Alex Lo
SCMP Columnist
My Take
by Alex Lo
My Take
by Alex Lo

The end of the dollar-based US empire will be a self-inflicted blow

  • The recurrent fights over America’s debt ceiling – which determines the US government’s ability to honour its debt, raise money and pay its bills – is about the most decadent sign of political decay and decline there is. Effectively, the US is threatening to financially sanction itself

In Game of Thrones, HBO’s smash hit series spanning almost the past decade, there was a common saying: “A Lannister always pays his debts.” The line was so important and epitomised House Lannister that it even warranted its own sombre musical theme in the series.

Since this dominant house was famous or infamous for its cunning and ruthlessness, the Lannisters did not honour their debts out of honesty and goodness. They understood that their reputation – what we might call creditworthiness – was the foundation of their power and dominance: they could borrow cheaply, whenever and as much as they wanted, to do whatever they liked.

The American government has been in a similar situation since the end of World War II; this has been called the “exorbitant privilege”. So why some US politicians would now want to threaten that special status, is indeed puzzling to outsiders. They are undermining their dollar supremacy, which ultimately underpins the United States’ global hegemony. They may again prove right a well-known observation by historian Arnold Toynbee, according to whom great states and civilisations do not die by murder but by suicide.

The most obvious self-inflicted injury in the US today is the ritual debate in Washington over the so-called debt ceiling. There ought to be no debate about the absolute commitment of the US government to honour its debts, but now they do, thanks to the Republicans. Many people brush it off, dismissing it as “just Washington politicians playing politics”. But imagine how the storyline of Game of Thrones might develop if a few Lannisters, say, Tyrion, who for a while was a drunk and a womaniser, and Joffrey, a sadistic narcissist, periodically threatened not to pay up.

OK, that’s the explanation for the 10-year-old me. I ask this same question about US sovereign debt, usually called US treasuries, of an engineering friend with an MBA from INSEAD. He offers a more technical explanation by sending me this equation:

ERi = Rf+βi(ERm−Rf) where: ERi = expected return of investment; Rf = risk-free rate; βi = beta or volatility of the investment; and (ERm−Rf) = market risk premium.

I have no idea what it means. The more financially and mathematically literate readers will know it. It’s the formula for the Capital Asset Pricing Model (CAPM) used to calculate the risks and expected returns of an investable asset that underpins much of modern finance.

But what you need to pay attention to here is Rf or the risk-free rate. To use this model, you need a risk-free benchmark. And that benchmark, no surprise here, is often US treasuries. Remember the Lannisters? They always pay their debts, they never default; they are risk-free, so far as their creditors are concerned. But are they?

Here is why you want to be considered risk-free and run the world’s dominant reserve currency. As the late political economist and international relations theorist Robert Gilpin wrote: “American hegemony has been based on the role of the dollar in the international monetary system … The United States must have the foreign exchange to finance its global position, which has involved the stationing of troops overseas, the fighting of major wars … and other costs.

“These economic burdens of global hegemony have been achieved in large part through taking advantage of the international position of the dollar … The price has been the transformation of the United States from a creditor into a debtor nation …”

In effect, the world has been lending to the US to dominate them! If I were to write a book, I would title it, “Financial Sadomasochism: How the World Bends over for Uncle Sam”.

The erosion of the status of US sovereign debt as risk-free would upend the entire global financial system. But the US has repeatedly undermined the security of its own dollar position. First it destroyed the “Bretton Woods” fixed system of international exchange rates by de-pegging the greenback from gold. Once, the US dollar really was as good as gold, even better, until Richard Nixon came along.

The dollar survived and retained its global dominance, even in a “non-system”, or the chaos of freely exchangeable rates.

Then came the last financial crisis, and the US government’s debt rating dropped. The economist Eswar Prasad wrote: “One of the countries that lost its AAA rating is the US. Standard and Poor’s downgrade of US sovereign debt from AAA to AA+ does not seem to have had much effect on the perception of its debt as a safe asset. For other countries, such a downgrade matters more and often takes their debt out of the safe asset category.”

In a class full of academically challenged students, a merely mediocre one can look like a genius. If other sovereign debts look unsafe or at least are less liquid, US treasuries are still your best bet. In fact, that’s what Prasad meant by the title of his 2014 book, The Dollar Trap: How the US dollar Tightened its Grip on Global Finance. It’s all relative.

But it’s not true that the US dollar has not been damaged by the serious blows. Over the decades, Prasad wrote, “the dollar’s roles as a unit of account and a medium of exchange” are being eroded. “Its true forte is as a store of value,” he wrote, and hence the perceived safety of US government debt.

But guess what? At the height of the global financial crisis triggered by the US property market implosion, Republicans in 2011 found a new way to mess with the Democrats and their president, Barack Obama. They threatened not to raise the debt ceiling. Brinkmanship lasted till the very last minute. That confrontation, more than anything else, led to the decision of S&P to lower Washington’s sovereign debt rating. Imagine what might happen: the US Treasury Department wouldn’t be able to raise money from the financial markets and make interest payments, and the US government couldn’t pay its bills. Effectively, the US would be financially sanctioning itself, and that’s what the American political class has been periodically threatening to do.

Since then, Republicans have made this confrontation a regular ritual, for short-term political gains, while risking the financial credibility of their own government. Last week, the US House of Representatives approved a short-term increase in the debt ceiling, thereby averting a debt default that could have come as early as this week. But it comes with a new deadline in early December when default will again threaten.

If this is not what Francis Fukuyama calls “political decay”, or what others call “hegemonic decline”, I don’t know what is.