Ning Liufu: Choosing the Trench over the Abyss - Reflections on Rereading the Book of The Real Crash

—By Ning Liufu (Assistant Researcher, Institute of American and European Studies, China Center for International Economic Exchanges) 

In the scorching heat of August, the deadliest wildfire in a century ravaged Hawaii, shocking the world. Meanwhile, another invisible wildfire continued to burn in the United States.

On August 1st, international rating agency Fitch downgraded the long-term foreign-currency issuer default rating of the United States from AAA to AA+. This marked the first time Fitch had downgraded the U.S. since it first issued credit ratings in 1994 and the second time a mainstream rating agency had downgraded U.S. sovereign credit since the downgrade by S&P in August 2011. On August 7th, Moody's downgraded the credit ratings of 10 small and medium-sized banks in the U.S., placed the credit ratings of six larger banks on potential downgrade watch, and changed the outlook for 11 major banks from stable to negative.

As is well known, sovereign credit rating is an assessment by credit rating agencies of a country's government's willingness and ability to meet its debt obligations. It has profound implications for a country's financing costs, credibility, economic stability, and financial health. The United States, as the world's leading economy and the issuer of the most significant reserve currency, losing its AAA rating means it no longer has the "highest credit quality" and "very strong capacity" to fulfill financial obligations. Coupled with the unresolved crisis in U.S. small and medium-sized banks earlier in the year, one crisis has not yet subsided before another quickly reignited, rapidly reigniting global concerns about the U.S. fiscal and financial condition, debt-servicing ability, and global financial stability.

At this moment, an "old book" published ten years ago has reappeared in the author's field of view. This is Peter Schiff's "The Real Crash: America's Coming Bankruptcy – How to Save Yourself and Your Country." Peter Schiff's core argument is that the United States is fundamentally incapable of repaying its massive debt and must undergo debt restructuring. He believes that "the chronic illness of the U.S. economy is excessive consumption brought about by debt financing, and to cure this illness, a recession may be necessary," and "a painful but limited recession can prevent an overly catastrophic collapse."

Following Schiff's logic, the author wants to discuss two aspects: the debt situation in the United States and the prospects for a debt crisis, and the way out of the U.S. debt problem.

The debt problem in the United States is indeed very serious. Data from the "National Debt Clock" shows that the total public debt of the United States has exceeded $32.7 trillion, equivalent to a debt burden of $97,566 per U.S. citizen or $253,686 per taxpayer. Federal debt accounts for the vast majority of U.S. public debt, reaching $30.84 trillion in 2022, representing 121% of U.S. GDP. Although it has slightly fallen from the historical record of 127.74% set in 2020, it is still higher than the record high of 119% maintained since 1946. In terms of the proportion of government debt to GDP, the United States is among the top ten countries globally with the heaviest debt burden, along with Japan, Venezuela, Sudan, Greece, Singapore, Eritrea, Lebanon, Italy, and Cape Verde.

However, at present, the United States is not facing an imminent debt crisis or a debt trap like Venezuela or Lebanon, and the collapse that Schiff is concerned about has not yet arrived. There are three main reasons for this: firstly, the United States is the issuer of the major reserve currency, and the debt is mostly denominated in its own currency. Unlike emerging markets and developing economies facing a shortage of dollars, the mechanism for the formation of a debt crisis is different. Secondly, the current U.S. economy shows strong resilience. Economic growth is the most effective and sustainable way to alleviate debt pressure. Thirdly, the United States has just experienced the highest inflation since the late 1970s, and current inflation is still above 3%. While inflation is generally unwelcome, it is good news for relieving debt pressure.

However, looking ahead, the outlook for the U.S. debt situation is not optimistic. Fitch's downgrade of the U.S. rating cited reasons such as the expected deterioration of the U.S. government's fiscal situation and the increase in overall debt burden over the next three years, as well as the "governance weakening" reflected in the political deadlock over the debt ceiling. Internally, U.S. fiscal expenditures continue to rise. Statutory expenditure items, including Social Security, Medicare, Medicaid, income support, pensions, and disability payments, have consistently accounted for more than half of U.S. fiscal expenditures. Since the pandemic, the rigid characteristics of expenditures have become more apparent. At the same time, federal debt interest reached $475.9 billion in 2022, a historic high. On autonomous expenditure items, military spending has continued to rise significantly under the drive to maintain hegemonic motives. Coupled with the large-scale industrial subsidies for semiconductors, new energy vehicles, and clean energy starting in 2022, the growth momentum even surpasses statutory expenditure items. With fiscal expenditures accelerating and revenue growth lagging, and the Democratic government emphasizing increased spending while the Republican government is keen on tax cuts, the fiscal situation in the United States is deteriorating, relying on debt issuance to cover fiscal deficits, and the debt scale continues to rise. The U.S. Congressional Budget Office predicts that U.S. debt will increase to $52 trillion by 2033.

