Before the Stroke of Midnight

Investors await their fate, again

Vice chairman of Goldman Sachs Robert Hormats is the latest observer to look up at the US foreign and domestic debt clock and see the hands about to strike midnight.

    Goldman Sachs guru warns of war-debt failure: Is America becoming a global credit risk?
    July 23, 2007 (Paul Farrell - Marketwatch)

    Recently Robert Hormats, vice chairman of Goldman Sachs (International), appeared before the U.S. House Budget Committee to "discuss an issue of great economic, financial and national security importance to our country -- the growing dependence of the United States on foreign capital." Currently we import $1 trillion new debt annually, with no repayment plans. That's a historic break from over two centuries of American policy.

    Hormats was in Washington with warnings from his brilliant new book, "The Price of Liberty: Paying for America's Wars." He traces the history of American wartime financing from the Revolution through the War of 1812, the cινιℓ ωαr, the two World Wars and the Cold War to the present.

    Conclusion: "One central, constant theme emerges: sound national finances have proved to be indispensable to the country's military strength" and long-term national security.

The argument is that domestic consumption fueled by foreign lending and household borrowing, versus domestic saving and investment, will eventually lead to inflation and recession, and wreck the economy.

The first compelling warning that these debt limits were about to be breached that we are aware was authored by Lester Thurow, ex-Dean of MIT's Sloan School of Management, writing for New Perspectives Quarterly: "He is concerned that our current prosperity resulting from debt driven consumption, will come to an abrupt halt when foreigners stop lending us money." We've made a couple of tweaks, indicated by brackets, to keep it relevant, and leave us with a punch line.

    When the Lending Stops

    This problem of accelerating foreign indebtedness began in 1981 with economic policies that presumed the rest of the world didn't exist. We had 22% interest rates while the Germans and Japanese had 5% and 6% rates. That disparity attracted a massive inflow of money from their economies to ours. This drove up the value of the dollar and made American products noncompetitive on world markets.

    As a result, a huge trade deficit developed, which forced us to borrow money from abroad to cover the difference between what we produced for export and what we consumed.

    By 1986, foreigners lent us one out of every four dollars we borrowed. Of the $800 billion we borrowed, $200 billion came from foreigners. In other words, if foreigners had not lent us the money, one out of every four cars could not have been purchased, one out of every four homes could not have been financed, and one out of every four credit cards would have to be taken away This debt is essentially the cost of living beyond our means.

    If the money we were borrowing from abroad all went into factories and robots, we wouldn't have to worry because the debt would be self-liquidating It's the fact that we are using it entirely for consumption that makes it a serious problem.

    Inflation & Recession

    In the absence of cooperation, it is very likely we will end up with simultaneous inflation and recession.

    Inflation is... a path of least resistance because it would make the hundreds of billions we owe the rest of the world worthless. For policy makers who realize that the debt will keep growing until we restore competitiveness to the US economy, inflation is a far more attractive option than facing a steep drop in the American standard of living.

    Add to this the decision to cut our balance-of-payments problem by letting the value of the dollar fail. [Otherwise imports] ...will become too expensive and their exports will fall. If they don't rebuild their economies for domestic-led growth, they will slow dramatically because they can't rely on exports. If they fall into recession, then we are dragged along because there is no one to purchase our exports.

    The central short term issue, then, is whether we may slip into a recession without the capability to do anything about it. Who can play the role of economic locomotive for the world when the US is so overburdened with debt there is no room for Keynes?

    When the Lending Stops

    It's true that up until now, the rest of the world has been willing to continue lending us money, and so we maintain the appearance of prosperity. Eventually, though, foreigners have to stop lending to us. As we build up our trade deficit and our international debtor position, we have to pay more and more interest, and then interest on the interest. Before long, the compound interest will eat us alive. We will have to borrow more than the rest of the world has to lend us.

    In reality, the lending will stop long before we get to that ultimate limit because foreign lenders fear they will be repaid in devalued dollars. In the first quarter... there was evidence that the private capital inflows from abroad began to stop. Most of the capital now comes from governments who have stepped in for fear of instigating a credit crunch that would set off bankruptcies and recession.

