America’s Achilles heel?

Before my September lecture on the relationship (if any) between external debt and external power, I read a lot of Niall Ferguson.  I even used the financial troubles of Egypt’s khedive - troubles Dr. Ferguson highlights in today’s FT -- to introduce my lecture. 

It is a great story. 

The Suez canal was originally a joint venture between Egypt’s ruling khedive (presumably for his own account) and a French consortium. When the khedive couldn’t pay his (personal) debts to private British bankers, he was forced to sell his stake in the canal to the British government to raise a bit of cash.   And that was only the beginning: the1875 sale of the Khedive’s 44% stake in the canal was followed by difficulties paying the government’s debt, by 1878 Egypt couldn’t pay its government debt - leading Britain effectively take control of Egypt’s Treasury and by 1882, Britain ran Egypt..  Ferguson:

"what began with asset sales continued with the creation of a foreign commission to manage the public debt, the installation of an "international" government and finally, in 1882, to British military intervention and the country’s transformation into a de facto colony.  "

In the Cash Nexus, Ferguson notes that the British management of Egypt’s Treasury "ensured an exceptionally high real rate of return on Egyptian bonds."   The US had better hope its creditors don’t get any ideas ... 

I wish I knew a bit more how the British government managed its stake in the canal. -- as it sounds like Britain ran something of a sovereign wealth fund at the peak of its empire. 

Broadly speaking, there are two views on the relationship between debt and power.

Egypt’s troubles in the 1870s - and for that matter, Latin America’s experience in the 1980s - suggests that external debt leaves a country dependent on its creditors, and ultimately increases the power of the creditor, not the debtor.   And it currently isn’t hard to see signs of the growing power of at least one group of creditors.

But Ferguson’s work also suggests that the ability to borrow large sums at a low cost can be a key attribute of national power.   Britain rose to global prominence in part because its government was able to borrow at a lower interest rate than other powers, and thus could more easily sustain a (large) debt stock.   This helped Britain spread the cost of war over time -- a huge advantage in the early part of the nineteenth century.

The United States’ capacity to place large sums of external debt with other governments in dollars and at low rates consequently can be considered a sign of the United States’ enduring strength.

Ferguson argues Britain’s ability to borrow at low cost -- and the resulting edge it gained over other European powers -- stemmed from the strength of its domestic institutions: the Bank of England, a well-established domestic bond market, a representative parliament that legitimized taxation and a skilled bureaucracy able to collect taxes efficiently.

There are - at least in my view - two differences between the US now and the Britain in the nineteenth century.

1.  Britain’s debt was always mostly domestic.  And at the peak of its power, it was a large external creditor.

2.  The key institutions that allowed the Britain to raise funds at low cost were British.  The key institutions that allowed the US to raise funds at low cost by contrast is the People’s Bank of China, which intermediates between Chinese demand for renminbi-denominated assets and the United States need for dollar financing.   Increasingly, the PBoC is being joined by China’s ministry of finance - which is funding the CIC - and, with oil at $100 a barrel, the big oil funds.  

That, it seems to me, leaves the US in position of vulnerability.   The US relies on the continued willingness of other governments to add to their dollar assets for low cost financing.    The UK relied on private investors’ faith in the Bank of England.

In the past, Dr. Ferguson has written favorably about Sino-American financial interdependence (Chimerica).   But he now seems rather more worried about the consequences of the United States growing external debt.

"We are indeed living through a global shift in the balance of power very similar to that which occurred in the 1870s. This is the story of how an over-extended empire sought to cope with an external debt crisis by selling off revenue streams to foreign investors. The empire that suffered these setbacks in the 1870s was the Ottoman empire. Today it is the US. ....

The US debt crisis has taken a different form, to be sure. External liabilities have been run up by a combination of government and household dis-saving. It is not the public sector that is defaulting but subprime mortgage borrowers.

As in the 1870s, though, the upshot of this debt crisis is the sale of assets and revenue streams to foreign creditors. This time, however, creditors are buying bank shares not canal shares. And the resulting shift of power is from west to east.

... Most commentators have been inclined to welcome this global bail-out : better to bring in foreign capital than to shrink balance sheets by reducing lending. Yet we need to recognise that these "capital injections" represent a transfer of the revenues from the US financial services industry into the hands of foreign governments. This is happening at a time when the gap between eastern and western incomes is narrowing at an unprecedented pace.

In other words, as in the 1870s the balance of financial power is shifting. Then, the move was from the ancient oriental empires (not only the Ottoman but also the Persian and Chinese) to western Europe. Today the shift is from the US - and other western financial centres - to the autocracies of the Middle East and east Asia.

In Disraeli’s day, the debt crisis turned out to have political as well as financial implications, presaging a reduction not just in income but also in sovereignty.  ....   It remains to be seen how quickly today’s financial shift will be followed by a comparable geopolitical shift in favour of the new export and energy empires of the east. Suffice to say that the historical analogy does not bode well for America’s quasi-imperial network of bases and allies across the Middle East and Asia.

Debtor empires sooner or later have to do more than just sell shares to satisfy their creditors.

The Suez canal’s role in global financial history didn’t end when the Khedive sold to the British government.  In 1956, Egyptian President Nasser nationalized the canal, prompting Britain, France and Israel to intervene.  The UN General Assembly - pushed by the US - passed a resolution encouraging the British, French and Israel to withdraw.

The UK at the time was intervening heavily to keep the pound pegged at 2.80 dollars to the pound.   Its reserves though were limited, and it needed an IMF loan.   The US, though, was unwilling to support an IMF loan to a country ignoring the UN.  Eisenhower’s Treasury secretary told the UK Treasury that:

United States would support the United Kingdom when the latter was "conforming to rather than defying the United Nations.

By the end of the year, Britain was faced with the prospect of disclosing that its reserves had fallen below $2 billion, something that it didn’t want to do -- at least not without being able to announce that it had arranged access to additional financing.   Britain signaled its willingness to pull back from the Suez.   Then the IMF, prodded by the US, indicated its willingness to provide a larger than expected loan ... 

For more, see IMF historian James Boughton -- including his paper on the IMF’s role in the Suez crisis.