Eurozone Crisis Overshadows U.S. Debt Concerns

The U.S. media and market analysts have been focusing so much attention on the Eurozone debt crisis that similar problems brewing at home in domestic credit markets are not getting any attention, say some critics. Now that the presidential election is in full swing, many argue that the growing U.S. debt debacle will go unattended as politicians focus all their time and energy on staying in – or getting into – office. With the Federal Reserve’s latest announcement that Treasury borrowing rates will remain at historical lows, it appears that policymakers are intent on letting the problem fester rather than making the tough decisions that represent sound fiscal sense. For more on this continue reading the following article from Tim Iacono.

Former Kansas governor Mark Parkinson appeared on CNBC yesterday and made the point that you don’t hear too much anymore these days with European credit markets being such a mess – that the U.S. will someday have a similar crisis.

Unfortunately, with the election season now well underway, officials in Washington are not likely to take any action to make the looming U.S. debt crisis any less menacing, in fact, with borrowing rates so low for the Treasury Department, you get the feeling that we’re whistling past the graveyard louder than ever.

This blog post was republished with permission from Tim Iacono.

Looming Default Reminder of Past Debt Problems

Currency expert Kathy Lien revisits a time in 1979 when the U.S. missed a Treasury bill payment, pointing out that the value of the dollar only dropped 0.6% immediately following the lapse; however, the value plummeted less than one month after the one-time default. Lien notes that it would be a mistake to attribute the drop in value on the actual missed payment, but the real reasons were increased inflation and global concerns over the security of the U.S. dollar. For more on this continue reading the following article from Kathy Lien.

Although the U.S. government has never officially defaulted on its debt, it missed payments on some Treasury Bills in 1979. Then as now, Congress was playing a game of chicken with Republicans and Democrats bumping heads on raising the debt ceiling. The debt limit was a fraction of its current levels and at the time, the dollar only fell briefly. The 0.6 percent drop in the Dollar Index was so small that it was barely left an imprint. However less than a month later, double digit inflation and concerns about the outlook for the U.S. economy along with the security of the U.S. dollar drove the greenback sharply lower. It may be tempting to attribute this decline to the short term default on U.S. debt but the Treasury started making its T-bill payments again after a very short delay.

Here’s a chart of how the dollar behaved when the U.S. government missed its debt payment in 1979:

This blog post was republished with permission from Kathy Lien.

US Debt Burden Can Only Be Resolved Through Inflation

Moses Kim writes that the deflationists' argument is flawed because it asserts that the dollar will rise in value despite being the largest debtor nation in history. He believes that the enormous debt burden can not be resolved through growth, but only through inflation. See the following post from Expected Returns.

Our leaders have painted us into a corner and we are at the precipice of yet another financial crisis. The ubiquity of braindead economic thinking at the highest level precludes meaningful action from taking place. While our leaders believe we can increase our debt burden and grow our way out of this, it's hard for me to imagine such a prosaic resolution to this debt crisis.

With our goverment handling its finances in a Greek-like manner, confidence is evaporating, adding another variable to an already complicated picture. Developments in the Euro prove how quickly currencies can collapse once confidence start slipping.

Europe may be mired in a debt crisis, but guess what, so are we. Our debt burden has risen at both the state and federal level as tax receipts fall- which suggests the economic recovery is a figment of our government's imagination.







The sustained weakness in the economy in the face of massive stimulus reflects the declining marginal utility of debt. To wit, we are pushing on a string.

Debt Defaults: Deflationary or Inflationary?

Deflationary arguments seem to be gaining resonance, especially in the Great Depression II crowd, since people tend to conflate Depressions with deflation. However, we must take into account the differences in monetary systems before jumping to conclusions about a potential deflationary collapse.

The U.S. government's ability to devalue via the printing press was constrained under the gold standard of the 1930's. As the dollar came under speculative attack in 1931, the U.S. raised interest rates to preserve the value of the dollar, and thereby maintain the viability of the gold standard. Rising interest rates were deflationary for an economy already in tatters.

In a floating exchange rate system, currencies can simply float to a "fair" price level. Currencies under speculative attack will simply devalue, and this is inherently inflationary. Governments can, of course, accelerate the debasement process by cranking up the printing press. Bottom line: it is far easier for governments to inflate today.

Anyway, we are seeing positive year-over-year CPI prints, so deflationary fears are a little overblown at this point.



