Are we about to witness the demise of the dollar?

SERIOUS MONEY:The US is almost certain to adopt policies that will undermine the dollar, writes CHARLIE FELL

ORESTES, A Roman politician who held the most powerful position of master of the soldiers, was captured and killed by the Germanic general Odoacer on this day in AD 476.

Odoacer deposed Romulus Augustus, the 14-year-old son of Orestes, in the days that followed and condemned the last western Roman emperor to exile in Campania. Odoacer renounced the title of emperor and officially became the first Germanic king of Italy. The western Roman empire was at an end and Europe plunged into the Dark Ages.

The decay of Rome was well under way by the third century and received a serious blow following the decision by Constantine I in AD 330to take up residence in Constantinople.

Throughout the fifth century, the empire’s territories in western Europe succumbed to the invasions of the barbarians.

Barter became increasingly common as there was little use for money amid the terror and ravages of the early years of the Dark Ages. The Roman solidus, the empire’s common currency, disappeared from sight.

Fast forward to today and the US’s fiscal train wreck has resulted in prestigious investors such as Warren Buffett questioning whether the same fate awaits the dollar.

The White House said on Tuesday that the federal government could face a cumulative budget deficit of more than $9 trillion (€6.3 trillion), which adds $2 trillion to the projections made earlier in the year.

The deficit for the current fiscal year to September 30th is forecast to be smaller than expected at $1.58 trillion or more than 11 per cent of gross domestic product (GDP). But deficits for the remaining years to 2019 are projected to be larger than originally forecast. The budget gap is expected to be $1.5 trillion, or more than 10 per cent of GDP in 2010, and $1.1 trillion, or 7.4 per cent of GDP, in 2011.

The red ink continues in the following years, with federal deficits likely to average 6 per cent a year to 2019, contributing to a doubling in the outstanding debt held by the public to more than 80 per cent. Standard analysis suggests that a one percentage point sustained increase in the debt-to-GDP ratio increases real long-term interest rates by five basis points.

The projected increase in outstanding debt could, all else being equal, result in a two percentage point increase in the equilibrium real yield on 10-year Treasuries.

The US’s fiscal position is even more concerning if you accept the calculations of Laurence Kotlikoff, professor of economics at Boston University. He believes the real liability facing the US government is $70 trillion, which represents the present value difference between all the government’s projected future spending obligations and all its projected future tax receipts.

This fiscal gap takes into account the need to service not only official debt but also the government’s unofficial debts, including its obligation to pay the social security and Medicare benefits of the soon-to-be-retired baby boomers.

The figure becomes even more alarming given that it does not include the value of contingent government liabilities and depends on relatively optimistic assumptions in relation to increases in longevity over time and federal healthcare expenditures.

The US is almost certain to adopt policies that undermine the dollar and the domestic value of dollar-denominated assets in the face of this dire fiscal position.

However, most investors dismiss the likely consequences of rising deficits and debts as insignificant, while some look to the recent Japanese experience where large deficits increased government debt to 160 per cent of GDP with little tangible effect on interest rates.

The comparison with Japan is misguided. Japan, unlike the US and its persistent external deficits, ran large current account surpluses averaging 3 per cent of GDP, which meant it had no need to depend on the kindness of strangers or capital inflows to finance its deteriorating fiscal position. And while nominal yields remained low due to continued deflation, real 10-year Japanese government bond yields averaged 1.7 per cent during the deflationary decade, or almost 150 basis points higher than the annual real growth rates recorded over the same period.

It is clear that investors demanded a significant premium to compensate for the increased default, while the higher real rates boosted debt-servicing costs and aggravated the already deteriorating fiscal position.

The US exhibits signs of emerging from the deepest and most protracted recession since the 1930s. However, the output gap is approaching 8 per cent of GDP such that inflation risks are minimal in the face of substantial excess capacity and surplus labour.

But the fiscal train wreck is approaching fast and politicians do not have the stomach to take corrective action in the short term, increasing the probability of inflationary policies later.

Could this spell the demise of the dollar? Time will tell, though the possible outcomes should be considered now.