Three related events were reported two weeks ago. At first they may seem unrelated.
First, the U.S. government ran up a deficit of more than $137 billion in November, raising the fiscal 2012 deficit (ending Sept. 31) to $1.1 trillion, and our national debt to $15.125 trillion which is approximately equal to our annual gross domestic product.
Second, the annual interest rate on the 10-year bonds which the government sells to keep going fell to an historic low of less than 2 percent. Considering inflation, this is negative interest.
Third, the Chinese and Japanese governments announced an agreement to accept one another's currencies in trade and investment transactions. Japan also agreed to purchase $10 billion of Chinese government bonds to add to its foreign exchange reserves.
The relationship among these events is admittedly not immediately apparent, but it could be of immense long-term importance to the U.S.
Consider that no lender, nation or otherwise, should be able to borrow for 10 years at a real negative interest rate if it is outspending its income by over a trillion dollars a year and is over $15 trillion in debt. Then why can we do it?
A significant part of the answer rests in the international trade, currency and currency reserve systems. Both governmental and private international transactions require something that is generally accepted and easy to use in trillions of dollars worth of payment and in investment transactions.
Wampum is out of style. We are off the gold standard. Solid currencies like the Canadian and Australian dollars are not abundant enough to provide liquidity. The Euro is in severe doubt. Commodities are in limited supply and are volatile. Thus, the U.S. dollar is the best of a sorry lot and retains its position as the world reserve and transaction concurrency because nothing else is better.
Since the U.S. dollar is currently recognized as the only alternative, lenders and investors are willing to hold dollars and dollar-denominated debt because they believe U.S. dollars will be accepted by others as currency reserves and in trade and financial transactions. Therefore, the U.S. dollar is in demand for functional reasons aside from the underlying strength of the U.S. economy. It is to a large extent a matter of necessity and faith rather than credit worthiness.
Enter the China-Japan agreement. These countries have the second- and third-largest world economies. They have historically used the U.S. dollar to settle cross-border transactions. Their recent agreement could in time, along with similar agreements China has negotiated with smaller Asian countries, lead to a sharp decline in the demand for the dollar. It could create an alternative to the dollar as a reserve and transaction currency.
If this occurs, the value of the dollar would fall closer to its intrinsic value and the interest rates on our bonds would escalate sharply. Our whole leveraged government fiscal house of cards could collapse with frightening consequences for our country.
There is an antidote. Reduce government spending and get our house in order so the economy stands on its own feet without the meretricious support of borrowing at rates not truly reflective of our financial strength. But, will you vote for candidates who will do this?
Letson is an attorney in Warren. He previously was general counsel of the U.S. Department of Commerce. He also was vice president and general counsel of Westinghouse Electric Corp.