    When the foreign lending stops, all of our debts - our foreign debt, the federal budget deficit, the Latin debt, corporate and consumer debt - will be harder to roll over because the amount of credit will be constrained. As I pointed out earlier, one out of every four dollars we borrow now comes from foreigners. If that suddenly stops, a tremendous tussle will erupt in our society over who gets the other three dollars of credit.

When did Thurow make this dire prediction?

In 1987, months before the October 1987 stock market crash, the last truly major crash since 1929, when US markets declined 23% in a single day. His phrase "In the first quarter... there was evidence that the private capital inflows from abroad began to stop," referred to the first quarter of 1987, although that phrase applies to 2007, as well.

But Thurow didn't predict a crash. He predicted recession, a crashing dollar, and rising inflation and interest rates. Why didn't this happen?

One reason, really. Central banks discovered how to cooperate to produce global asset bubbles. As a result, every area of imbalance that Thurow warned about 20 years ago has grown so unimaginably large that the numbers are hard to comprehend.

The three majors are the trade deficit, domestic debt, and foreign debt.


Around the time Thurow first sounded the alarm about the trade deficit, it reached an extreme of $40 billion in Q3 1987. Immediately following the stock market crash October 1987, the trade deficit declined more than 50% over four years, reaching $17 billion in the second quarter of 1991. Since then it has continued to increase, reaching an extreme of $219 billion in Q3 2006, more than eight times its previous peak. The trade deficit has declined to $201 billion in Q1 2007, but it's not clear what that means.


When Thurow wrote his warning about government and household debt in 1987, domestic financial debt was around $2 trillion, household debt was also near $2 trillion, and total debt was approximately $7.5 trillion. Since then total debt has increased by almost four fold to over $28 trillion, household debt has more than tripled to almost $7 trillion, and financial debt has exploded nearly seven times to nearly $14 trillion. Meanwhile, real GDP has only doubled, from $6.5 trillion to $13 trillion.


(Thanks Aaron Krowne for the chart)

How has the dollar held up over the past 20 years since Thurow's warning?

The dollar had peaked for the cycle by 1986 and was on its way down when Thurow wrote "When the Lending Stops," due to declining foreign demand for US financial assets. No one was sure what that meant, and that uncertainty was one of the causes of the crash of October 1987. The dollar bounced along from 1987 until 1995 when it started to rise, not coincidentally, in our opinion, with the start of the US-centric stock market bubble.

Note that correlation between dollar depreciation and net foreign purchases of US securities is sometimes positive and at other times negative. We believe that the recent de-coupling of US equity markets from other global markets, and gold from equities, indicates that the correlation is about to reverse again, with unfortunate consequences for US markets on the order of October 1987.


One future event that Thurow did not dream of back in 1987 was one where household balance sheets turn upside down. How could he? This had not occurred before, going back to 1946.

In sum, what has happened since 1987? Every measure of imbalance that Thurow warned about has become so extreme that measures defy imagination.

Does this mean that imbalances don't matter?

Returning briefly to the present and Goldman Sachs' Robert Hormats, he goes on to say:

    America's new faith-based guns-and-butter policy is hurting both guns and butter. The war is costing us $12 billion a month. Hormats examined the Congressional Budget Office's projections for domestic costs: "In 2006, spending on Social Security, Medicare, Medicaid and interest on the federal debt amounted to just under 60% of government revenues" and "if they continue on their current path, they will account for two-thirds by 2015."

    * Social security from $550 billion to $960 billion
    * Medicare from $372 billion to over $900 billion
    * Medicaid from $181 billion to $390 billion

    Worse yet, these commitments will continue skyrocketing in later decades. The CBO projects the federal debt rising from 40% of GDP to 100% in the next 25 years: "Continuing on this unsustainable path will gradually erode, if not suddenly damage, our economy, our standard of living, and ultimately our national security."

In our view, Thurow's warning is more relevant today than 20 years ago, and Hormats brings it up to date and into focus.

What does it mean? Given the extremes of imbalance that have developed since 1987, we'll state the risks simply: the market event we are due, when it occurs, will make the October 1987 crash seem benign by comparison. The trigger, as Hormats implies but does not say, will likely be related to the Iraq War.