U.S. Financial Collapse Is At Hand -- Or Not?

Yesterday we argued that the United States Government had no reason to destroy the US dollar through hyperinflationary money printing. But Paul Craig Roberts, Deputy Secretary to the US Treasury under Ronald Reagan, suggests that no reason for destroying the US dollar is required. Federal Reserve incompetence, US megalomania, and Wall Street greed have combined to create a situation in which the dollar will almost certainly lose its World reserve currency status and in the process much of its value.

Roberts' analysis begins with this question:

How can the Federal Reserve maintain [as it has promised to do for several years more] zero interest rates for banks and negative real interest rates for savers and bond holders when the US government is adding $1.5 trillion to the national debt every year via its budget deficits?

The answer, Roberts gives, is that it cannot do so for very long:

It will not be possible to continue to flood the bond markets with $1.5 trillion in new issues each year when the interest rate on the bonds is less than the rate of inflation. Everyone who purchases a Treasury bond is purchasing a depreciating asset. Moreover, the capital risk of investing in Treasuries is very high. The low interest rate means that the price paid for the bond is very high. A rise in interest rates, which must come sooner or later, will collapse the price of the bonds and inflict capital losses on bond holders, both domestic and foreign.

That the policy is feasible for the time being Roberts attributes to transient factors such as the current focus on the Euro and European sovereign debt and fear among private investors of the equity market, plus collusion by US banks, which "can borrow from the Federal Reserve at zero interest rates and purchase 10-year Treasuries at 2%, thus earning a nominal profit of 2%".

In addition, Roberts asserts, the US banks are keeping up the price of US Treasuries by selling interest rate swaps:

The big banks are positioned to make the Fed’s policy a success. JPMorganChase and other giant-sized banks can drive down Treasury interest rates and, thereby, drive up the prices of bonds, producing a rally, by selling Interest Rate Swaps (IRSwaps).

A financial company that sells IRSwaps is selling an agreement to pay floating interest rates for fixed interest rates. The buyer is purchasing an agreement that requires him to pay a fixed rate of interest in exchange for receiving a floating rate.

The reason for a seller to take the short side of the IRSwap, that is, to pay a floating rate for a fixed rate, is his belief that rates are going to fall. Short-selling can make the rates fall, and thus drive up the prices of Treasuries.

But everyone, including the US banks, Roberts asserts, have an interest in getting out of Treasuries ahead of the crowd when the exodus will become a deluge. What that means is that US Treasuries are bound to crash sooner or later and and, when they do, they will take the dollar with them.

A bond crash will cause a dollar crash because the Fed will be obliged to print dollars to buy up the bonds dumped. Trillions of these newly printed dollars will go to foreign sellers of US assets who will dump them on the foreign exchange markets, thus driving down the dollar's value.

In addition, Roberts suggests, it is not within US power to determine when a trickle of funds out of the bond market turns to a flood.The US, he says, is in the hands of foreign creditors who can unleash a tidal wave of US-dollar-denominated asset sales if sufficiently provoked.China, for example, could drop $2 trillion in US assets.

But, as Roberts admits, dumping US dollar assets will cost China dear, as those assets will lose much of their value before they have all been sold.What's more, dumping US dollar assets will drive down the US dollar renminbi exchange rate, thereby destroying China's largest export market and driving China into recession, if not a socially destabilizing depression.

As for the US banks, they can exit the US bond market without setting off a collapse provided that the Fed buys up the bank-owned bonds for its own portfolio. The dollars that the Fed needs to buy the paper will come back to it as the banks pay down the zero-interest Fed loans with which the bonds were initially purchased.

While, for all I know, the US plan for global financial hegemony may result in the mother-of-all financial collapses, I don't see that that is by any means certain or even likely. By maintaining zero interest rates the US Fed is enabling America's largest corporations to acquire control of much of the World's business, agricultural and real estate assets at zero cost. And if something goes wrong in the process and the dollar collapses in a new gigantic financial crisis, the US will come out of it, as Nazi Germany did after the great inflation, with a vastly more competitive, highly capitalized industrial sector well placed to capture an increased share of World markets.