How’s this for a question:
The struggles in Europe to keep Greece in the euro zone and the brinkmanship in America over the debt ceiling have presented investors with an unattractive choice: should you buy the currency that may default, or the one that could disintegrate?
As usual, the Economist packs more insight into fewer words than any other publication I know of. Here are some additional excerpts for this week’s lead editorial:
In the early days of the economic crisis the West’s leaders did a reasonable job of clearing up a mess that was only partly of their making. Now the politicians have become the problem. In both America and Europe, they are exhibiting the sort of behaviour that could turn a downturn into stagnation. The West’s leaders are not willing to make tough choices; and everybody—the markets, the leaders of the emerging world, the banks, even the voters—knows it.
Though both about debt, the arguments in Europe and America have very different origins. The euro crisis was brought on by investors with genuine worries about the solvency of several euro-zone countries. By contrast the stand-off in Washington is a political creation . . .
The similarity between the European and American dramas lies in the protagonists’ refusal to face reality. European politicians, led by Angela Merkel, have gone to absurd lengths to avoid admitting two truths: that Greece is bust; and that north Europeans (and Mrs Merkel’s thrifty Germans in particular) will end up footing a good part of the bill, either by transferring money to the south or by bailing out their own banks. They have failed to undertake a serious restructuring: the current rescue package reduces Greece’s debt, but not by enough to give it a genuine chance of recovery.
America’s debt debate seems still more kabuki-like. Its fiscal problem is not now—it should be spending to boost recovery—but in the medium term. Its absurdly complicated tax system raises very little, and the ageing of its baby-boomers will push its vast entitlement programmes towards bankruptcy.
Yet Mr Obama and his party seem a model of fiscal statesmanship compared with their Republican opponents. Once upon a time the American right led the world when it came to rethinking government; now it is an intellectual pygmy. The House Republicans could not even get their budget sums right, so the vote had to be delayed. A desire to curb Leviathan is admirable, but the tea-partiers live in a fantasy world in which the deficit can be reduced without any tax increases: even Mr Obama’s attempts to remove loopholes in the tax code drive the zealots into paroxysms of outrage.
In both Europe and America electorates seem to be turning inward. There is the same division between “ins” and “outs” that has plagued Japan. In Europe one set of middle-class workers is desperate to hang on to protections and privileges: millions of others are stuck in unprotected temporary jobs or are unemployed. In both Europe and America well-connected public-sector unions obstruct progress. And then there is the greatest (and also the least sustainable) division of all: between the old, clinging tightly to entitlements they claim to have earned, and the young who will somehow have to pay for all this.
Sometimes crises beget bold leadership. Not, unfortunately, now . . . For all their talents, both Mr Obama and Mrs Merkel are better at following public opinion than leading it.
Our views on what the West should do will be painfully familiar to readers. Europe’s politicians need to implement not just a serious restructuring of the peripheral countries’ debts but also a serious reform of their economies, to clean out cronyism, corruption and all the inefficiencies that hold back their growth. America’s Democrats need to accept entitlement cuts and Republicans higher taxes.
Spend a few bucks and get yourself a subscription to the Economist.
The Boehner plan passed the House today, but only after he added a constitutional amendment requiring a balanced budget to it.
Two days ago, the Speaker was a guest on conservative radio host Laura Ingraham’s morning show. Responding to a question regarding the motivation of the obstructionist members of the Republican party, the Think Progress blog quotes Boehner as saying
Well, first they want more. And my goodness, I want more too. And secondly, a lot of them believe that if we get past August the second and we have enough chaos, we could force the Senate and the White House to accept a balanced budget amendment. I’m not sure that that — I don’t think that that strategy works. Because I think the closer we get to August the second, frankly, the less leverage we have vis a vis our colleagues in the Senate and the White House.
To get the votes he needed, Boehner had to submit to blackmail from members of his own party. I feel sorry for him. I really do. Everybody knows he doesn’t support legislation that bears his name. What an embarrassing position to be in.
It doesn’t matter. The Senate, wasting no time, has already tabled his bill.
A definite maybe, says Neel Kashkari, who established and led the Office of Financial Stability and the Troubled Assets Relief Program until May 2009. His view is that
a U.S. downgrade has the potential to be as bad or perhaps worse than the Lehman shock. The more strongly held a belief, and the larger the asset class it supports, the greater the potential damage to the economy when the belief is turned upside down. We may not be certain what will happen if U.S. credit is downgraded, but there is no upside to finding out.
Unfortunately, some politicians seem intent on finding out.
In her column in the Financial Times, Gillian Tett poses five questions for the Fed and Treasury Department. If the Republicans hadn’t linked the budget to the debt ceiling, none of these questions would have to be asked.
● What might the US government do to support the US money market funds if American debt is downgraded, or suffers a technical default? These funds currently hold a large volume of Treasuries, and if Treasury bonds tumble in value – or go into technical default – this could erode the net asset value of these funds. This, in turn, could potentially spark a run on these funds of the type that started to occur in 2008, particularly since these funds (unlike bank deposits) are not protected. But since this might have systemic implications, it is uncertain whether the government will – or will not – act.