Deflationists point to the deflationary side effects of debt destruction. But debt defaults contract money supply indirectly, and only to the extent that banks withhold funds to fulfill capital reserve requirements. While this does keep a temporary lid on inflation, accumulating excess reserves are an inflationary accident waiting to happen. Furthermore, the Fed can always step in with a zero interest rate policy and help banks repair balance sheets. Yes debt implodes, but the Fed can restart the debt cycle at the push of a button.




This debt crisis will be resolved through inflation. The flaws in the deflationary argument are numerous, but at the very core, deflationists are implying that the dollar will rise in value. This is positively nuts since we are the greatest debtor nation the world has ever seen. And I don't care how well the dollar does versus other flawed fiat currencies; I am only concerned with its value relative to goods and services.

In all likelihood, we will see the reinstatement of stimulus efforts, such as homebuyer tax credits, which will put renewed pressure on the dollar. Each round of newly issued debt pushes us closer to the tipping point when the dollar and bonds falter. Timing is the only question here. Investors will be wise to wait out the storm in gold.

This article has been republished from Moses Kim's blog, Expected Returns.

Is The Low Treasury Yield Midguiding Policy Makers?

Many policy makers seems to dismiss the need to address the large US debt, which Tim Iacono compares to the time when policy makers like Ben Bernanke dismissed the housing bubble. Tim Iacono thinks that economists and policy makers should be cautious about relying on the presently low borrowing costs reflected in the low 10-year Treasury yield. See the following post from The Mess That Greenspan Made.

All this talk about how borrowing costs are so low that Washington couldn’t possibly be facing any sort of a debt crisis – that the 3.2 percent yield on the ten-year note is somehow a vote of confidence in policies coming out of the nation’s capitol – makes me think that, just as the insane fixation on a low consumer price index was a major contributor to the financial crisis, signals coming from U.S. debt markets are being similarly misinterpreted today and this may ultimately lead to an even bigger crisis in our not-too-distant future.

Misreading what these indicators are saying – or simply reading into them what one wants to believe instead – has led to bad policymaking before and is likely to do so again.

Perhaps sooner than anyone might think…

For a good example of this, one has only to look back to the middle of the last decade when the housing market was booming and economists across the land marveled at how the Federal Reserve had not only tamed the business cycle and kept prices low, but made nearly every homeowner wealthy to boot!

The central bank’s fixation on the green light being emitted by the consumer price index (and then, unbelievably, fear of deflation in 2002-2003 as home prices were rising at 10 or 15 percent a year) blinded policymakers to the flashing red light of an asset bubble that would meet its pin a few years later.

Similarly, the eagerness demonstrated by many elected officials in Washington to keep making that national debt clock spin faster and higher (with the blessing of most economists) while marveling at how little it costs to keep paying interest on the $13+ trillion tab could be setting the stage for a vicious cycle of sharply higher borrowing costs and even higher deficits.

When “freakishly low” interest rates approach more normal levels, just like when millions of overextended homeowners’ HELOC payments started to bite a few years back, Washington could have a major problem servicing the country’s ginormous debt.

Most policymakers dismiss this idea in 2010 just as they scoffed at the idea of the existence of a housing bubble back in 2003, 2004, and 2005 when something could be done about it.

Have a look at the now classic Bernanke was Wrong video at about the one minute mark where Maria Bartiromo asks the soon-to-be Fed chief about the worst case scenario if home prices were to drop precipitously:

I guess I don’t buy your premise. It’s a pretty unlikely possibility. We’ve never had a decline in house prices on a nationwide basis. So, what I think is more likely is…

What the Fed chief thought was more likely wasn’t even close.

Now, compare that to Nobel Prize winner Paul Krugman’s op-ed not long ago:

Right now, investors don’t seem at all worried about the solvency of the U.S. government; the interest rates on federal bonds are near historic lows…

Brad Delong went so far as to put up a chart of Treasury yields and ask readers:

Look at this and tell me that the U.S. federal government is running up against the limits of its debt capacity…

In both cases, indicators provided signals that economists and elected officials desperately wanted to hear – that inflation was low early in the last decade, so monetary policy was appropriate and borrowing costs are low today, so servicing the U.S. debt isn’t a problem – yet this thinking in 2005 proved to be horribly wrong, prompting the very reasonable question of whether something similar is going on today.

