15 March 2009

Debt and sovereignty: another issue for the White Paper

In Climate change and nuclear proliferation I raised an issue that requires serious consideration in the context of the forthcoming Defence White Paper – the issue of how we should respond to the prospect of finding ourselves in an increasingly nuclear-capable world and region.

Here is another, based on consideration together of three issues that might appear to have only weak links to each other, and tenuous links to Australian strategic policy: the global financial crisis, some of the predictable consequences of recovery when it happens, and the impact of debt on sovereignty.

On ABC Radio National’s PM program on Tuesday 10 March, Stephen Long interviewed risk analyst and author Satyajit Das, author of a 2006 paper entitled “The Coming Global Credit Crash”, which highlighted the toxic debts that would poison the global financial system.

Das’s comments in the course of the interview indicate that we can be anything but relaxed about the outlook for the world financial system. The full interview can be found here; selected quotes follow:

I think this is actually the first phase of a major, major problem that will play out to the rest of 2009 and beyond. What we're seeing is money to emerging markets get cut off but a primary reason for that is the major developed nations, like the United States, Great Britain and so forth have to raise somewhere between US$3-trillion and US$4-trillion. The US alone has to raise US$2-trillion, and they have never raised more than about 500, a billion dollars, so that's four times their normal borrowing need. They're squeezing everybody else out of the market.

...Great Britain recently issues 30-year bonds and one dealer to me described this auction as a debacle, as this process unfolds over 2009 we are effectively seeing the US issue between $40-billion and $60-billion of paper every week. And at some point in time there is going to be a problem of demand.

Will people buy it? It depends now on the Chinese and Japanese and these developing countries - their appetite for this paper.

The problem is they themselves are in a position where their surpluses are turning to trade deficits, we've just seen that with Japan. And so under those circumstances, there just isn't the money. So this is the million-dollar question, or the trillion-dollar question – will they be able to get this paper away, or will they have to resort to literally the Zimbabwean option of printing money.

In another contribution in this vein, Kenneth Rogoff, in an article in The Guardian (full article here), says that governments, in trying to sell all this paper, will eventually find themselves paying much higher interest rates. “Within a couple of years, interest rates on long-term US Treasury notes could easily rise 3 to 4%, with interest rates on other governments' paper rising as much, or more”.

He also sees the prospect of sovereign default:

As debt mounts and the recession lingers, we are surely going to see a number of governments try to lighten their load through financial repression, higher inflation, partial default or combinations of all three. Unfortunately, the endgame to the great recession of the 2000s will not be a pretty picture.

Second issue: an inevitable consequence of any sort of economic recovery will be a dramatic rise in oil prices. This will hit the United States hard – the U.S. imports 60 per cent of its oil – and make it harder to service its debt. Oil prices do not hurt everyone, however; they benefit states for which oil and gas loom large in their exports and GDP. These include Russia, Iran, Venezuela, and in our own region, Burma. All of these states, the first three in particular, are problematical to the United States, and it is a wicked problem for Australian strategic policy that economic recovery will in itself create problems for our major ally and at the same time strengthen some of its key adversaries.

The third issue derives from a very interesting article by Clifford G. Gaddy, senior fellow at the Brookings Institution, and Barry W. Ickes, Professor of Economics at Pennsylvania State University, in the latest issue of The National Interest (issue No. 99, Jan/Feb 2009). Entitled Putin's Third Way, the article relates how for eight years Putin pursued two main economic policy imperatives. The first was to set up a system that could maximally exploit the advantages of the market economy while ensuring that the interests of private business owners would always remain subordinate to the strategic interests of the state.

The second priority was to make the Russian economy robust to crisis. Gaddy and Ickes note that when Putin became President in January 2000, Russia had only $8.5 billion in foreign currency reserves, and the government’s external debt was $133 billion. They say:

For Putin, paying off that debt was an imperative if he was to achieve his stated goal of restoring Russia’s status as a sovereign nation. This was the lesson he learned from the collapse of the Soviet Union. For all the underlying weaknesses of the Soviet economy, the USSR did not collapse because it had been defeated militarily. It collapsed because it lost real political sovereignty as a result of losing all financial autonomy.

...In Putin’s view the Russian state must never again surrender its autonomy to foreign interests. The state must have the financial reserves to withstand any future crisis.

The article recounts how Putin set out to achieve this, and the outcome: by mid-2008 Russia had almost $600 billion in foreign currency reserves, much of it in the form of U.S. Government securities. Russia had joined China and Japan as a leading financier of the U.S. current account deficit.

To summarise these issues in the context of the Australian Defence White Paper:

- The United States has to raise prodigious amounts of debt – in unprecedented quantities, at a time when the UK and many continental Europeans are also borrowing prodigiously

- The process of raising that amount of debt will force up interest rates and make it harder to pay off

- The situation raises the prospect of sovereign defaults

- Any kind of recovery will force up oil prices, adding to the economic difficulties of the - United States, but placing large additional revenues in the hands of Russia, Iran and Venezuela

- As astute and determined a political leader as Vladimir Putin at least recognises the connection between sovereign debt and national sovereignty. It is to be hoped that Western leaders will get the message some time, but on current form they are unlikely in the foreseeable future to have the economic opportunity or the political will to take the measures that would be necessary to reverse the current situation. Any government that attempted to do so would be out of office.

What all this indicates is that there is in train a massive realignment of global economic, political and military power, and hence a fundamental transformation of Australia’s strategic circumstances. What we are seeing is not a blip in the story of Western dominance of a process of endless economic growth, with a return to “normal” in a year or two’s time – it is a fundamental change. There is no “normal”, there will be no going back to the status quo ante.

So to turn to the question posed by Cameron Stewart in his article “Money or the big guns” in the Weekend Australian of 14-15 March:

As election promises are being shredded routinely by the dire economic circumstances, taxpayers are entitled to ask the Government to explain more clearly why defence spending should remain sacrosanct. What are the strategic circumstances that justify treating defence as a sacred cow in such grim times?

This a fair question. My answer to it would be that grim and unpredictable things happen in grim times. The Australian public can have as much defence as it is prepared to pay for, and it is at times like these that the nation’s leaders should be thinking very carefully about how much defence capability they can afford not to have.

Hopefully the White Paper will present us with some convincing answers.

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