January 17, 2011

“Full Faith and Credit of the United States” – Time To Take It Seriously!

by Hal Gershowitz

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The 112th Congress of The United States should have one mission above all others as it begins its walk through the pages of history…to protect the full faith and credit of The United States of America.  These are perilous times in which we are feeling our way and, make no mistake about it, we are feeling our way. And as we devalue our currency as we currently are doing by printing more and more of it in order to pay for more and more of what we can’t afford, we are simultaneously devaluing the very essence of the most important guarantee ever devised by man…that we will meet all obligations that are backed by “the full faith and credit of the United States” no matter what.

Just how are we going to do that?  For most of our history through the first third of the 20th century we maintained a pretty firm relationship between the money we printed and gold with which it could be redeemed on demand.  We only deviated from that standard during crises such as wars or economic extremis such as the great depression.  For the most part, the full faith and credit of the United States was good as gold. Not any more.  Now it is as good as people think it is.  That is, its value is as good as the confidence people have in the fiscal management of the country.

The demand for our debt is a pretty good indicator of that confidence and right now that is hard to measure because the Federal Reserve is a major player at every auction for buying our debt. The Fed is, in effect, creating demand that keeps interest rates lower than they would ordinarily be.  That’s making people who are living on the fixed income from a lifetime of savings downright poor or forcing them to invest their savings in riskier investments than they would ordinarily consider.  And for the time being, given the basket case that is so much of Europe, US debt is still considered safer than the debt of most any other nation.

But there have been warning signs that it would be foolhardy to assume that the mere words, full faith and credit of the United States instill, as if by magic, some assurance of high confidence in the credit worthiness of the nation. Within the past year, bond investors were willing to settle for 3.5 basis points less to own Berkshire Hathaway’s debt as compared to U.S. treasuries of similar maturity.  In fact, investors in the bonds of Proctor and Gamble and Johnson & Johnson were also willing to settle for lower yields than U.S. treasuries.  This, according to Jack Malvey, who was the chief fixed-income strategist as Lehman Brothers was an “exceedingly rare event in the history of the bond market.”

Particularly irksome to us is the position the Administration is taking in the current debate to, yet again, raise the $14.3 trillion debt ceiling, which Congress has imposed upon itself.  The Republicans are willing to raise the debt ceiling if the Administration will agree to simultaneously reduce spending going forward to help offset (or reduce) the debt.  That seems to us to be a responsible way to at least attempt to protect the value of the full faith and credit of the United States. The Administration, however, has responded with something akin to “damn the torpedoes, full speed ahead.” Just last week the White House warned Republicans “not to undermine the full faith and credit of the United States,” as though reducing spending going forward was the threat rather than the unbridled spending that is driving the need to raise the debt ceiling.

Every business and most adults understand what is a line of credit.  It is how much others are willing to lend and at what cost based on their perception of one’s ability to repay what they borrow.  Of course, no business or individual has the right to print money to pay its debts as does a sovereign (non-Euro) nation such as The United States.  But if they did, the lender would understand that printing money to settle a debt isn’t an acceptable means of payment.  They, correctly, would understand that the newly printed money simply wouldn’t have the same value as the money they had loaned.  No ordinary borrower can unilaterally decide to raise its debt limit in order to borrow more money to repay debt it doesn’t otherwise have the means to repay.  The government, however, does have that right. If it has borrowed to the limit and can’t meet its obligations, it can (and does) unilaterally raise its debt ceiling and simply borrow more and go merrily on its way.  It can, that is, until those who lend us the money we need say, in effect, “not so fast.”

They do that by demanding a higher return on the treasuries they buy or by diversifying their portfolios out of dollars and into other alternatives.  The worst kept secret in international finance is that the Chinese and the Arabs and the French and the Russians are actively seeking other alternatives to US dollars as the international reserve currency.  China and Russia have already entered into agreements to use their own currencies in trade instead of dollars and French President Nicolas Sarkozy has been outspoken in his criticism of the US dollar as the international reserve currency calling that model “unstable.” Foreign governments hold over $3.12 trillion of US treasuries.  What is worrying these governments now is the possibility that, just as individual owners of Treasury bills are subject to the risk of government mismanagement, they also run the same risk.

Barry Eichengreen, professor of economics at the University of California, Berkeley, warned this week that economic mismanagement, that is, failure to reign in the budget gap could cause a fiscal crisis that “would make the dollar “tank” and that the impact on the international system would not be pretty.”  Blaming both Republicans and Democrats he noted, “2011 will see another $1 trillion deficit. It is hard to imagine that 2012, an election year, will be any different. And the situation only deteriorates after that as the baby boomers retire and health care and pension costs explode.”

Eichengreen continued, “We know just how these kind of fiscal crises play out, Europe having graciously reminded us. Previously sanguine investors wake up one morning to the fact that holding dollars is risky. They fear that the U.S. government, unable to square the budgetary circle, will impose a withholding tax on Treasury bond interest – on Treasury bond interest to foreigners in particular. Bond spreads will shoot up. The dollar will tank with the rush out of the greenback.

The impact on the international system would not be pretty. The Canadian and Australian dollar exchange rates would shoot through the roof. A suddenly strong euro would nip Europe’s recovery in the bud and plunge its economy back into turmoil. Emerging markets like China, reluctant to see their exchange rates move, would see a sharp acceleration of inflation and respond with even more distortionary controls. With exorbitant privilege comes exorbitant responsibility. Responsibility for preventing the international monetary and financial system from descending into chaos rests with the U.S.”

Obligations backed by the full faith and credit of the United States have been the gold standard for credit worthiness. It has, at least until now, always been deserving of the highest debt rating in the world (AAA). But the rating agencies have warned us that the full faith and credit guarantee is not sacrosanct.  As Professor Eichengreen warned, “with exorbitant privilege comes exorbitant responsibility.”  The new 112thCongress has, more than any other Congress in memory, the responsibility and the opportunity to protect the incalculable value inherent in the pledge that US debt is backed by “the full faith and credit of the United States.”  Those words have always had tremendous value. It is this congresses’ responsibility to see that that value is not diminished.

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