Friday, February 19, 2010

The Greenspan-Guidotti Rule (or Guidotti–Greenspan)

I'd never heard of this till a few days ago. But those of us who find ourselves under the tender mercies of the U.S. government should probably pay attention.

Former chairman of the Federal Reserve Board, Alan Greenspan, and former deputy minister of finance for Argentina, Pablo Guidotti, published an academic paper in 1999 that suggested, to avoid a default, a country needs to maintain hard currency reserves equal to at least 100% of their short-term (maturing in the next 12 months) foreign debt.

PIMCO, one of the world's largest fixed income managers, explains it this way: "The minimum benchmark of reserves equal to at least 100% of short-term external debt is known as the Greenspan-Guidotti rule. Greenspan-Guidotti is perhaps the single concept of reserve adequacy that has the most adherents and empirical support."

Now. People "in the know" point out that this "rule" was created for emerging market economies: you know, the "poorer brethren."

As someone on the Motley Fool board commented, "This problem just applies to countries issuing foreign debt in a currency not their own. That makes them vulnerable to an attack on their currency (leading to a devaluation and the impossibility of servicing debt in Euros or USD). The US faces no such issues with their foreign debt."

And I ask, "Oh, really? . . . What is good for the goose is, somehow, not good for the gander? The U.S. thinks it can get away with borrowing funds from poorer neighbors 'forever' and let them take the hit for the massive inflation of currency being carried out by the U.S. federal government in cahoots with the Federal Reserve and the U.S. Treasury?"

As the guy who first brought this subject up on the Motley Fool forum commented,
From my days in the credit-related business, the first sign of debt distress is not the actual delinquency itself. The first signs are spending in excess of income. The second sign is an inability to change either the spending habits or the income level. After those, the distress is just a matter of time and circumstance. Many folks put off the inevitable for years as they find external sources of money (marriage, inheritance, etc.). But they assuredly will run through whatever windfalls because of problem number one.

The US has developed a habit of spending beyond its income. It also exhibits no desire to change either the spending habits or its income level.

So, what does that suggest?
Financial advisor Porter Stansberry comments,
The principle behind the rule is simple. If you can't pay off all of your foreign debts in the next 12 months, you're a terrible credit risk. Speculators are going to target your bonds and your currency, making it impossible to refinance your debts. A default is assured.

. . . [H]ow does America rank on the Greenspan-Guidotti scale? It's a guaranteed default.
And how does he come up with that?
According to the U.S. Treasury, $2 trillion worth of debt will mature in the next 12 months. So . . . the Treasury will have to finance at least $2 trillion worth of maturing debt in the next 12 months.

That might not cause a crisis if we were still funding our national debt internally. But since 1985, we've been a net debtor to the world. Today, foreigners own 44% of all our debts, which means we owe foreign creditors at least $880 billion in the next 12 months - an amount far larger than our reserves.

Keep in mind, this only covers our existing debts. The Office of Management and Budget is predicting a $1.5 trillion budget deficit over the next year. That puts our total funding requirements on the order of $3.5 trillion over the next 12 months.

So where will the money come from? Total domestic savings in the U.S. are only around $600 billion annually. Even if we all put every penny of our savings into U.S. Treasury debt, we're still going to come up nearly $3 trillion short. That's an annual funding requirement equal to roughly 40% of GDP.

Where is the money going to come from? From our foreign creditors? Not according to Greenspan-Guidotti. And not according to the Indian or the Russian central banks, which have stopped buying Treasury bills and begun to buy enormous amounts of gold. The Indians bought 200 metric tonnes [last November]. Sources in Russia say the central bank there will double its gold reserves.

So where will the money come from? The printing press. The Federal Reserve has already monetized nearly $2 trillion worth of Treasury debt and mortgage debt. This weakens the value of the dollar and devalues our existing Treasury bonds. Sooner or later, our creditors will face a stark choice: Hold our bonds and continue to see the value diminish slowly, or try to escape to gold and see the value of their U.S. bonds plummet.

One thing they're not going to do is buy more of our debt.

Which central banks will abandon the dollar next? Brazil, Korea, and Chile. These are the three largest central banks that own the least amount of gold. None own even 1% of their total reserves in gold.
Stansberry wrote these comments last November. He "updated" his perspective a couple of weeks ago--on February 2nd (and I mentioned his update article in passing in my post on February 8th):
A few years ago, I got in hot water by insisting General Motors was bankrupt. Supporters of the company (whether investors or unionized employees) got mad at me and said I was exaggerating. They rightly pointed out GM was still servicing its debts and was still owned by its equity holders. Thus, technically at least, GM wasn't bankrupt.

In order to avoid any unnecessary litigiousness, I began to write in parody, pretending to be the chairman of General Motors and warning of the company's impending bankruptcy. One of the few ways you can still speak unpleasant truths in America is by using - or pretending to use - humor. . . .

Meanwhile, the bankruptcy of General Motors was far from a laughing matter.

GM had no conceivable way to repay its debts. It was even borrowing money to pay for the interest expense on its existing debts.

Monitoring the company closely between 2006 and 2009 taught me quite a bit about willful self-deception. Here are the three key traits I look for now in companies facing major financial stress . . .

No. 1. There's never any real tally of the total amount owed. . . .

No. 2. None of the company's "turnaround" plans include any efforts to actually repay principal amounts owed.

No. 3. The company's spending is out of control. In GM's case, it was also rife with fraud and absurdity - like, for example, its jobs bank where people were paid not to work.
Sound like the government of any country you know?

It does to me!

. . . I encourage you to read the rest of Stansberry's update article.

Sobering stuff.
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