.

Now, eight months later, we must ask an even tougher question: Is America too big to fail? And who is capable of saving it if necessary?

First, let me explain the reasons why it might fail. Because of the brain-dead management of the U.S. federal government under George W. Bush, the American government went from the biggest surplus in history to the biggest deficit in history, and at precisely the worst time. (Frankly, how Bush could ever consider himself a conservative is beyond me, but that’s another discussion.) The reasons why it was the absolute worst time fall into two categories: those we knew about, and those we didn’t know about ahead of time. Those we knew about were the impending insolvency of Medicare around 2019 – 10 years from now – and the somewhat more distant insolvency of the U.S. Social Security System in 2041. And meanwhile, these two programs cost the federal government more than $1 trillion last year, or about one-third of the entire budget.

America has, for decades, been piling up debts to be paid by later generations, ably aided and egged on by the U.S. Congress, which loved the fact that it could make promises of immediate benefits to voters, especially vote-happy seniors, and leave the tab for someone else to pick up. Moreover, lobbyists and voter interest groups make it very hard for any elected official to resist the temptation to raid our children’s piggy bank, because our children and grandchildren don’t have enough votes to stop us. The result, before last year’s financial crisis, was an unfunded liability that was estimated in a report published by the U.S. Federal Reserve Bank of Kansas City to amount to $65 trillion by 2050. And according to the Government Accounting Office, the non-partisan watchdog of the American government, the only solution would be for the federal government to start getting its financial house in order immediately if not sooner, by making tough choices, cutting spending, trimming benefits, and postponing the age at which voters qualified for benefits.

Clearly, that’s not what Bush did. (Although to his credit, he did try to do something about Social Security. His proposals were wrong-headed, and insufficient, yet the U.S. Congress spiked even that weak-kneed attempt.) Accordingly, even before the crisis, the U.S. government was driving towards a brick wall at 60 miles an hour.

Next was the U.S. trade deficit. America, as a nation, consumes more than it produces, with its trade deficit reaching a record $847 billion a year in 2007. This means that its trading partners, notably but not exclusively China, are selling Americans that much more in goods and services than America is selling to them in return, with foreigners accepting IOUs for the difference. China alone has something approaching $2 trillion in foreign currency, and while there are Euros, Yen, and other currencies in there, most of their reserves are in the form of U.S. treasury bonds and T-bills.

Since Americans consumed more than they produced, this meant, in effect, that they were systematically transferring their past or future wealth to their trading partners in exchange for a more luxurious lifestyle today.

Clearly, neither the build-up of an unsustainable U.S. federal debt because of government deficits, nor the export of America’s wealth to its trading partners can continue forever. Yet, America has the largest economy in history, so it can run up a tab for a long time before this becomes a problem.

Now let’s turn to the issues we didn’t know about before the crisis: the costs of bailing out the banking system from the worst financial crisis since the Great Crash of 1929, and the hopes of forestalling what might become the worst recession/depression since the Great Depression of the 1930s. The Bush government, via the Treasury and the Federal Reserve Bank, decided they had no alternative but to weigh in, throwing money around without regard to long-term consequences. If they hadn’t, they believed the global banking system would likely have come crashing down around all of our ears, and the global economy would have collapsed with a devastating crash that would have thrown tens of millions of people out of work, and done enormous harm to the global economy. And the U.S. government was not alone; virtually all of the world’s major central banks (eventually) went along with the policies for the same reasons, and many of the world’s governments also plunged ahead, trying to spend their way out of recession.

I have real concerns about the apparent ease with which President Obama has taken to spending money. It is true that he inherited this mess, and probably had no choice but to spend, and it’s also true that he’s only been in power for five months, but he seems to be trying to do everything at once, and ignoring the cost. And while I understand the political imperative to make your major moves early in your mandate, the scope and size of his moves are breath-taking. For the current fiscal year, the total of U.S. federal government spending is projected to be $3.6 trillion, so that the government will have to borrow almost $1.8 trillion to finance its deficit, compared to $1.2 trillion in fiscal 2009, and $0.455 trillion in fiscal 2008. In short, the deficit has almost quadrupled in two years.

That’s the situation as it is today. And the net effect of all of this emergency spending is to bring the brick wall America was racing towards much closer, and to push the pedal to the metal, so now America is racing towards it at 180 miles an hour instead of 60 miles an hour. The only question is: How many years will it take before we go splat?

But while these issues would naturally come home to roost in a matter of years or decades, there’s a more immediate problem: the financial markets look towards future events, and use their best efforts to avoid holding securities that they think will depreciate. Now add to this general observation the immediate reality that the U.S. government must sell an unprecedented amount of bonds and T-bills to finance 46% of U.S. federal spending. But who is going to buy them? With the U.S. already the biggest debtor nation in the world, with its biggest creditor, China, already musing publicly about whether the U.S. government is capable of supporting the debt loads projected, and with market players musing about whether the U.S. government will lose its AAA credit rating, who is going to want to step up and buy more U.S. securities than have ever been sold before? Why would any sane investor want to take that kind of risk? I can’t find any good answers to these questions. Even if they make it through the next year, and find buyers for $1.8 trillion in new debt (in addition to rolling over the existing debts), the Obama administration is projecting deficits, and hence borrowing needs, amounting to some $7 trillion over the next five years or so ­– and those projections are thought to be optimistic. The net result is that whether it happens today, or three years from now, sooner or later America won’t be able to borrow as much as it needs.