[Note: In one of the more disturbing developments over the last few years, despite overwhelming evidence to the contrary, most Federal Reserve economists have yet to concede that "freakishly low" interest rates were a major factor in the housing bubble's inflation and demise. This remains a very troubling issue for many reasons (not the least of which is that the interest rate pedal has been nailed to the floorboard again for the last year-and-a-half) but, for the purpose of this article, let's assume that "Fed policy" back around 2004-2005 also included the "hands free" approach to regulation and goading potential homeowners into taking the plunge by, among other things, denying the very existence of a housing bubble as detailed in this item earlier today.]

So, flash back to the first half of the 00’s and the relationship between home prices and the CPI (Consumer Price Index) was as shown below. Yes, there were a lot of other things going on at the time, but the government’s official measure of inflation was a major factor when central bank economists deliberated over whether short-term interest rates of one percent were appropriate.



Stripped of anything that resembles home prices since 1983 when the costs of homeownership were replaced by the nefarious “owners’ equivalent rent” (see this 2007 item for more on that subject), as the housing bubble was reaching its maximum level of inflation, the vast majority of the nation’s top economists (and virtually all economists involved in policymaking) were much more interested in patting themselves on the back for a job well done rather than considering that the housing-neutered CPI might not be the only thing they should be watching.

Fast forward to today and you’ll hear similar arguments about the relationship between the nation’s growing debt and the yield that bond investors are demanding to hold it as shown below. The not-so-well trained eye of some of today’s crack economists look at this and conclude that, if anything, there is an inverse relationship between the level of U.S. indebtedness and interest rates – the more we borrow, the less it costs!



But, once again, there is a key piece of information that the above data omits and that key piece of information turns the conclusions that many economists are reaching on its head:

The world is awash in easy money and investors are scared to death!

Where else are wealthy nations, corporations, and individuals going to put their money in a global financial system that appears to be teetering on the edge of an abyss as it did before falling in back in late-2008?

Well, yes, they seem to be fond of gold lately, but there’s so little of the stuff around…

Over the last couple years, central banks and governments have been flooding the world with money in the mistaken belief that even more easy money will cure the problems created by the excessive easy money policies from a few years ago.

Naturally, doing the same thing and expecting a different result is no way to run a global economy, but that’s a discussion best left for another day.

Simply put, U.S. borrowing costs are so low because the rest of the world is so freaked out about what they see happening all around them and they can’t think of anything better to do with their money – not because they are blessing the large and growing U.S. debt!

Moreover, the fact that a lot of the most recent easy money is going from the Federal Reserve to big Wall Street banks and then right back to the Treasury Department to purchases U.S. debt (pushing prices up and yields down) should give great pause to anyone thinking that low U.S. borrowing costs are flashing a green light for more borrowing.

Really!

Are policymakers that stupid?

As for how the dismal science is being practiced these days, it sure would be nice if economists could factor “common sense” into some of their vaunted models, then they could dial in a little or a lot of it as they saw fit.

This article has been republished from Tim Iacono's blog, The Mess That Greenspan Made.

Is The US Headed Toward A Debt Time Bomb?

Harvard Economist Ken Rogoff says we should be very worried about the growing national debt and that the current growth rate of debt could lead to a second wave of financial crises within years. However Mark Thoma discredits Rogoff, arguing that his concerns about debt caused him to advocate raising interest rates and argue against a stimulus in June of 2008. See the following post from Economist's View for more.

Ken Rogoff says the debt crisis he has been warning about for many years is still a risk:

From Financial Crisis to Debt Crisis?, by Kenneth Rogoff, Commentary, Project Syndicate: ...How can policymakers be so certain that financial catastrophe won't soon recur when they seemed to have no idea that such a crisis would happen in the first place?

The answer is not very reassuring. Essentially, there is still a risk that the financial crisis is simply hibernating as it slowly morphs into a government debt crisis.

For better or for worse, the reason most investors are now much more confident than they were a few months ago is that governments around the world have cast a vast safety net under much of the financial system. At the same time, they have propped up economies by running massive deficits, while central banks have cut interest rates nearly to zero.

But can blanket government largesse be the final answer? Government backstops work because taxpayers have deep pockets, but no pocket is bottomless.

