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WW3?

http://prudentbear.com/index.php/commentary/featuredcommentary?art_id=10129

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A mere United States security …

Investors around the world are now faced with a deterioration in the creditworthiness of the world’s largest borrower. Scrooge’s nightmare, described by Charles Dickens, in which "solid" British assets are changed into "a mere United States security" may become a reality.

Foreign investors may not continue to finance the US. At a minimum, the US will at some stage have to pay higher rates to finance its borrowing requirements. Ultimately, the US may be forced to finance itself in foreign currency. This would expose the US to currency risk but most importantly it would not be able to service its debt by printing money. The US, like all borrowers, would become subject to the discipline of creditors.

For the moment, the dollar is hanging on – just. This reflects structural weakness in the Euro and Yen based on deep-seated problems in the respective economies. The artificial nature of the Euro is also problematic.

The dollar is also a beneficiary of the "too big to fail" syndrome. Foreign investors, especially central banks and sovereign investors in East and South Asia, Russia and the Gulf, have substantial dollar investments that would show catastrophic losses if the US were to default or its currency devalue. The International Monetary Fund ("IMF") estimated that Gulf Cooperation Council (Saudi Arabia, the United Arab Emirates, Qatar and other Gulf States) may lose US$400 billion if they decide to stop pegging their currencies to the dollar.

Every lender knows Keynes’ famous observation: "If I owe you a pound, I have a problem; but if I owe you a million, the problem is yours." In history’s largest Ponzi scheme, foreign creditors must keep supporting the US. As the old observation goes: "The only man who sticks closer to you in adversity than a friend is a creditor."

Traders have a saying: "Don’t panic but if you are going to panic, panic first." The present MAD (mutually assured destruction) pact that binds the US and its creditors is fragile. Dollar holders are acting like a cartel. A break in the cartel - a major investor deciding to exit in the belief that it can get out – could be extremely disruptive.

Does any of this matter? Walter Wriston, then chairman of Citigroup, opined that: "Countries don't go broke". In 1982, shortly after this statement, Mexico, Brazil and Argentina defaulted inflicting near mortal losses on Citibank.

Sovereign debt crisis, especially in emerging markets, are characterised by high levels of debt, especially foreign borrowings, poor fiscal policies, persistent trade deficits, a fragile financial system, over-investment in unproductive assets and a sclerotic political system. Arturo Porzecanski (in Sovereign Debt at the Crossroads (2006)) noted that: "Governments tend to default specifically when they must increase spending quickly (for instance, to prosecute a war), experience a sudden shortfall in revenues (because of a severe economic contraction), or face an abrupt curtailment of access to bond and loan financing (e.g. because of political instability). He further observed that: "governments with large exposures to currency mismatches and interest rate or maturity risks are, of course, particularly vulnerable."

Can the status quo continue? The US must ultimately pay the piper. Max Winkler, who had warned against the excesses of the boom that culminated in the Great Depression, in his book Foreign Bonds: An Autopsy (1933) noted: "The history of government borrowing is really the history of government defaults."