Chris Sanders: The Unsustainable Nation

If any of us had known before the 11th of September just what was getting ready to happen, buying volatility would have been an obvious trade to do. We didn’t know, and didn’t buy. In the run up to the events in mid September, volatility in stocks bonds and currencies was falling. They shot up on the big day. What a difference a day makes.

The events subsequent to the launch of the War on Terrorism (WoT?) have been truly bizarre to anyone schooled in the language of free markets and the politics of a democratic republic. It seems obvious to us that the authorities are targeting asset prices along with the Taliban. What one is supposed to make of this is really anyone’s guess, because the historical precedents are rather imperfect. However, we can make some sense of events by identifying the major drivers and working backwards from there.

At the top of our list is the American debt burden, which is one of those things that, like George Bush, will always be with us whether or not we want it. Importantly, it is not a static variable. It keeps growing through the miracle of compound interest as seasons come and seasons go. It has been growing steadily for more than two decades now, facilitated by developments in financial services that have made it possible to make the money sweat more profusely. That should not confuse one about the significance of the expanding balance sheet. As long as the American economy has access to abundant credit, this can go on. With personal savings so low, (i.e. negative, whatever the government statisticians say) and the Federal government likely to be running a deficit in twelve months time of $300 billion or more, the carrying cost of the expanded national balance sheet is very sensitive to changes in interest rates. The fact that many of us have lived with the debt for most if not all of our professional lives does not make it a neutral factor. Far from it – it needs to be financed at a politically acceptable price.

Many Americans with portfolios of stocks, bonds, and real estate feel as though they save a lot, the more so because these assets have all appreciated in price in recent years. This is an understandable perception, but unfortunately it is somewhat beside the point. Thos assets classes can fall as well, and they have largely risen in price because the cost of borrowing to finance them has fallen dramatically. What really counts is savings not as a balance sheet matter, but as a matter of cash flow. How much cash is available to finance the cost of carrying debt?

At 280% of GDP and rising America’s total debt burden relative to GDP has far outrun the ability of the economy to finance it out of retained earnings. With net foreign investment income negative, financing the debt requires ever-greater investment from foreigners. Although this latter point is so obvious that you may well gloss over it, consider: the implication is that the maintenance of American economic growth requires an accelerating rate of net foreign investment. America already pre-empts more than 70% of net world savings.

This is a national security issue of the first order to a country that considers itself the "indispensable nation" if for no other reason than that it needs to finance the world’s biggest military budget. We discussed this at some length last week, but it is worth repeating that the US defence establishment will find it difficult to continue to finance weapons systems, each new generation of which costs more than the last in real terms not only to acquire but to operate. Foreign military sales are one route, and it is worth noting the immense importance of Saudi Arabian arms purchases over the last thirty years. This is a useful way to recycle part of the trade deficit, but it obviously cannot proceed indefinitely, especially with low oil prices, a point to which we will return presently.

It is little short of miraculous, we think, that market analysts are so slow or so shy about drawing the appropriate inferences from this situation. At the top of our list for fuzzy thinking is analysis of Japan. Given the immense strategic importance of a dependable increase in the flow of low cost foreign savings to the United States, it is remarkable that the investment and banking industry still attributes Japan’s "economic problem" to incompetence, stupidity and corruption. The issue for the Japanese is a foreign policy problem as much as it is a domestic economic or "reform" matter. After more than six years of suppressing the yen, nil interest rates, and massive deficit spending by the government of Japan, Japanese GDP still remains mired in the doldrums and consumer prices continue to fall. Foreign observers seem so confused about the situation that they can’t make up their minds what the Japanese are supposed to do. On the one hand they need to "reform", which presumably means opening the Japanese economy to unrestricted foreign competition and investment and writing off the bad debts of the banking system. On the other hand, foreign analysts then forecast a meltdown in the Japanese economy if the Japanese do follow this advice. Oh well, who says that good analysis needs to be consistent?

There is little critical energy directed at the impact of the present Japanese policy mix on the money and credit system in that country. As we have periodically observed, by lifting capital controls, driving interest rates to zero, and intervening massively to suppress the yen, the Ministry of Finance and the Bank of Japan have ensured that Japanese savings will go abroad via the banking system. The banks have little incentive to lend at home since the "weak" yen increases the amount of reserves that the system needs to hold against its growing net foreign asset position. Never have we heard of the economic theory that holds that impeding domestic credit supply is a way to boost GDP and final demand.