And that brings us to the crux of the matter: What happens when that time arrives? I hope to hell I’m wrong, but just for the moment let’s suppose my reasoning is correct. If the American government tries to sell all of this new debt, and doesn’t find enough takers, than the U.S. government won’t have enough money to pay the bills it is so freely running up. Its checks (or cheques) will start to bounce; it will be functionally bankrupt.

If that were to happen, the next logical step would be for the U.S. Federal Reserve Bank to step up and buy the bonds and T-bills itself. It, technically, has the ability to do that, but practically it would mean printing money to cover government IOUs, and an absolutely unprecedented amount of money at that.

But the U.S. dollar doesn’t trade in a vacuum. Printing this amount of money would do two things, both of them bad. First, America’s trading partners would sell U.S. dollars in favor of almost any other currency. (This may be one of the factors driving the Canadian dollar up so quickly in the last few weeks, for example.) And secondly, it would trigger domestic inflation, as greenbacks became worth progressively less and less. Both would move towards the same end: it would trigger a run on the U.S. dollar, pushing it into a downward spiral as currency traders sought to sell, but could find no buyers. The dollar would go into free-fall.

In turn, these events would have three knock-on effects, none of them good. First, it would mean the U.S. government would have to cut its spending drastically, or risk having its checks bounce. This happened to the government of New Zealand in 1984 , and it caused a national crisis there. But America is not New Zealand, and if it cuts its spending, both the American economy and the global economy will get hit hard at a time when both are beginning a fragile recovery. Second, it precipitates another financial panic, worse than the one last year, only this time the biggest rescuer is the one that needs rescuing, which could crash the entire global financial system. And third, the global trading system, which uses U.S. dollars as its principal medium of exchange, slows to a crawl because there is no other currency big enough to replace the greenback. This might mean that global trade would plummet.

What happens after that is anyone’s guess, but it’s hard to paint an encouraging scenario, or even one that’s not wildly pessimistic. So let’s circle back to my opening question: Is America too big to fail? Perhaps, but who is big enough that they could possibly save it? There are only two players even close to having the size for this task: China, and the European Union. Neither of them are big enough. Probably the two of them together aren’t big enough. And it may be that all of the central banks of the world, combined, and backed by their national governments, may not be big enough. Moreover, it would take a degree of cooperation and willingness to accept losses by the rest of the world that, going by past performance, is unlikely in the extreme. So, based on what I can see now, America will probably go bankrupt, and create a panic and even deeper global recession in the process.

Of course, people are endlessly inventive, and it may be that someone will come up with clever solutions that will save the day. For instance, the Federal Reserve could raise interest rates significantly to help make America’s debts more attractive. But that won’t happen unless there is a crisis that trumps domestic politics, because raising interest rates by much would likely throw America back into recession, dragging global growth down with it. So, absent some miracle solution, America is going to crash – I just don’t know when.

Believe me, I hate writing about this, especially since I know that many people will inevitably blame the messenger. So instead, let me turn this into a question: Am I wrong? Is my reasoning incorrect, or are my facts wrong, or my interpretation too pessimistic? Perhaps I have the timing wrong, or am overestimating the scope of the problem. Let me ask, then, does anyone else have a different view? I’m not asking for political views, pro-Democrat, pro-Republican, anti-Democrat or anti-Republican; that is frankly a boring and unimportant sideshow. What I’m interested in is: Is American likely to fail? And if so, what can be done about it?

I’d like to hear your thoughts. Thanks.

© Copyright, IF Research, June 2009.


1 – “Recession Drains Social Security and Medicare,” New York Times website, May 12th, 2009.

Comments on this entry are closed.

  • Gil Jun 3, 2009 Link

    Yes, I agree this is a distinct possibility….but since you asked for responses I’ll try to accommodate you.

    It seems the one thing you have NOT gone into in much detail, though I’m sure you are aware of the good investigative work being done by the Gold Antitrust Assn. (GATA), is what money is backed by (nothing at the moment as far as all fiat currencies are concerned). This seems to me crucial in every aspect of your projections. If governments refuse to “come clean” with their citizens as has been shown by GATA with respect to the Federal Reserve, their currencies are not honest and we can expect a chaotic future.

    The required agreement which needs to be sought by all nations would therefore involve a return to a precious metal standard; while all players would have to agree to the inevitable drastic increase in the price of gold/silver – along with interest rates – this might give breathing room to the entire world while it redefines what money should actually be based on, and this must be an open discussion.

