A US default could send shockwaves across global markets: US banker
Dr Hani Findakly speaks in an exclusive interview with Reconnaissance Research
KUWAIT: A US default, directly or indirectly through inflation, can emit shockwaves throughout the global markets, disrupting trade, finance, and investments. For as long as the dollar is at the center of global finance, the risk of contagion is high, confirming the old maxim that when the US sneezes, the rest of the world catches a cold, said Dr Hani Findakly, an investment banker and Vice Chairman and Director of Clinton Group Inc, New York, in an interview with Reconnaissance Research. “The dearth of exit options creates a Hobson’s choice as many financial indicators of US debt are fast approaching a red zone. The numbers are alarming, the trends are discomforting, and the solutions are elusive,” Dr Findakly said during the interview. Excerpts from the interview.
Question: How serious is the US Federal budgeting process on the US and the Global markets?
Dr Hani Findakly: The US budgeting process is a very serious issue that has become increasingly intensely political reflecting the deep ideological fissures within the US. These divisions have rendered economic and fiscal policy fully dysfunctional. By 2001 Fiscal Year (which runs from October 1st to September 30th), the Afghanistan and Iraq wars forced the Government to drop all pretense of disclosing the cost of the wars.
Instead, it submitted a ‘continuing budget resolution’, an arcane provisional gimmick, based on prior budgets, which can be violated at will. Under this budgeting process, the equivalent of the military’s ‘Don’t Ask, Don’t Tell’, both the Administration and Congress pretend to be fulfilling their constitutional mandates. Incredibly, this charade has continued for 20 years as the world’s biggest economy ran without a formal budget.
Q: The world’s biggest economy ran without a formal budget?
Dr Findakly: Yes. Meanwhile, profligate spending continued, as Congress approved successive budget ceilings to allow the government to operate. In October 2021, Congress approved a stop gap measure to extend the debt ceiling to $28.5 trillion, barely adequate to fund the government until December when another game of one upmanship will return. While there is high expectation that Congress blinks, as it often does, by finding a short-term solution to the debt ceiling, there is always a risk that a political impasse can one day lead to a catastrophic breakdown of a default on US obligations, including payments of salaries and social programs. A default also has negative implications for the domestic and international markets, and significantly, to the US dollar as a reserve currency.
Q: Have similar situations like this happened before in the US?
Dr Findakly: Yes. Unfortunately, it has happened more often than necessary, ever since Congress first adopted the concept of debt ceiling in 1917. The purpose then was to allow the government to borrow without having to revert to Congress every time it needs money, while keeping an overall constitutionally mandated congressional oversight over the budget. Over the past 50 years, the debt ceiling was raised almost routinely over 80 times. But the process of raising the debt ceiling has turned increasingly contentious, resulting in a series of crises starting in 1995 forcing a threeweeks government shutdown, followed by more shutdowns in 2011, 2013, 2018, and 2019. The increasing frequency of debtextension crises is worrisome, as much because of its implication to the securities markets where US public debt is a key source of liquidity, but because of role of the US dollar as a major instrument of trade, international transactions, and the pricing of international commodities.
Q: What are the possible solutions and what will it take to implement them?
Dr Findakly: This is an intractable problem, deeply embedded into the US system where Congress has the ‘power of the purse’ and the debt has spun out of control. The only way to avoid it, other than a constitutional amendment, which is nearly impossible, there are no feasible short-term solutions. Broadly, there are three ways to ease the debt burden: faster economic growth, higher taxes, or lower spending. While faster growth is possible, the size and maturity of the US economy preclude a sustainably high growth. Raising taxes, as the third rail in American politics, is a major challenge in a combustive political atmosphere and corrupt powerful interests. Finally, cutting spending is nearly impossible since discretionary spending constitutes only 30 percent of the Federal budget of $1.5 trillion, half of it is defense. The nondiscretionary spending now absorbs 62 percent of the budget (29 percent in 1969) including 48 percent for social security and healthcare (19 percent in 1969), and 8 percent for interest payment.