● Will the US authorities step into the markets and act as the dealer or financier of last resort, if parts of the market freeze up? Right now, it seems unlikely that Treasury bonds would become illiquid after any downgrade; after all, this is the deepest bond market in the world. But a downgrade of US debt could, ironically, force some asset managers to sell more risky instruments (such as triple B bonds) to maintain average ratings benchmarks in their portfolios. That might create bottlenecks. There is also a risk the so-called repurchase (or repo) market might freeze. That would almost certainly prompt the government to step in (by accepting bonds as collateral and making loans); how this might work, though, is uncertain.
● What will regulators do about capital standards if some banks’ balance sheets balloon? In recent weeks, signs have already emerged of a flight of money towards supposedly “safe” banks in Europe and the US; if this accelerates, it could mess up some banks’ attempts to tidy up their balance sheets. Bankers guess that regulators will be lenient; but – again – this is unclear.
● How will regulators and risk managers respond if the “risk-free” status of US debt starts to crumble? Treasuries are currently zero risk weighted for bank capital adequacy purposes. Bank supervisors are unlikely to change this. However, some banks are reviewing collateral policies. On Thursday the Chicago Mercantile Exchange raised collateral haircuts for clearing Treasuries.
● What rules will apply for paying interest, accrued interest and principal on Treasury bonds, if a technical default occurs? On a normal day, asset managers and custodian banks make huge numbers of payments to investors, linked to the treasury market; but many institutions are uncertain what to do if a technical default occurs.
On occasion, the WSJ doesn’t enforce its subscription barrier. I sent the following link to my wife, who was able to access the article on her computer.
Give it a try if you’re not a subscriber.
Ronald Reagan is a hero of the Tea Party. Perhaps these obstructionist members of Congress should do a little research. If they did, they’d find that in a radio address on September 26, 1987, the Gipper said this:
“Congress consistently brings the Government to the edge of default before facing its responsibility. This brinkmanship threatens the holders of Government bonds and those who rely on Social Security and veteran benefits. Interest rates would skyrocket. Instability would occur in financial markets and the Federal deficit would soar. The United States has a special responsibility to itself and the world to meet its obligations. It means we have a well-earned reputation for reliability and credibility, two things that set us apart from much of the world.”
By the way, I voted for Reagan.
Finally — and I do mean finally — somebody (besides this egotistical blogger) is looking beyond D(efault)-Day. Mohamed El-Erian certainly has credentials far superior to mine. He’s the CEO and co-CIO of PIMCO, a global investment management firm and one of the world’s largest bond investors with approximately $1.2 trillion of assets under management at the end of 2010.
Before looking beyond D-Day, El-Erian outlines the damage that has already been done by the “political mess” in Washington. The debris: already-weak business and consumer confidence has been dealt a further blow; companies with massive cash holdings have been given another excuse to stay on the sidelines; and foreigners have been stunned by the political dysfunctionality of the country in which they have placed factories, whose financial instruments they buy with their savings and whose money serves as the global reserve currency.
That’s a lot of damage. But there’s more to come.
In just a few days, analysts will take another slice off their already muted growth projections. Fed Chairman Bernanke’s recent prediction that economic growth will accelerate in the second half of the year will be proven wrong. The postponement of the much-hoped-for robust recovery will result in the deepening of the unemployment crisis. Worse still, the budget reductions may make matters worse:
It is far from certain that, in forcing spending cuts, a resolution to the debt-ceiling debacle will materially improve the U.S. economic outlook. Indeed, because of the standoff’s detrimental impact on growth and employment, it could tip the United States closer to the very debt trap that reformers are seeking to prevent.
What is the “debt trap” and how does it come about?
. . . fiscal solvency is not merely a function of deficits and debt, interest rates and the profile of maturities. It is also highly sensitive to economic growth: The lower an economy’s growth rate, the higher a budget deficit is likely to be, the larger the debt accumulation, and the greater the need for yet another round of fiscal austerity to safeguard solvency. All are components of the much-feared debt trap.
To borrow a phrase from the Brits, El-Erian is spot-on.
Doug Elmendorf is the Director of the Congressional Budget Office. Today’s entry in the Director’s Blog is sobering:
Even a slight increase in the perceived risk of U.S. government securities would probably raise interest payments by a lot for years to come. If Treasury rates were pushed up by just one-tenth of a percentage point, the government would pay $130 billion more in interest over the next decade . . . If, instead, Treasury rates rose by four-tenths of a percentage point, the government would pay more than half-a-trillion dollars in additional interest over the next decade.
