Mittwoch, August 04, 2010

Setting Up For A Fail...

Let's see if I've got this right.

First, the government, all of it (Federal, State and Local) has gone seriously into debt for any number of reasons. The debt right now is manageable because interest rates are held extremely low and because there are plenty of investors - most of them foreign - who are willing to put their money into the US because the outlook everywhere else was even worse (largely speaking, of course). meaning that supply - investor's money - and demand - government borrowing - were meeting at a very, very low point in terms of interest rates, but not in terms of volume. In standard supply/demand curve curve terms, the interest rate curve has gone flat while the volume has moved all the way over, reflecting the risk bonus that US bond stability has, despite very low interest rates for US bonds.

This is, for the US government, the perfect situation: they can sell all the bonds they want without paying anything more than a very small amount in interest payments, relatively speaking.

We know why there is a practically limitless demand side (the US government continues to have a serious jones for debt spending, and, if anything, the more the merrier). But where is the supply coming from?

First of all, it's recycled US dollars from trade partners that have extremely large positive trade balances with the US. Buying US government bonds is a safe way for these countries to maintain their best customer (or to put it a different way, they're keeping the deficit addict supplied with just enough dope to keep them alive and continuing their habit) in the lifestyle that lets them continuing to do more and more business with the US.

Second of all, despite very low interest rates, the US continues to be The Safe Haven world-wide. Until conditions improve elsewhere, the US is where people park their money.

Third of all, the US continues to be an attractive place to do business and hence companies in other countries (and, increasingly, countries directly via sovereign funds) invest in the US because their returns are better than elsewhere.

So far, so good, right? Sounds like a pretty good set-up for the US: debt financing till the cows come home, because there is enough cash out there.

Of course, it's a bubble and is unsustainable.


Let's work backwards.

First, a weakening dollar - and the dollar must weaken further if US competitiveness is to be restored! - makes further exposure to the dollar world less attractive. Add to that the emerging middle classes in China and India, as well as the (admittedly still very slowly) rising business liberalization of those countries (reducing bureaucracy and providing investment incentives in the form of tax breaks is a fairly cheap way of drumming up enormous interest and is more than offset by increased employment with regionally attractive wages) and you can see where a scenario develops that will reduce foreign investment in the US to that which foreign companies see appropriate to serve the US market, not the world market as a whole. Given that the US is only 25% of world GDP, other markets are going to become significantly more attractive for foreign investors, especially for large-ticket investments such as automobiles, chemical and other industrial plants, as well as refineries.

Second, when world trade recovers and demand increases, there will be more demand for investments elsewhere, leading capital away from the US.

Third, and this is the critical point, the sustainability of US government spending depends on these large inputs from foreign capital, as interest rates remain very low, held down by the Fed and the lack of alternatives for US dollar investments. This is very, very, very important: when capital starts to become less readily available, it increases in price.

In other words, interest rates rise.

This will first appear in junk bonds, but will quickly spread up the risk ladder until the rate increases hit AAA commercial paper.

At that point the bubble will start to burst.

If the US government - which in its infinite wisdom (thank you, President Clinton!) is now largely financed short-term - fails to succeed in oversubscribing a bond sale, the game is all but over. Normally, bonds are oversubscribed, meaning that there are more buyers than sellers and that all bonds are sold (and no government puts up bonds for sale when it doesn't actually need the money!). Failure to sell all the bonds would be disastrous: the market would be telling the world that there are better places to earn interest and that the demand is too large for the supply.

The result would be, in order to re-finance the deficit (and this is key: we're not talking about new debt, but rather rolling over old debt!), that the government would either have to raise interest rates or reduce the selling price of bonds (which is effectively the same thing).

The problem? The sheer volume of the US deficit, plus the fact that a significant majority of bonds are short-term, needing to be rolled over every 2-5 years, means that even a tiny increase in interest rates means significantly higher dollar outlays for the US government, which means that one of several things has to happen (dismal science, economics...).

Either the government reduces its debt by using taxes to retire bonds to match the new lower level of sustainable debt financing, or spending on interest payments will increase significantly (also paid for by tax dollars), or spending has to be cut, or taxes have to be increased (or supplemented by new taxes). In reality, there is a continuum of choices, but these are the four poles that cannot be moved.

Those are really the only four choices (although there is a fifth, more about later).

The first and the third are the fiscally prudent approaches that tells any banker that the entity in debt is actively moving to clear and retire debt, or, at least, reducing the exposure to debt. It means cutting discretionary spending, reducing or eliminating automatic spending increases, and cutting benefits to many who enjoy the breaks. It also means ruthless trimming of spending on pet projects (aka "pork") and bringing in federal wages back into line where they once were, smaller than in the commercial sector, with increased job security to compensate. All highly unpalatable decisions that will not be made unless the writing is clearly on the wall and a consensus can be reached.

The second and the fourth are the nightmares, because it means that the entity in debt is looking for a way to increase the debt without changing. That is the path paved with danger, because the lack of a commitment to change in the face of an existential debt problem is usually the sign that there is something seriously wrong and that wishful thinking is replacing serious analysis of how to get out from under water.

This is, largely, where we are now: no party is seriously calling for fiscal prudence because it means making spending cuts now, before the crisis arrives (since it will reduce the vulnerability to interest rate increases, this also pushes back any sell-by date into the future, giving the government time to reduce its vulnerability even further.

What is the fifth option?

It is the simplest for the borrower and it is the reason why interest rates are charged. It is debt repudiation, of refusing to pay any more, of bankruptcy. Where bankruptcy laws are heavily biased to the debtor, this is a popular way out because any real costs are mitigated by the inability of the lenders to actually take what was used as a security.

In the case of sovereign debt, the problem is even more complex: it is easy to renounce the debt, but it generally means that you lose access to capital markets until people have either forgotten or are, for some god-forsaken reason, willing to believe that this time it's different.

The security that the US has been (ab)using is the reputation of the US as a safe haven.

To put it bluntly, the current financial and fiscal policies of the US is setting up the US for a fall. If interest rates pick up, the whole house of cards starts to fall apart, as it will mean a mixture of massive cuts in US government spending and massive increases in taxes in order to finance those higher interest rates.

Bursting bubbles are never fun. The US government has never faced one with its own spending. It will not be a pleasant experience. It will also the be the death of Keynesian economic policy.

And not a moment too soon.

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