Americans suffering from an immediate gratification fix should really monitor their decisions when they are restless. When feeling restless, they may decide to sell their house and buy a bigger, more expensive one. Then, they could easily take some cash out – or simply a draw-down on their home equity loan - and go shopping until they drop! Foreign goods fly off the shelves at patriotic stores like Wal-Mart, sending more dollars to China for goods we have imported. These dollars get stuffed into government securities – in the United States and elsewhere – where they wait to get spent.

How much of this is actually going on?

But wait, there’s more! The United States government is running federal deficits of over $400 billion a year, and we’re not alone. As reported by the Financial Times, JP Morgan Chase estimates that global government bond supply will be $2,320 billion, up two-thirds from 2001!

This insatiable need to borrow by governments and American households totally overwhelms the world’s savings. So, where is all the money we are borrowing coming from? Thank the accommodative central banks. (See table below):

It works something like this: Central banks create new money by buying something. The central banks almost always buy their own government debt, or debt of another country, theoretically printing money out of thin air (for a central bank to have a ‘reserve’ it must buy the debt of some other country). Foreign central banks own $280 billion worth of securities issued by United States’ government agencies – go Fannie Mae! The Federal Reserve, as an example, holds United States’ government and agency debt in custody for foreign central banks.

We are looking at a mutual back scratching of world central banks printing up new money, the likes of which the world has never seen before! Will it ever end?

As long as commercial banks continue to offer home equity lines of credit, issue credit cards to anyone regardless of age or credit worthiness, and finance companies that are cash-flow-negative with more high-yield debt, this party will continue. Borrowing by the government and consumers creates new money and spending which “makes the world go ‘round.” Over the last decade, every world central bank has remained accommodative to America’s willingness to borrow and spend without limit. Indeed, while the war in Iraq has already cost $300 billion, it's all been paid for by foreign central banks printing up fresh cash and handing the new money to the United States Treasury in return for those quaint treasury bills and bonds. Meanwhile, over-spending in the United States has created a $650 billion trade deficit that threatens the very existence of the dollar as the world reserve currency.

The Federal Reserve realizes that if they raise interest rates to stabilize the dollar – by making its yield more attractive on dollar investments, as well as lowering the trade deficit – serious pain will be inflicted. Rising interest rates will crunch real estate sales as fewer consumers will be able to afford to pay current outrageous prices for housing, and service mortgages with higher monthly payments. Moreover, the burden of servicing consumer and home equity loans – whose costs are tied to rising short-term interest rates – will squeeze the American household even further. More money for debt service means less to spend on domestic and foreign goods.

If and when the Federal Reserve starts the “big squeeze” to save the dollar, the trade deficit will come down. However, if the dollar rallies, American companies will become less competitive just when the consumer is feeling strapped financially and spending less. In addition, our trading partners will not be happy that the free ride on America is over. When 40 percent of S&P corporate profits are related to financing, higher interest rates do not bode well for corporate profits. Moreover, rising interest rates would inevitably impact the price of stocks, bonds and housing.

Perhaps investors should start paying closer attention to the statements and actions of the Federal Reserve governors. The question is “will central banks stay super easy or will they start acting like adults at the end of a wild party?"

© 2005 Richard Benson
Specialty Finance Group
Benson's Economic & Market Trends
Editorial Archive  l  www.sfgroup.org

About the Author:
Richard Benson is a widely-published author on securitization and specialty finance, and a sought-after speaker at financing conferences on raising equity for mid-market companies. Before founding the Specialty Finance Group in 1989, Mr. Benson acted as a trading desk economist for Chase Manhattan Bank in the early 1980s, started in the securitization business in 1983 at Bear Steams, and helped build the early securitization businesses at Citibank and E F Hutton. Mr. Benson graduated from the University of Wisconsin in 1970 in the Honors Program in Math, and did his doctoral work in Economics at Harvard University. He is a member of the Harvard Club of New York and Palm Beach. The Specialty Finance Group, LLC is a Florida Limited Liability Company and is registered with the NASD/SIPC as a Broker/Dealer.