Aging population and the future cost of medical care for several million veterans of the Afghanistan and Iraq wars, estimated at $4-6 trillion, will keep the cost of the social safety net programs high for decades.
Absence of a major reduction in defense spending (America’s sacred cow), there is little room to cut spending as red ink will endure. A conceivably palatable solution to the political elite in the near term is to allow inflation to rise at a faster rate. By inflating our way out of this dilemma, real spending and the real value of the debt will shrink, offering some short-term optical relief, but potentially creating more problems in the long term. This solution was adopted in the mid-1970s after the Vietnam war that ultimately caused a series of economic crises including the breakdown of the Bretton Woods system where the US dollar fixed convertibility into gold was abandoned leading to a major devaluation of the US dollar against the Japanese Yen and major European currencies (save for the UK). It is not inconceivable that a similarly unwise option may be contemplated again, adding further uncertainty into the post-COVID-19 economy.
Q: Who might gain or lose from this matter?
Dr Findakly: There are no major winners. First, since most financial crises arise out of excessive debt, uncertainty over default could stress the credit markets and snowball into a 2007-type crisis. Second, a cycle of inflation and devaluation could undermine the banking system as the prospect of rising defaults curtails lending and investments. Third, currency and market instability will impact developing countries who could struggle to finance their debt as well as shrinking demand for their products. Fourth, the prospect of higher inflation discourages savings and investments, slowing economic growth. Fifth, the US-China standoff can deepen the fissures in the global economy, aggravate geopolitical tensions and increase the likelihood for accidental conflicts. Sixth, economic crises hit the poor the hardest, thereby widening an already bad economic inequity. While there may well be certain marginal winners, e.g., large borrowers who will pay back in depreciated money, and possibly some geopolitical winners, e.g., China, the dynamics of any crisis often produce unpredictable consequences.
Q: What else keeps you awake at night?
Dr Findakly: Debt! It is a ticking timebomb. Historically, every systemic financial crisis has been rooted in excessive debt and leverage. For a perspective on the rise of US public debt, consider that US federal debt was at an interim high of $250 billion in 1945, which in current Dollars equals to $3.8 trillion. Today, US debt is $28.3 trillion or 7.5 times its 1945 real value. While interest on the debt remains low at around 1.5 percent of GDP, because of the low and negative real interest rates, an anticipated rise in rates could raise the cost of borrowing significantly. A 1 percent rise in interest rates could raise the annual interest on the public debt by $285 billion. Already, the staggering fiscal deficit of $3 trillion in FY2020, will top $3.7 trillion in FY2022, or 15 percent of
GDP. Meanwhile, low interest rates and fear of inflation have unleashed a borrowing binge that has catapulted household debt to a record $16 trillion, while non-financial corporate debt reached $12 trillion. Excluding unfunded liabilities, overall US debt exceeds $56.5trillion, or 2.5 times GDP. Repaying this mountain of debt under persistent twin fiscal and current account deficits is a Herculean task.
Q: What is needed then?
Dr Findakly: It requires draconian measures and a consensus on priorities that the US political system lacks. Although US debt is in US dollars, a quarter of it, or $7 trillion, is held by central banks, including 15 percent of which held by China. Therefore, a US default, directly or indirectly through inflation, can emit shockwaves throughout the global markets, disrupting trade, finance, and investments. For as long as the Dollar is at the center of global finance, the risk of contagion is high, confirming the old maxim that when the US sneezes, the rest of the world catches a cold. The dearth of exit options creates a Hobson’s choice as many financial indicators of US debt are fast approaching a red zone. The numbers are alarming, the trends are discomforting, and the solutions are elusive.
Note: Dr Hani Findakly is Vice Chairman and Director of Clinton Group Inc, an investment management firm in New York. He is a graduate of Baghdad University (BSc, Magna Cum Laude), and the Massachusetts Institute of Technology (MIT): Master of Science (SM, Systems Analysis) and Doctor of Science (ScD, Decision Theory).