It is an article of faith among some that the US and Japanese economies are now so closely entwined that they can never be driven asunder. This may be true, but it is worth mentioning a few caveats. The present policy mix is very lopsided in its costs. and requires an ever bigger Japanese external surplus to supply the ever growing American deficit. This is not sustainable policy in a democratic world, we would venture. And indeed, Japan is not exactly a model parliamentary democracy, dissent from the American alliance having been crushed in the 50s and 60s with covert American help and financing. Japan has gained, if that is the right word, the right to abstain from playing an international military role in return for its provision of bases to the Americans. Yet here too we see a long running contradiction impelled by American budgetary exigencies. The cost of maintaining those American bases has been shifted considerably to the Japanese taxpayer, and American demands do not end there. Japan spends some $70 billion a year on its own military, has a sizeable navy and air force, and possesses the capability of deploying an ICBM force in the near future. The US would like to see the Japanese taking up more of the burden of "peace keeping."

Having lasted for so many decades, we see no reason to forecast the imminent demise of the Japanese-American strategic relationship. On the other hand, it is precisely because it has lasted so long that it may be difficult to see change coming. Again, it is the American debt burden that attracts our interest, for it is now too large for Japan to finance alone. Asian central banks collectively now hold over $1 trillion in dollar reserves, or nearly half of America’s net foreign debt. Japan accounts for some 40% of this figure with some $400 billion in reserves, followed by China, with just under $200 billion in dollar reserves (nearly 20% of the total), Taiwan with $115 billion, and Korea with $100 billion.

Considering the historical rivalry between these Asian powers, it is of more than passing interest that the US is so dependent on their cooperation to finance its credit expansion. To be successful over the long haul in holding such a disparate group together, America basically needs to make itself indispensable to each. Maintaining (as it does) sizeable military forces in three of them is certainly one way of doing so. But it is hard to see this as an even trade, because it is America that gets to borrow, and everyone else who gets to lend. At some point, theoretically, America will find itself borrowing all of everyone’s savings. At that point, or actually somewhat before it, as we see in the case of Japan, they will find it difficult to grow themselves.

At this point we arrive at another "unsustainable" trend. World petroleum production is peaking, just as was predicted over thirty years ago. Even the vaunted Caspian Basin, were it to be open for business and pumping for all it is worth, cannot alter this basic fact. At around 50 giga barrels, it is equivalent to "only" another North Sea or some quarter or a fifth of Persian Gulf reserves. It is a fact that production everywhere except the Persian Gulf has peaked.

It would be hard to imagine a more important fact of life for the future of the American political economy. The bargain between governed and the government during the last one hundred and fifty years or so in America has turned on the ability to exploit cheap space, which itself has been possible thanks to cheap energy. There is simply is no plausible alternative to oil for the modern economy on the horizon yet. The industry has already discovered some 90% of the oil in the earth, and managing to extract more from existing wells depends on being able to do so without expending more energy extracting it than one gains. In places like the US, this point will soon be reached. In the Persian Gulf, where it is so close to the surface that it pumps itself, it is not so relevant. In any event, production in that region will peak within the next fifteen years of so, and indeed, in many of the older fields already has.

There are many alternatives to oil, but none that can replace it. Oil has been by far and away the most productive source of energy. It has been cheaper to extract, transport and burn than any other source. Hopes that fuel cells, for example, could be an alternative are a chimera, given that the hydrogen that this technology is based on is extracted from methanol that is itself produced from fossil fuel.

When one begins to come to grips with the outlook for the oil market, one begins to understand more clearly what is going on in the world around us. As we write, the world is shifting from a model based on expectations of virtually unlimited energy produced from a variety of sources, to one in which energy is not unlimited and is produced mainly by the OPEC Five.

In such a world, the Indispensable Nation begins to look more and more like the Unsustainable Nation. The shift in modern American military doctrine away from conventional war and towards urban warfare and militarised policing looks like sound policy, at least if you are a member of Skull and Bones and own an oil company. The campaigns in Columbia (oil), Kosovo (oil pipeline) Somalia (oil) and now Afghanistan (oil and pipelines) make eminent sense if viewed as part of a strategy to secure and control the sources of a vital and disappearing resource.

In such a world, the civil liberties that we in the west have enjoyed for so long may well become, if they have not done so already, a memory. This is important for investors, if for no other reason than this implies that finding a hedge against the economic consequences may be not only difficult but illegal. It was all very well to own gold in 1933, but the government took it away from you.

In such a world, if Osama bin Laden did not exist, we would probably have to invent him. But then come to think of it, we did, didn’t we?

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AUTHOR NOTE: Chris Sanders has been a banker and asset manager for 21 years, and is a visiting professor in international finance at the School of Public Administration at the University of Göteburg in Sweden. He has degrees from in political science from Duke University and Arabic literature from the University of Michigan. He began his financial career as a private banker in Saudi Arabia in 1979. Since 1984, he has lived in London and worked in the international investment management industry. He founded Sanders Research Associates in 1996 and since 1998 has been a director of WorldInvest and head of its currency and fixed income investment business.

(c) Copyright http://www.sandersresearch.com, republished with permission.

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