We’ve been on an AI bent of late. Today we shift gears and discuss the resource curse and the US debt situation. Grab a cup of coffee because it’s going to get wonky.
The resource curse is a well-studied phenomenon where countries with plenty of natural resources (oil, minerals, etc.) tend to have less economic growth, less democracy, or worse development outcomes than countries with fewer natural resources. This phenomenon is also known as the paradox of plenty; the more you have, the worse your outcome. In discussing this phenomenon, countries such as the Democratic Republic of Congo, Angola, Libya, Iraq, and Venezuela come to mind, while countries such as Singapore, South Korea, and Taiwan are contrasting examples.
Various academic literature has attempted to explain the reasoning behind this observation:
- Over-reliance on commodity exports leads to these countries experiencing increased revenue volatility since commodity prices tend to be cyclical.
- Revenue generation through source extraction is relatively easier than building government institutions, education, and the development of human capital. This then contributes to underinvestment in institutions that improve the country in the long run. This is one reason why resource-cursed countries tend to have autocratic and corrupt governments.
- The Dutch disease, whereby natural resource-producing countries export their commodities, resulting in the appreciation of their currencies and making exports of other things less competitive in the global market. Then, when commodity prices inevitably go down, these countries experience higher debt and a diminished manufacturing sector.
Anecdotally, can one apply the same principle in other sectors? In a recent interview, Stanley Druckenmiller said that the USD as the reserve currency has allowed the US government to play fast and loose with the US dollar, akin to an emerging country encumbered by the resource curse. Here are his quotes, annotated for clarity:
”Probably the best way to explain the resource curse is to take the opposite, that is, Israel. They have no resources. They have dramatically outperformed the rest of the Middle East who has all the resources” — Stanley Druckenmiller.
In case you’re wondering, here is the GDP per capita growth of Israel compared to its neighbors (Figure 2).
Note: A more impressive example is Singapore, especially compared to the surrounding countries in the Southeast Asia region. In 1960, Singapore had the same GDP per capita as Suriname. Fast forward to 2021, Singapore’s GDP has exceeded that of the US. See Figure 3 below.
Back to the Druckenmiller quote:
“The reserve currency is an unbelievable privilege. Unfortunately, that privilege, while you have it, allows you, if you choose to do so, to run very myopic policies that don’t address the long-term and allows you to behave in a way because markets don’t check you because you’re being funded by outside sources. Everything we just described: the fiscal recklessness, the monetary recklessness, all that. No other country could have pulled that off. And it’s fun, and it’s great while it lasts. But it enables you to keep digging and digging into a deeper hole until the consequences come to bear, and ironically, it probably to some extent, you do it enough, you lose the privilege, and then you only have the consequences. So that’s why I call it the curse of the reserve currency.”
“When Britain tried to do fiscal stimulus with Liz Trust [former British PM], the market immediately shut them down, and they immediately went to a more responsible form of government. [In contrast], we have no check on us. All this craziness we just talked about when in ‘21 and ‘22, the dollar went up. In any other place, the market would have rejected it, and we would’ve gotten our house in order immediately. [But] when you’re the reserve currency, you can keep digging your own grave until finally you’re dead and you’re under the soil.” — Stanley Druckenmiller.
A person’s debt is another’s asset
Who owns the debt?
In discussing deficits and debts, it is important to recognize that there are two sides to the balance sheet equation of debt. One person’s debt is another’s asset. In the case of US government debt, it works as follows:
- The US government earns its revenue primarily from taxes. It then spends this income on various things (defense, welfare spending, etc.). If the spending exceeds income, then the government runs a deficit. The deficit from past years adds to the current year, and as long as the spending increases at a faster rate than the increase in tax income, the deficit will increase.
- To cover this deficit, the US government issues debt (in the form of US Treasury securities), and the US Central Bank (the Fed) buys them, transferring cash from the Fed to the US government, allowing the US government to pay its bills. This is one way cash is created and injected into the economy.
The Fed is not the only buyer of US government debt, however (it owns about 40%). Other US government agencies, domestic investors, corporations, and foreign governments also hold US debt. US debt is considered a safe asset, and demand for it increases during turbulent times (thus, in a way, the US Fed acts as a bank for other governments). This is the extraordinary privilege Druckenmiller was referring to. In effect, there’s always demand for US debt because the US acts as a bank for other governments.
Having the largest economy and military in the world, combined with the fact that the USD is the reserve currency of the world, has given the US government much leeway to operate in the deficit and issue more debt since the demand for US government debt is insatiable.
