July 26th, 2011


Debtordammerung, Part III: What happens?

I'll start with this up front: I don't know what will happen. There are too many permutations possible, and a lot of it has to do with what and how the US Federal government reacts when presented with the debt limit maximum.

I'll tell you first what I think won't happen: bond holders getting shorted for real. There might be some delays in payments, which is bad enough, but no actual cancellation. This is partly because constitutionally, there are issues, but mostly because 1) finance p0wns this government, and 2) if you do that, the US doesn't get downgraded from AAA to AA; it gets downgraded to something starting with a B.

"Who cares what S&P says? They haven't got a thing right in the last decade!" I hear you cry. Believe me, I know. But there are a lot of funds out there that can only - in some cases I believe by law - invest in AAA-rated investment tools. If the ratings agencies that matter drop the US's AAA rating, suddenly all those funds are out of US government bonds. And that's what people in the business call bad.

Another reason is because rates paid on money lent are affected by ratings - in no small part because of the above reason. Ratings go down, interest rates go up, suddenly your borrowing - if and when you finally get to do it again - gets a lot more expensive. I'm not willing to rule out that this isn't part of the plan; if the cuts-only crowd is pulling a Calhoun manoeuvre, then a great way to veto borrowing after you're dead and gone is to make it long-term more expensive.

Confidence has been shaken, no matter how this falls out. That's even if there's a deal, unless it makes substantial progress on deficit (note: deficit; not specifically size of government; this doesn't have to be cuts-only). We're already seeing collateral requirement hikes today for US bond holdings. Federal debt is becoming more expensive now.

I have heard the argument made that the US has already been effectively downgraded to AA in the markets; I think that's unlikely, because while it's deserved, most people are still considering all this just a kind of particularly aggressive posturing. The psychological effect of losing an A off the rating will be substantial; similarly to the effect on the passengers when Titanic started firing its flares; before that, people had been told abandon ship, but didn't really believe it. After the flares? Oh shit, this is real. And talking of real: somebody very, very large shorted about US$850M in T-bill futures today. Somebody large is betting large that the US is moving to a AA rating.

So all that is damage already done by this particular process. A deal that raises the debt limit without making meaningful deficit progress will make the above worse, but let's say that there's no extension of the debt ceiling for a few weeks. Negotiations are not going well, so - what happens?

I think things start more slowly than most people seem to expect. I don't think there will be the kind of in-your-face explosion I think a lot of people are talking about. Even now, it takes time for money - and information - to filter through the system, and paper changes take a lot longer to turn into real changes. Plus, there will be an assumption that they'll settle this thing in a few days - it won't drag on weeks. If that's wrong, look out; but that expectation will buffer the impact.

First, a lot of cheques stop coming. Exactly how that happens affects the specifics of the outcome. Assuming they're not mad enough to stop bondholder payments, my guess would be a combination of emergency service stops and across-the-board cuts. The US's FAA have already issued a bunch of STOP WORK orders at various construction projects at airports; this will be magnified across anything receiving Federal money, hitting employment and a lot of other aspects of the economy. Extended unemployment cheques are likely to take a huge hit or maybe just go away; honestly there's no telling. The cuts will be deep; the Tea Party hopes entire sections of government will be shut down. (C.f. HUD, Education, others.)

In other words, you'll have that 8.8% hit to GDP, and probably more. The effects on the private sector will magnify the effect, but if you're not getting Federal money, you won't feel it so quickly.

How this affects the banking sector - hoooooo boy. The banking system is still fundamentally insolvent. There has been substantial pretence towards the idea that all those worthless mortgage-backed CDOs actually have some value, and that's why the banks are alive - that, and holy crow US$16T in emergency loans, according to the Fed audit - but if money is withdrawn (and/or not re-extended), you could have a serious banking crash.

All this is true despite state-level retroactive immunity being granted over and over again for mortgage fraud (for chump change in fines), as well as Federal refusals to prosecute clearly documented and defined systemic fraud. As documented repeatedly, everything's fucked up, and nobody goes to jail. But we don't know, because we don't know how much liquidity is still in the system - ever since the Fed reclassified their loans as not-actually-loans, they don't have to report them.

The effect on the US$ will be mostly downward, across several apparently contradictory vectors at once. International traders did not like the opposing statements tonight and sent the USD downwards, but sentiment is already so negative that being oversold in the short term isn't out of the question. And the Euro is glad everyone else is looking over here, as Italy withdraws bond auctions because nobody wants them, and rates keep ticking up in general.

But regardless, with no bonds to buy, there will be less demand for the USD, which drives the dollar down against other currencies. Plus, the mere political failure will send people away from the USD, possibly chewing off whatever's left of its old "safe haven" shine.