    It is obvious to me that if we want to stop devastating the earth currencies must ultimately be backed be units of energy, say the calorie – equally negotiable (exchangeable) in oats or oil or for that matter electrons. This would also provide a way to harmonize the economic costs (cap ‘n trade, carbon charges, etc) of all the choices that we had better make quickly before its too late – that is, before we have to come to the excruciating (!) conclusion that there may be more important issues on our plates than those to be seen on “America’s/Britains’s Got Talent”!

  • Ray Jun 3, 2009 Link

    Other than timing, which is difficult to assess, I believe you’ve nailed it.
    Like yourself, I don’t like it, but if Obi1 continues to amass debt in the name of change, change will happen, just not what everyone had in mind. What we need to see is a guenuine economic conservative come to power and release the USA from being the world’s policeman. A huge amount of money is being spent on wars.. somehow this has to stop.
    Cap and trade is a cruel joke.. drive up energy prices so that energy companies can make a fortune on a totally invented commodity, while the rest of us pay and pay and pay.

  • Richard Worzel Jun 3, 2009 Link

    I like the idea of calories (or kilocalories) as the common unit of exchange. It is, after all, the most fundamental unit: energy.

  • Art Jun 4, 2009 Link

    Hello Richard: I am betting you are wrong but I am planning in case you are right. We can watch our neighbours go bankrupt, but we can also learn from their mistakes. Canada has fresh drinking water and some gas, oil, minerals and a stable Banking system. Economically, we are holding some choice cards. Personally, if you have a job, are paying down your house, apply your natural talents, are physically active and are reasonably healthy … your life is good!

    We won’t live long if we can’t drink the water. You can’t operate machinery without gas/oil. A military is useless without these necessities. Transportation and food production would cease to exist.

    Canadians are intelligent. Our Universities are educating people who will be productive and are wise enough to learn from past mistakes. We are also leaders in the study of Virus and Diseases.

    If we can just apply all the lessons we were taught in kindergarten we will survive. Example: Wash your hands, look both East and West when crossing the street, get a good night’s sleep, play, earn your allowance, help your friends, stay in school … etc.

    Western civilization has the strength to get through this together. But the Pandemic … now that is scary. Diseases and virus do not recognize borders, intelligence, or wealth. Canadians might overcome a Pandemic by applying basic survival skills. Have enough basic food (chicken soup, bread) and water available for 10 days.

    Humans will survive. If not, the Earth will get along very nicely without us. Currently, Canadians “expiry date” is only 82 years.

  • courtney rodash Jun 6, 2009 Link

    Richard, as usual you provoke a lot of thought and perhaps tirades from interested parties. Us Westerners should finally accept that we are not the “be all and end all of cultures” . Who cares, or more pertinently what difference does it make which “civilization” is in power or I should say who controls the money supply. We cannot as individuals have any impact whatsoever on where we are going, the trend is irreversible now that we are dooming our planet environmentally and economically. The only control the world or specific cultures have is over money and the control of trade. The USA is now relegated to perhaps third place and falling behind who??!! what would you expect-the most populated cultures and intellectually progressive China and India. I’m not impressed with the Eastern way of life which still appears to be obsessed with procreation to the nth degree, subsequently choking the planet for materialistic pleasures (the West has already seen this film and it doesn’t end well!!). Safe to say Richard, in my opinion and for whatever it’s worth, the USA are now spiraling and will never regain the grandeur of the 20th century. There are now “new players” in the game which will control the money supply without any input from the USA. As one of your previous bloggers stated, our life span is perhaps 80 therefore, let the next generations take control and mold the future of this world. It now not matters where we have been, rather the world course is ultimately set, yet, keep in mind, the stage is open and only the actors are not known!!!??
    Cheers! F for thought. Courtney

  • Grant Sep 16, 2009 Link

    I believe your analysis is correct in all aspects. I am intrigued watching the EU quietly consolidating their economic footing. Something else they are doing, also quietly, is slowly and surely trying to disentangle themselves from the decades-long dependence on (tradition?) the US dollar as the primary medium of trade. The Euro started strong and has stayed strong, and if the EU stays the course they will carve a large chunk out of the US dollar’s dominance.
    Juxtapose that with the fact that China already owns a very large piece of the US dollar and economy; that China’s massively expanding capacity to feed the world and particularly the US with, yes, foodstuffs and particularly with consumer goods — China will hold all the trump cards in the not-too-distant future. And as Richard pointed out, China is already musing publicly about abandoning the US Dollar (read: lack of confidence in the dollar and the US economy) in favour of some “other” international currency of trade. China has learned and understood capitalism better than the world’s original, soi-disant “true” capitalists, and they will beat the true capitalists at their own game. China has understood that American and broader western capitalism is based upon consumption economics — and China is poising itself to consume the US and then other western economies themselves. Pretty smart cookies, if you ask me.
    As soon as the rest of the world stands back and sees what China already sees and what the EU suspects, there will indeed be a run on the US dollar, and the scenario will roll out as described in the article. Heaven help us all, unless we each reduce our own individual exposure to what can — if the current course continues much longer — only result in a massive global economic collapse.