Druckenmiller is warning that the US should not continue to abuse this privilege. If the US continues down this path, it may enter a debt spiral, shaking confidence in the USD as the reserve currency. Roughly, here is what the spiral may look like:
- As the population ages, the burden of healthcare and social security will increase. In 2022, social security and healthcare spending is already 46% of the Federal budget. And as the population ages and enters retirement, they will not contribute to the tax base, which will reduce revenue.
- As interest rates go up, the burden to service the debt goes up. Currently, about 7% of the Federal budget goes toward paying interest. As the Fed increases interest rates to fight inflation, this burden will increase.
- Both the aging population and rising interest rates will increase the budget deficit, which will increase the need to borrow even further, and so on.
How to fix things?
Druckenmiller and others have suggested that the US government work towards reducing the deficits, either by reducing social spending or increasing taxes. However, both approaches might not be palatable and are counterproductive.
Reducing social spending impacts the older population, who are generally more likely to vote. This is not a popular choice for a democratically elected government. Meanwhile, increasing taxes may reduce GDP growth. Recall that the GDP is a function (see eq (1) below) of consumption (C), business investments (I), government spending (G), plus net exports (X – M). If taxes go up, there will be less money for consumption, the largest contributor to GDP, as 70% of GDP is US consumer spending, and investments will go down. This will hurt nominal GDP.
Nominal GDP = C + I + G + (X – M) eq (1)
An alternative: monetization of debt
Is there a better way to reduce the debt burden without taking bitter medicine? Perhaps. Another alternative would be to monetize the debt away. To do this, ideally, you have a prolonged period of high inflation while maintaining interest rates below that inflation level. This effectively devalues the existing stockpiles of debt in real terms.
This has been done before. For example, between 1942 to 1951, the Fed helped the US Treasury finance WWII. At the time, the US debt was increasing to finance the war. To prevent the ballooning cost of servicing said debt, the US Treasury worked with the Fed to control the interest rate to about 2.5% despite running inflation at an average of 6% per year. The Fed achieved this interest rate control by buying Treasury Bills to get the right yield target (employing yield curve control). This inflationary burst, coupled with lower interest rates, helped reduce the U.S. debt-to-GDP ratio from 119% in 1946 to 92% in 1948.
So, is the Fed currently monetizing the US debt? While it has not been the explicit policy, the Fed might have been doing so through quantitative easing (which began after the great financial crisis a decade ago) and through the slow response to rapid inflation post-COVID. As a result, inflation levels have been above the Fed interest rate for the past decade (red area in Figure 7 below), characteristic of debt monetization.
Bad is relative
In reality, it’s not just the US. The whole world is running on debt. China’s total debt (governments, households, non-financial corporations) to GDP ratio hit 279.7% at the end of Q1 this year.
To make matters worse for China, after decades of local government debt-fueled expansions to hit GDP targets, there is a lot of hidden debt issued by thousands of financing companies set up by provinces and cities. Many Chinese investors invest in these municipal bonds thinking the government backstops them. And now, the total local debt has ballooned to an estimated value exceeding $23 trillion.
Similarly, Japan is also gorging on debt. Its government-to-debt ratio is 263%, double that of the US. The Bank of Japan (BoJ) has been on a yield-curve-control (YCC) program since 2016, buying the majority of debt the Japanese government is issuing. Their overarching goal was to achieve a 2% inflation by keeping the 10-year interest rate at zero to stoke domestic growth further. The extent of the bond market distortion via BoJ’s YCC has been massive, so much so the Bank of Japan owns roughly 50% of outstanding Japanese government debt. As a result of the artificial suppression of the Japanese domestic interest rate, its local investors have been chasing yield elsewhere. As a group, they’ve become the largest purchasers of foreign bonds in the world. As of 2023, Japanese investors own almost $1.1 trillion in US government bonds.
It might be time for the BoJ to cease YCC, but it might be unable to do so. After decades of deflation, Japan’s inflation has finally fluctuated between 3 – 4% this past year, and with a rapidly aging population, Japan has a new set of challenges ahead of it. If the BoJ and Japan’s investors stopped acting as the biggest consumer of debt for others, the US would have a liquidity crisis.
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This video is meant to be informative and not to be taken as an investment advice and may contain certain “forward-looking statements” which may be identified by the use of such words as “believe”, “expect”, “anticipate”, “should”, “planned”, “estimated”, “potential” and other similar terms. Examples of forward-looking statements include, without limitation, estimates with respect to financial condition, market developments, and the success of or lack of success of particular investments (and may include such words as “crash” or “collapse”.) All are subject to various factors, including, without limitation, general and local economic conditions, changing levels of competition within certain industries and markets, changes in interest rates, changes in legislation or regulation, and other economic, competitive, governmental, regulatory and technological factors that could cause actual results to differ materially from projected results.