How This Recession Could Change the World

November 18, 2008 | From

The falling price of oil, China’s stimulus plan, and a developing U.S. bond market massacre. Say goodbye to America’s high standard of living.

Robert Morley

Your gas tank has probably noticed the return to lower prices. It is easier to keep it full at only $2.50 a gallon. That is a welcomed respite: More money in your pocket, more frequent trips to the grocery store, less guilt about driving the family suv.

That’s great. But did you know that lower oil prices may set events in motion that will have a much bigger impact on your wallet than a few dollars off at the tank? There is an unexpected side effect of today’s breathe-easier gas prices—and it is a big one.

As expensive as $147-per-barrel oil was for consumers, and as bad as that was for the economy in general, believe it or not, it was a bit of a blessing for the U.S. government. As U.S. consumers sent hundreds of billions of dollars to oil exporters such as Saudi Arabia, Kuwait, Nigeria and others, these countries recycled large portions of those dollars into the United States by lending them to the federal government. They did this by purchasing U.S. treasuries and other U.S. agency debt, such as Fannie Mae and Freddie Mac bonds.

This oil-dollar recycling had one huge short-term benefit for Americans: It helped keep interest rates low. The government had no need to raise interest rates to attract lenders since oil exporters (as well as Asian manufacturers) provided an ample supply of credit to the U.S. government. The willingness and ability of foreigners to lend is incredibly important to America, since the U.S. is the world’s largest borrower. In each of the past two years, Washington borrowed about $550 billion from foreigners.

Low interest rates have been the foundation of America’s economic model. This model—also known as the “borrow and spend model”—has fueled America’s economic growth as the nation has transformed from a manufacturing to a service-oriented, consumer economy.

Low interest rates help boost consumer spending, corporate expansion, mergers and acquisitions, new businesses start-ups, construction, exploration, and research and development—over the short term. In general terms: the lower the interest rate, the greater the quantity of money available for people and businesses.

And America is hooked on cheap credit. If you look at a graph of interest rates, you will find that over recent years, when America attempts to raise rates, it has the effect of sending the economy into a tailspin. That is why the economy is now often called a bubble economy. If you raise the rates—reduce people’s ability to borrow—you pop the bubble.

However, now that oil prices have plunged 62 percent from their highs, there is a whole lot less oil money around to lend to Washington. That could have serious implications for interest rates in the U.S. According to the Treasury Department, oil-exporting nations as a group hold about $180 billion in Treasury debt, making them the third-largest holders, as of August. However, oil exporters probably hold hundreds of billions more worth of Treasury debt, since Caribbean Banking Centers, Luxembourg, and the United Kingdom are known for acting as banking middlemen, thus obscuring who really owns Uncle Sam’s obligations.

Yet, if it was just oil exporters potentially slowing their purchases of U.S. treasuries and other agency debt, it is possible America could find lenders elsewhere. But the reality is that the whole world is now facing difficult economic conditions.

America’s other lenders are tightening their belts too.

Consider China, America’s second-largest lender. China holds $541 billion in U.S. treasuries. In recent years, China has become the single most important lender to the United States.

Many people think that China can’t stop lending to the States. Some analysts feel that if the Chinese ever cut America off, it would be equivalent to cutting their own throats, since Americans wouldn’t have any money to purchase Chinese goods. But due to current economic conditions at home, China’s hand may be forced. As times get tougher, Chinese politicians will choose the immediate welfare of their people over lending to America.

China’s recently announced $586 billion stimulus plan may be a step in that direction. In relation to the size of its economy, the package dwarfs America’s $700 billion bank bailout. The equivalent would be akin to spending $3 trillion here in America. China says it will use the money to build infrastructure and create jobs.

“Unlike America, China is unlikely to borrow to finance its stimulus package,” says Euro Pacific Capital senior market strategist John Brown. “Indeed, it is likely to spend its own national earnings rather than continue to invest in U.S. treasuries” (emphasis mine throughout). China’s $586 billion is money that may no longer be available to America. “Worse still, China might even begin to sell part of its massive holdings of … U.S. treasuries,” says Brown. “However it is financed, China’s stimulus packages is decidedly bad news for America.”

According to analyst Morgan Housel, the thought of China reducing lending to America—or worse, selling portions of its U.S. debt holdings—should make you quiver. “Not unlike the over-leveraged financial companies pinned up against a wall in recent months, the U.S. relies on the kindness of strangers to fund its insane dependence on debt. As Wall Street learned in the past two months, things go downhill quickly once those strangers shift their priorities from lending to hoarding.”

Housel says the bigger concern for America isn’t that the economic crisis is spreading, but that like China, other countries “may place less importance on plowing hard-earned surpluses into the U.S., and focus more on their domestic dilemmas.” Already, Japan, Germany, and others have announced stimulus plans of their own.

So if the oil exporters have less money to lend and the Chinese have less money to lend and the whole world has less money to lend, how is America going to get the money to fund its grandiose stimulus packages? Estimates suggest America will need to borrow $1.4 trillion in 2009! That is more than three times as much as America borrowed last year.

If America expects to borrow the money, it may have to significantly raise interest rates to attract lenders. And this realization could send the streets into a Treasury bond market massacre.

America’s foreign creditors may be about to get burned. When the government raises the interest rates that its newly issued bonds yield, it has the effect of devaluing the worth of all existing bonds. All those people who previously lent money to the U.S. will instantly be left holding less-valuable bonds.

A bond market crash becomes all the more real when you consider recent headlines suggesting that because of all the extra debt the government will be taking on, the U.S. may be on course to lose its triple-A credit rating. A credit downgrade will similarly gut the value of existing U.S. treasuries.

The odds that America will tighten its belt by reducing spending, slashing services, and hiking taxes is remote—after all, stimulus packages are about spending more, not less.

When you consider America’s growing debt load, the under-funded Social Security, Medicare and Medicaid liabilities, and the slowing global economy, you are looking at a looming bond market massacre of the ages.

And when the bond market crash alienates our foreign lenders, how then will America borrow the money it needs each day to keep functioning?

That is the take-home message: Foreign indebtedness, coupled with chronically living beyond our means, is crippling America. “The U.S. is so vulnerable, its true condition is indescribable,” says economic analyst Jim Willie.

As the Bible warns: “And it shall be, as with the people, so with the priest; as with the servant, so with his master; as with the maid, so with her mistress; as with the buyer, so with the seller; as with the lender, so with the borrower; as with the taker of usury, so with the giver of usury to him. The land shall be utterly emptied, and utterly spoiled … because they have transgressed the laws …. Therefore hath the curse devoured the earth, and they that dwell therein are desolate” (Isaiah 24:2-6).

The days of borrowing to spend are coming to an end.

For insight into the new economic system that will soon replace the current system, read Joel Hilliker’s article “A Suggestion for Correcting the Economy.” •

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