Externally, the U.S. debt financing model is becoming increasingly unsustainable, and the credit of U.S. bonds is being eroded. This can be seen from at least two indicators. In the second quarter of 2020, the proportion of U.S. federal debt held by foreign and international investors relative to U.S. GDP reached a historic high of 35.91%. Since then, this proportion has generally been on a downward trend, reaching 28% in the fourth quarter of 2022, an unprecedented decline in both magnitude and speed. Another indicator is the yield on 10-year U.S. Treasury bonds, influenced by factors such as benchmark interest rates, future inflation expectations, and the maturity structure of government bonds. It is closely related to investors' return requirements or assessments of risk. Currently, this yield is at its highest level since October 2007. Former U.S. Treasury Secretary Summers predicts that the average yield on 10-year U.S. Treasury bonds will reach 4.75% over the next 10 years, and U.S. banks even claim that 5% will become the new normal. These all indicate a growing lack of trust in U.S. bonds. U.S. bonds, known as "golden bonds," are hailed as the safest assets globally and serve as the "anchor of global asset pricing." Changes in the attractiveness and status of U.S. bonds are shaking the foundation of the U.S. dollar reflux mechanism built on U.S. bonds, and the foundation of U.S. dollar hegemony is being shaken.

At the same time, the United States is imposing sanctions on other countries, especially unilaterally freezing the US dollar reserves of countries such as Afghanistan, Iran, and Russia, severely damaging the credibility of the US dollar. Many countries are forced to "de-dollarization" to protect their financial security. One manifestation is the decreasing share of the US dollar in global foreign exchange reserves. In the fourth quarter of 2020, the US dollar's share dropped to the lowest level in 25 years, reaching 59%, and it remained at this level in the first quarter of 2023. Another notable development is the global central banks' purchase of gold. After the collapse of the Bretton Woods system, gold began the process of "de-monetization." From 1989 to 2009, central banks globally continuously net sold gold. Starting in 2010, global central banks became net buyers of gold for the first time. In 2022, global central banks made a net purchase of 1136 tons of gold, the highest record since 1950. Although this does not mean the overnight loss of the US dollar's dominant position, as Schiff stated in the book, "when the world no longer trusts the currency and credit of the United States, the real collapse will be imminent." The relationship between the US dollar and US bonds is like skin and fur, with the skin gone, to what can the hair attach itself?

Returning to the second question mentioned earlier, Schiff, as a Wall Street investment giant, has an extremely forward-looking perspective, able to see future scenarios that ordinary people cannot see or are unwilling to face. In the book, he describes the US debt problem as "the US economy and government sitting in a completely out-of-control car, accelerating continuously, sliding towards the icy and chilling abyss." Faced with this situation, he believes that the United States has three choices: first, "pretend to be calm, pretend that it can still repay the debt as promised," second, "escape the pain of debt repayment through inflation, but the United States will face the threat of malignant inflation"; third, "do everything possible to control this car," "turn the steering wheel, adjust the direction, choose a ditch that can still survive," "prepare for the imminent impact." Schiff believes that the third option is the best choice, actively defaulting on debt, implementing debt restructuring, making the US government, as the "chief evildoer," "return to the basics," and "implement large-scale streamlining." It is evident that Schiff's prescription is a typical proposition of the Austrian School, advocating the "small government" philosophy, believing that the "free market is the key to solving problems." From the perspective of the United States, in the context of rising populism, severe party political polarization, and the dominance of great power competition, Schiff's prescription is too advanced, deviating from the mainstream, and may be difficult for the government to adopt.

For China, Schiff's proposition that "letting the largest creditor of the United States bear some losses is not a bad thing" should be given high attention. Borrowing Schiff's words in the preface of the Chinese version of the book, "significant flaws in economic thinking have led to wrong decisions by the two major countries on both sides of the Pacific." Faced with the US debt expansion model and Schiff's prescription, China needs to have a clear and decisive direction and answer.