And when governments, particularly large ones, get into trouble, there is no backstop. With government debt levels around the world reaching heights usually seen only after wars, it is obvious that the current strategy is not sustainable. ...

We are constantly reassured that governments will not default on their debts. In fact, governments all over the world default with startling regularity, either outright or through inflation. Even the U.S., for example, significantly inflated down its debt in the 1970s, and debased the gold value of the dollar from $20 per ounce to $34 in the 1930s. ...

The ... rate at which government debt is piling up could easily lead to a second wave of financial crises within a few years. Most worrisome is America's huge dependence on foreign borrowing, particularly from China... The question today is not why no one is warning about the next crisis. They are. The question is whether political leaders are listening. ...

How Paul Krugman might respond:

So is there anything to worry about? Yes, but the dangers are political, not economic. ... Over the really long term,... the U.S. government will have big problems unless it makes some major changes. In particular, it has to rein in the growth of Medicare and Medicaid spending.

That shouldn’t be hard in the context of overall health care reform. After all, America spends far more on health care than other advanced countries, without better results, so we should be able to make our system more cost-efficient.

But that won’t happen, of course, if even the most modest attempts to improve the system are successfully demagogued — by conservatives! — as efforts to “pull the plug on grandma.”

So don’t fret about this year’s deficit; we actually need to run up federal debt right now and need to keep doing it until the economy is on a solid path to recovery. And the extra debt should be manageable. If we face a potential problem, it’s not because the economy can’t handle the extra debt. Instead, it’s the politics, stupid.

Note also that the bond price data do not show any signs of worry over inflation, default, or crowding out.

One more note. This is Rogoff in June 2008. He argues that there should be no stimulus, the risk posed by deficits is too large, and that interest rates should be raised to prevent inflation:

[P]olicymakers must refrain from excessively expansionary macroeconomic policy ... and accept the slowdown... For most central banks, this means significantly raising interest rates to combat inflation. For Treasuries, this means maintaining fiscal discipline rather than giving in to the temptation of tax rebates and fuel subsidies. In policymaker’s zealous attempts to avoid a plain vanilla supply shock recession, they are taking excessive risks with inflation and budget discipline that may ultimately lead to a much greater and more protracted downturn.

My own view is that "significantly increasing interest rates" in June 2008 would have been a disaster, and that deficit spending was needed to prevent conditions from deteriorating even further. Opposition to deficit spending from people like Rogoff only served to delay putting this policy in place. (Also: This was prior to Lehman, inflation was being driven by commodity price increases, i.e. by relative price changes which do not pose long-run inflation risks, and had the Fed followed this advice and raised rates, it would have likely reversed course after Lehman further undermining its credibility at a time when credibility was needed the most.)

This post has been republished from Mark Thoma's blog, Economist's View.

Geithner Urges Congress To Raise $12.1 Trillion Debt Ceiling

Although the US debt ceiling currently stands at $12.1 trillion, the ceiling could be shattered by October as the national debt is rapidly approaching $12 trillion. Should the national debt be allowed to grow without limit? Tim Iacono from The Mess That Greenspan Made discusses this.

In a letter to Congress yesterday, Treasury Secretary Timothy Geithner urged elected officials to raise the $12.1 trillion debt ceiling since, according to current projections, that limit may be reached as soon as mid-October.

If there is a more inane concept than a U.S. debt "ceiling" - one that is moved upward, regularly, whenever necessary - someone please tell me what that inane concept is.

And, no, Geithner's justification for the higher level of U.S. government debt does not qualify since it is directly related to the ceiling itself.

It is critically important that Congress act before the limit is reached so that citizens and investors here and around the world can remain confident that the United States will always meet its obligations.

You see, in the twisted logic that passes for policymaking in Washington, it's critically important that the limit be increased before it is reached. Otherwise investors may lose confidence in the entire system - not so much because of the spiraling debt and the lack of any sort of realistic plan that would see the money be repaid, but because lawmakers hadn't paid close enough attention to the relationship between the debt and the debt ceiling, failing to move the ceiling upward when conditions required such action.

The debt ceiling was last raised just six months ago when the stimulus bill was passed.

This post was republished from Tim Iacono's blog, The Mess That Greenspan Made.

Can Obama Convince The World To Buy US Debt?

