When will the sovereign Ponzi scheme stop?

All weird days start in one way.

I wake up with a throbbing headache, its sunny outside and I have this great need to have coffee but we have run out of milk. Yesterday was another such day.

And to top all that, I had this funny feeling. Something I had been thinking would eventually happen, but had not.

And it was finally happening today.

I woke up with absolutely no feelings for her. Like life was a clean slate, and I was ready to start all over again. And there was no coffee; to make us bond, to talk and figure out a few things.

It reminded me of a time, when we had first met, and in order to impress her I had told her this wonderful couplet by Dushyant Kumar: “Ek jungle hai teri aankhon mein, main jahan raah bhool jaata hoon. Tu kissi rail-si guzarti hai, main kissi pull sa thartharata hoon.” And she had been impressed.

But that was a long time back.

She was sleeping and I almost woke her up asking, “Don’t you feel something bad is going to happen today?”

This was the difficult part. How would I tell her this?

“You are looking rather pale today V,” she had said with one eye open, getting me back into the real world.

“Yeah, been feeling a little uneasy,” I replied.

“Can I make some black coffee for you?” she asked.

“Nah.”

“Okay. So let me ask you a question. You know I was reading somewhere that fiscal deficits and debts of countries like the US, Japan and the UK had reached unsustainable levels. Is that correct?” she asked.

Now this was a hopeless situation. Here I was waiting to tell her, that it was all over, and there she was asking me a question that would inevitably lead to a discussion and delay what I wanted to tell her.

“Yes you are right. Fiscal deficit is the difference between the amount a government earns and the amount it spends. Now take the US. For 2010, its fiscal deficit is projected to be around 9% of the gross domestic product (GDP) of $14.3 trillion. This works out to around $1.3 trillion. Now how will the government fill in this gap?”

“It will borrow.”

“From whom?”

“From anyone who is willing to lend.”

“Yeah. But who are these lenders?”

“Well, anyone who has the dollars and is willing to lend,” she replied emphatically.

“Hmmm. Let me explain. A country can either borrow from its own citizens or from other countries willing to lend. In case of the US, its citizens, as I have explained in the past, are under huge debt and are no longer in a position to bailout the government. So the government has to borrow from other countries like China and Saudi Arabia, which are sitting on a huge pile of dollars. Now how do the outsiders get the dollars to lend to the US government?” I asked.

“Well, they get the dollars against the goods and services they export to the US. Also they import goods and services from the US as well. So the difference between the exports and the imports is what is the left over and is known as the foreign exchange reserve,” she replied.

“Hmmm, that is right. And this amount can be lent to the US by investing in financial securities issued by the US government to borrow the money that they need to spend but they don’t earn. Let us say a country exports $100 billion of stuff to the US and at the same time it imports $60 billion of stuff from the US. So that leaves it with $40 billion to lend to the US in a given year. Now if we add up these dollars lying with all the countries, around $500 billion is available this year. If all of it were to be invested in financial securities issued by the US government to finance the fiscal deficit, it would still be around $800 billion short ($1.3 trillion-$500billion). And this shortfall will be assuming that all the dollars earned this year will go to the US. We haven’t taken into account other countries like the UK and Japan which are also running huge fiscal deficits,” I explained.

“Yeah, we haven’t taken that into account.”

“Now take the case of UK. The fiscal deficit projected for this year is £175 billion. Now where will they get the money from? Well, the only way to get that money is to print it. As investment newsletter writer Gary Dorsch writes in a recent column, “the BoE monetised 90% of the UK’s budget deficit in the past fiscal year.”

“Simple English please,” she interrupted.

“Well what he means is that the Bank of England (BoE) printed pounds to meet 90% of the fiscal deficit. That’s the only way out when lenders are not ready to lend and the citizens of the country are themselves heavily indebted and are in position to help the government.”

“But what about Japan?”

“Japan is a little different. They government has been able to finance its enormous fiscal deficit by borrowing from its citizens. As John Mauldin, an investment manager, wrote in a recent column, “Japan is an instructive example. The government debt-to-GDP ratio would have risen to over 220% by the end of 2011 from 51% in 1990, absorbing almost all of the rather enormous savings of the Japanese public.” But the thing is that the Japanese savings rate has been falling for a while. Currently, the savings rate in Japan is around 3% of the GDP, which is similar to that of the US. So how will they finance their fiscal deficit? Money from abroad as I explained earlier is not enough to meet the needs of the US, so forget Japan.”

“So what do you think will happen?”

“Edward Chancellor, the author of Devil Take the Hindmost: A History of Financial Speculation explained it best in a recent column, “Public finance is a Ponzi scheme. As long as new creditors can be found to roll over existing loans and provide fresh funds, the debt juggernaut can continue.”

“Simplify.”

“A Ponzi scheme is a financial scam in which an illusion of fantastic returns is generated by paying the money invested by the new investors to the older investors. The way governments finance their fiscal deficits is similar to a Ponzi scheme except for the fact that there is no intention of a fraud. Conventional wisdom tells us that money that is borrowed needs to be invested in areas where it can get a return higher than the interest to be paid on debt. But the government cannot always work with the profit motive in mind. At most times, a government does not earn enough money to pay back the interest on its debt, as well as the maturing debt. So what does it do? It takes on more debt to repay its earlier debt and also to pay interest on its existing loans. It works like a Ponzi scheme where money being brought in by the new set of investors is paid off to the older investors.”

“But this cannot go on forever.”

“Yes. A Ponzi scheme goes on till the money being brought in by the newer investors is more than the money needed to be paid off to the older investors. And one day that breaks down. The government Ponzi scheme goes on till people and other countries, which have money are ready to buy newer financial securities issued by an indebted government so as to help it continue finance its huge fiscal deficit and all the accumulated debt.”

“And what happens when the arrangement breaks down?” she asked.

“The governments simply print more currency to pay off investors. Of course, that is assuming that the maturing debt and the interest to be paid on that is in its own currency. This is largely the case with the US, the UK and Japan, which have largely got debt in their own currencies: the dollar, the pound and the yen. The UK is already printing large amount of currency to finance its fiscal deficit, Japan has given enough hints that it might print, and the US too will get there pretty soon.”

“So what is it that you are suggesting?”

“Oh. This is the beginning of the end.”
(The example is hypothetical)

References:
The Last Chapter, John Mauldin, Sep 4, 2010, www.safehaven.com
The Last Half, John Mauldin, Sep 12, 2010, www.safehaven.com
Japanese Style Deflation Strikes Global Bond Markets, Gary Dorsch, Aug 12, 2010, www.sirchartsalot.com
British Gilts vs Gold, — Vying for ‘Safe Haven’ Money, Gary Dorsch, Aug 25, 2010, www.sirchartsalot.com
Reflections on the Sovereign Debt Crisis, Edward Chancellor, July 2010