. . . public statements by many financial-market participants and experts have made clear that default by the federal government on obligations to debt holders would be a significant shock to the global financial system and economy. That shock could trigger large swings in stock prices, private interest rates, and the value of the dollar relative to other currencies; it might also generate massive disruptions and damage to the payments system and the flow of credit; and it would probably weaken the economy and reduce output and employment relative to what they would otherwise be. Indeed, the lack of a plan for increasing the debt ceiling may already be hurting household and business confidence, and default would reduce confidence further and increase uncertainty about future government policies, which would lower spending even apart from the effects of changes in asset prices and interest rates.
It is also unclear what would happen if the federal government were to default on obligations other than Treasury debt . . . debt holders might be unconcerned because the payments due to them would not be directly affected; however, debt holders might conclude instead that if the government is willing to default on some obligations, it could default on its obligation to them next. In any event, the individuals, businesses, and state governments that are owed money under current law and are counting on receiving it would clearly need to deal with sudden and unexpected shortfalls in their own finances.
The budget is on an unsustainable path. Debt held by the public is already higher relative to GDP than it has been in more than half-a-century, and CBO projects that it will exceed its all-time high in about a dozen years under current policies.
[...] Following the intensive public discussions of the past few months, a failure to agree on credible, specific policy changes would increase doubts about the ability of the government to manage its budget. That could, in turn, raise the perceived risk of U.S. government securities, which would lead to higher Treasury interest rates, higher government interest costs, and the possibility of dislocations in financial markets.
Moreover, and with a larger immediate impact on most Americans, the economy remains mired in a severe slump. Three-and-a-half years after the recession started, roughly 10 million fewer Americans have jobs than if employment had continued to expand at its pre-recession pace. Total output of the economy this year will be about $700 billion less than would occur with high use of our labor and capital resources. In addition, 44 percent of the workers who were unemployed in the first half of this year had been out of work for more than 26 weeks—an unprecedented share in the period since World War II. CBO expects that the lingering difficulties of the long-term unemployed in finding jobs, as well as the loss in business investment during the slump, will weigh on the nation’s output for years to come.
[...] With the federal budget and the economy both facing such serious problems, the additional problems that would probably be caused by a default on the federal government’s obligations could be especially damaging. We are on the brink of harming the budget and the economy, possibly undermining the international financial system, and doing significant damage to the credibility of legal commitments made by the U.S. government.
Congressional Budget Office Analyses
Wall Street bankers, from senior executives to traders, are complaining that the Federal Reserve is refusing to engage in planning for any downgrade or default by the US. With only days to go to the US Treasury’s August 2 deadline to raise the debt ceiling, bankers say they are not getting a response to efforts to discuss the market impact of a failure to reach a deal in Washington or if credit rating agencies cut the US triple A standing.
The Treasury has so far refused to make public any contingency plans for the event that there is no rise in the debt ceiling. Unless the Treasury indicates, for example, whether it would prioritise interest payments, it is hard for the Fed to discuss the implications with banks.
Presenting, courtesy of Bloomberg, le chart du jour — an eye opening inversion of the US credit default swap curve:
That means, as Bloomberg eloquently put it, that it costs more to insure US Treasuries for one year than it does for five years, for the first time ever.
Perhaps the most long-standing and widely-believed part of the conventional wisdom about the stock market is that it anticipates changes in the strength of the economy — and, therefore, of changes in corporate profits — by six to nine months. That’s what I was taught in business school, and that’s what I saw during my Wall Street career from the 1970s to the 1990s. This anticipatory nature explains why the market sometimes responds favorably to bad news and unfavorably to good news.
Something seems to have gone wrong. The conventional wisdom doesn’t seem to be working anymore. The graph below show the recent levels of after-tax profits for non-financial corporations.
Based on the two most recent observations, the conclusion is clear: instead of anticipating directional changes in profitability, investors reacted to them. The default explanation for this is that the level of uncertainty was so great that investors, as a group, lacked the confidence to attempt to anticipate change.
In my judgement, investors are still in reactive mode. Notwithstanding the weakness of the past few days, the market has held up remarkably well in the face of the dual debt crises — the one in Europe and the one here. Our crisis has not exacted a toll on profits — yet. Since investors no longer seem to anticipate change, recent experience suggests that the market won’t experience a serious downturn until after corporate profits fall short of expectations. The level of uncertainty — the lack of confidence — is still so high that it’s hard to imagine investors will revert to their former anticipatory ways.
The preconditions for disappointing corporate profits are falling into place. Dismay over the shenanigans in Washington have hurt both consumer and business confidence. Less confident consumers will spend less, as will less confident businesses. Even assuming that a default is avoided, there appears to be a growing likelihood that the credit rating of U. S. government securities will be downgraded. This would result in higher interest rates for the government (adding to the budget deficit), business, and consumers. The larger the cut in government spending, the greater will be the impact on the economy. The smaller the cut in government spending, the lower will be the confidence that the government is capable of dealing with the long-term budget problem.
This is not the time to be fully invested in stocks. Another piece of conventional wisdom — one that I abide by — is don’t catch falling knives.