As the government plans to sell $65 billion in notes and bonds this week, we will see whether Obama, Geithner, and Bernanke were able to renew the confidence of overseas investors in America's ability to repay debt. Will countries like China and Saudi Arabia continue to buy US debt? Peter Schiff from Money Morning discusses this in the following post.

Just last week, Team Obama took its financial-crisis dog-and-pony show on the road. U.S. Treasury Secretary Timothy F. Geithner went to China. Federal Reserve Chairman Ben S. Bernanke visited Capitol Hill. And President Barack Obama, himself, embarked on a Mideast tour that started in Saudi Arabia.

This full-court press is not coincidental, and comes just as the federal government began unloading trillions of dollars in new U.S. Treasury obligations. The coordinated charm offensive is meant to assure the world-at-large that the United States can repay these obligations - without destroying the dollar.

Given the renewed weakness in the dollar and the recent expressions of concern from China-our largest creditor-about the safety of its current holdings, this is no easy sell. Not only must our leaders convince holders of our debt not to sell what they already own, U.S. officials must persuade these same foreign investors to back up the truck and buy a whole lot more. The hope is that a Dream Team - consisting of a charismatic politician, a skilled Wall Street banker with longstanding ties to China, and a respected Fed chairman - can close the deal. However, no matter how slick the sales pitch, no amount of lipstick can dress up this pig.

The most obvious fear the trio must address is that oversized deficits will persist indefinitely. Reading from a carefully scripted rebuttal book, all three proclaim that as soon as the stimulus revives our economy, the government will take all necessary steps to reign in the deficits that result. Bernanke’s testimony showcases this rhetorical shift. The Fed chairman claimed that catastrophe has been averted and that the recession is nearly over. As a result, he advised Congress to now focus on debt management. How he expects U.S. lawmakers to do that was left unexamined.

Setting aside the fact that the recession is far from over and that the stimulus will actually weaken the economy in the long run, Bernanke’s words were less a practical guide to Congress than a bromide for our foreign creditors. Meanwhile, President Obama carefully peppers his speeches with calls for Americans to live within their means, to save more and spend less, to produce more and consume less. But nothing in the government’s current fiscal or monetary policy will encourage such behavior. In fact, the objective of economic stimulus is to prevent such changes from taking place!

The laughter of Chinese students that greeted Secretary Geithner at Peking University shows how ridiculous this spiel sounds overseas. Actions speak louder than words, and the actions of the Obama administration are deafening. Multi-trillion-dollar deficits, bailouts, nationalizations, quantitative easing, and grandiose plans for government-provided healthcare, education, and alternative energy, render all of the administration’s claims of future prudence meaningless. If our leaders will not make tough choices now, why should anyone believe they will do so later, when those choices will be even harder to make?

Of course, it’s not just major holders - such as China and Saudi Arabia - that need to be convinced. Since the largest holders are already in so deep, they have the greatest short-term incentive to play ball. While throwing good money after bad is certainly a lousy investment strategy, it is politically expedient as it delays the need to officially acknowledge losses.

The spin is designed to keep all the smaller, more nimble holders from dumping their U.S. Treasury securities. The major holders can publicly pledge their commitment to Treasuries, while they privately planning their exit strategies, as long as they feel that the smaller holders won’t spook the market by front-running their trades.

However, once the psychology turns, there is no way to stop the rush for the exits. Remember how quickly the secondary market for subprime mortgages collapsed? One day, investors were lining up to buy; the next day, the stuff couldn’t be given away.

Make no mistake about it, we are issuing subprime paper and no amount of political spin can alter that reality. Bogus credit ratings aside, I think the world already knows this and it’s just a matter of time before someone admits it.

In the meantime, by continuing to lend, our creditors merely supply us the shovels to dig ourselves into an even deeper economic hole. Their credit enables our government to grow when it needs to shrink, finances bailouts of companies that should be allowed to fail, and enables a nation that should be saving and producing to continue borrowing and spending. As a result, the more money the world loans us, the less capable we are of paying it back. I really wish the world would stop doing us favors, as neither party can afford the consequences.

For a timely example, just look at California. With an unmanageable $20 billion deficit, California recently asked Washington for a bailout. With none immediately forthcoming, California was forced to make real and needed budget cuts. The hard choices, which will benefit California in the long run, would not have been made if federal funds had been committed. We all should be so lucky.

This article has been reposted from Money Morning. You can view the article on Money Morning's investment news website here.