finance only, but interesting. ht to ‘Andrewj’ at



Whilst general trends are correctly identified by many on these blogs, for example the long term economic and social risks of a currency union across economic regions with significantly divergent rates of productivity, I think that it can be a useful exercise to attempt to join up the dots in a world of interlinked but unintended consequences or random events in order to get an early warning on the next major event. 

If we join up the dots by starting with the dot that is likely to have the biggest effect on all the others, I would suggest that that dot would be the size of net US debt and the continuing size of the US deficit. A US default on its debt would be the equivalent of an earthquake, tsunami, and nuclear meltdown all rolled into one with regard to its effect on the world’s financial systems.

Banks, large and small across the globe would have their balance sheets vapourized overnight as the value of their dollar assets are downgraded. Interbank transfers would instantly freeze, credit would be non existent and global trade would be something in the rear view mirror.

But what would trigger a US default? As in all bankruptcies (because that is what a default is) the underlying cause is transaction insolvency (or if you prefer, a business model that no longer works). The signs of overall economic transaction insolvency are a combination of persistent rising debt (the US has that in spades) and rising unemployment particularly among the young (again the US is a star in this category).

In other words wealth is being consumed in the economy at a greater rate than it is being replaced. This is typical of economies where the capacity of voluntary transactions (private sector) to replace the loss of wealth through government induced coercive transactions (made possible only through taxation) has been exceeded.

Therefore a US default is increasingly likely if random or unintended events cause the US deficit to grow. Hence the importance of the other global dots derives their importance in relation to how they affect long term US solvency.

So how do the other dots around the world positively or negatively affect US solvency today?

Let us consider Japanese, Middle East, Euro and BRICS dots and their effect on US solvency.

The catastrophes in Japan – result negative effect due to repatriation of US denominated assets reducing liquidity for US treasuries and hence raising yields first in the US and thereafter worldwide. Increased interest rates on US debt increases the US deficit through increased interest expenses.

Middle East – no brainer – oil price rise results in falling US consumer demand equals reduced US solvency equals increased US debt as total tax revenues fall. Secondary effect – increased cost of US borrowing as sovereign risk rises.

Euro area – Increased interest rates plus increased energy costs equals falling demand and hence rising insolvency first within PIIGS and later to the core. Failing Euro equates to greater Fed exposure through central bank support in liquidity to the EMU banking system. This is turn equals increased likelihood of US insolvency. Secondary effects include declining US exports to the Euro area as consumer demand falls generally in the EMU region – increasing US insolvency.

BRICS – China in particular – rising inflation results in rising interest rates which further drains liquidity from the US Treasury market. Secondary effects include falling Chinese trade surplus as US demand falls and when coupled to falling Chinese domestic demand due to interest rate increases (and hence falling property values), Chinese GDP contracts more than anyone has predicted. Chinese repatriate foreign holdings in the form of food commodities. Overall effect is to advance US insolvency by raising US yields.

The sum of these interacting variables are rising US yields in a thinning market against a backdrop of increasing doubts about long term US solvency. As these doubts grow two trends emerge (a) major countries central banks begin to take actions to insulate their national financial systems from US contagion (Glass Steagall type legislation enjoys a renaissance), and (b) the pressure for a “world currency” increases from the lunatic fringe in an attempt to bury the underlying global insolvency problem.

We have always lived in dangerous times but Fort Moraymint looks increasingly like a good destination before they raise the drawbridge.


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