At the same time, though, fewer dollars in circulation is strongly deflationary, so while imports would become more expensive, incomes would drop and the cost of borrowing (in real dollars) would rise. That means no pricing ability; goods may cost more, but nobody will pay, thus limiting inflation. Despite falling value vs. other currencies, it'll be a good time to have a lot of cash.

Sadly, all that will come just as US consumers have been kicking up credit card use for basic necessities, mostly thanks to stagnant and falling incomes in the face of sharply rising food and energy costs. Zero Hedge has a great, great chart on the non-recovery recovery that really illustrates a lot of what's gone wrong.

Now, what if they do something really stupid and stiff the bondholders?

That won't happen, because that ends the US dollar. Serious business ends it. At that point the debt ceiling does not fucking matter, because the currency is just done. If they stiff the bond holders, you'd want to hide in stock market index funds or something, because index funds and the like - anything indexed to actual value - will move up as the currency devalues. But, again, I don't think for a moment the government would do that; it's suicidal. (eta: And reports say that's just what the administration has been quietly telling banks.)

All this sounds like a disaster. And, really, it is. And that begs the question of, "Why would anyone do this?!" Well, there are reasons. We'll talk about them in Part IV.

Debtordammerung, Part IV: But why?

In Part I of this series, we discussed, briefly, salient elements of the politics of the current debt and budget conflict. Part II discussed the politics of economic statistics, and why the way GDP is calculated means that the total amount of government spending never gets reduced. Part III discussed possible economic ramifications of the current clash as it thus far appears to be playing out, ramifications acknowledged by at least some members of the Tea Party and economic right to be extremely negative.

We have not yet, however, discussed why the Hayakian right insists upon pursuing this path. The answer, of course, is quite simple: the alternative is worse. Not immediately, no; but in the medium term at best. The pain you take now is to avoid worse pain in the future.

Settle in, kids; this is gonna take a while.

First, briefly but importantly, you have to understand the corrupt nature of the finance system: the corporate socialism of bank and investment house bailout, the overweening arrogance of the executives of these beneficiaries, and in particular, the utter lack of ramifications they faced for driving the latest series of fraud-fueled bubbles leading to the crises of 2007-2008. This was systemic, blatant, intentional fraud, and, as I keep noting, nobody involved in those mechanisations has been punished - indeed, these same organisations are posting record profits, at taxpayer expense, throughout.

As impossible as it may seem to some on the progressive side of things, the Tea Party is much more upset about this than the Democratic party, supposed defender of the Common Man, but in reality, Defender of the Financial Interests, Banking and Finance. (The GOP, by contrast, are Defenders of Oil and Coal, if you're wondering. Both sides have War backing.) This provides no small amount of ethical justification and fervour.

It's also directly related to the actual question of Federal debt, though the connection is not obvious unless you've been following this for a while. This is critical, even in summary form, and starts with Ronald Reagan.

Really, here, I want to write about eight paragraphs about Ronald Reagan. I want to talk about the Junk Bond Crisis, the Savings and Loan Crisis, and the Crash of '87 - look it up, kids - but this post is already monstrously large, so I'll sum up: the banking system came closer to collapse than it had at any point since the Great Depression.

The take-away: it was a bubble, or more correctly, a couple of out-of-phase bubbles. Mr. Reagan came in to office promising to cut government and taxes and ran straight into the GDP calculation I described in Part II of this series. So instead, he borrowed-and-spent his way to deficits never before seen in the peacetime history of the West.

Then, we had the big tech boom - Apple and Microsoft and the PC wars, OS/2 and DESQview and VisiON and GEM and Windows and Novell. Mr. Greenspan spiked it, leading to the the first generation of the web, first boom, then bubble. Do you remember GEM? Do you remember pets.com? Stamps.com? Do you remember eighteen million other worthless companies boosted to insane valuations despite no way of ever making money, particularly in the web half of that boom?

Mr. Greenspan's new philosophy of blowing replacement and hopefully manageable bubbles in the face of severe downturns really took root here. It took root in the stock market and in finance and in investments, all of which eventually cascaded down in a shower of destroyed retirements and fortunes and the tip of a new Great Depression as it all fell over at the turn of the millennium, just like the tech boom of the 1920s - that one in telephone and radio - had fallen over in 19291.

In the Y2Crash, fewer people faced much punishment than in the previous couple of bubble pops. In the junk bond fiasco and the savings and loan debacle - both of which featured a lot of fraud - people went to jail. Oh, white-collar prison, and not all of those who should've got time did - but enough that it made an impression. In the tech crash - not as much. Fortunes were lost, though - that still hurt. The bailout architecture wasn't complete.

And Mr. Greenspan went to work: pump in liquidity, spike up debt, blow a new bubble with liquidity injections.

The new bubble was in property. The tech bubble at least had actual asset value under it; residential housing, particularly exurban single-family housing, is a fool's investment. Oh, it's good to own your residence outright; you do well enough by that. What you don't do is treat it as a profit-making investment that you use as an ATM - something, by the way, Mr. Greenspan himself encouraged. To brew this bubble, combine Mr. Greenspan and Mr. Bush's cheap-money and kickback policies with free trade with asymmetrical economies of scale (hi, China) finishing off a lot of the old American industrial base, and letting international money flood together into what CPR/PRI's This American Life later called "The Giant Pool of Money that Destroyed Everything." That pool of money started sloshing around, and built the housing balloon. It also built a secondary bubble in commodities. The housing bubble was the biggest bubble yet.

Then - as, again, in the 1920s - all that exploded, starting with housing. (Remember how subprime was "contained"? Heh. Remember really old jokes about swampland in Florida? That comes out of the investment land boom in the South in the 20s, also driven by fraud. But I digress.) And this bubble collapse is where things really changed, in several ways.

One: Nobody moneyed - nobody really responsible - got punished. Nobody. All the naked fraud in the world, and not one punishment. A few fines which pale to nothing in the face of both profits and bailout gifts; that's an insult. They're still nakedly violating the law in foreclosures, as moral hazard has come to full flower.2

Two: No fortunes lost. Everyone at the top made whole, on the backs of the taxpayers. For bonus points, they bragged about it, and howled indignation when questioned; the arrogance and entitlement discussed above was ground in deeply.

Three: None of the bad debt was written down to zero. It's still all out there, as people pretend all those worthless CDOs and MBSes and so on have value, when they simply do not. That's a boat anchor on the economy that won't go away until that massive overarching debt - $16T if not more - is written down.

And worst of all, Four: A lot of those worthless instruments got backed by the Feds, courtesy the swap facilities set up after the crash.

So Mr. Greenspan set about blowing his latest bubble. This one is in government debt. It's a reinflation of the currency supply to make whole all those lost trillions of dollars, but without creating underlying value to support that kind of money supply. It simply isn't there, and there is no reasonable growth rate possible to make it up. Most projections aimed at making that liquidity whole make annual growth rate estimates which are frankly farcical - 8% per annum over 10-15 years, something achieved approximately never in modern history. It's not going to happen.

And this time, the bubble is in the currency itself. Who covers that when it pops?

And as part of that, right now, the US government is paying around US$375B a year in interest on debt, despite interest rates at zero by policy. With a ratings downgrade, rates go up. JP Morgan's analysts think a AA rating adds around $100B a year in interest to current debt, which is to say, more than the most severe cuts proposed will actually deliver.

That's right: the ratings downgrade alone will wipe out that "one trillion dollars in cuts! (across 10 years)" GOP plan, overnight. An actual rise in interest rates could double or quadruple that. You've heard of bond market vigilantes? You've laughed at the concept? Hi, these are they.

But, I hear you cry, back up! "Why the US?! There are other countries with worse debt to GDP ratios!" This is true. Japan is an example. They typically also lack the kind of massive and systemic trade deficit the US carries. I think you can get away with one or the other; the borrowing load in the case of the current-accounts deficit can be mediated by the net trade balance revenue, or a trade balance deficit is acceptable enough if you're not borrowing yourself to the limits at home. I don't think you can get away with both.

The thing is: that's not the scary part. No. That's a problem - a big problem - and it's scary, but it's not The Scary Part.

This is the scary part:

The higher percentage of budget you're paying to cover debt3 the more you have to borrow to do it, unless you start cutting other expenditures to balance, thus cutting headline GDP and some actual economic growth. And the more you have to borrow, the tighter credit gets, raising interest rates, and suppressing economic activity - cutting GDP and reducing tax revenue yet again, requiring increasing borrowing... which puts you back to the beginning of this paragraph.

This is called a currency death spiral4. They're scared of it, for good reason. It brings down governments. It's why they're willing to pull the debt-ceiling trigger: they'd rather play a round of Russian roulette than take an assured bullet straight to the brain.

Make sense, now? There's nothing crazy about that, now, is there?

1: Or did you think that was all cascading margin calls? Aheh, no. Tech and land, just like now.
2: It was neat, by which I mean infuriating, watching every Cascadian financial institution of note get handed over to Chase or someone else well-connected - and bailed out.
3: All else equal, which it never is; this is where I think they're insane with the no-taxes part of the demand. The counter-argument to that is that money is now too fungible; if you raise taxes you'll just prompt capital flight. There is some merit to this argument, but I think less than they think. Of course, you can really get at it by erecting further capital controls, which leads straight to hi there, Smoot-Hawley. That didn't work out so well last time.
4: And no, you can't print your way out of it; that devalues the currency and sends rates up just as assuredly, and also depresses economic activity. Well, okay, you can, sorta, if you don't mind not having a currency. That trick... rarely works.