Wednesday, June 01, 2011

We're betting on default...

After pondering some deep ponders, we are girding our loins for a default by the US Treasury, to be followed by a deeper recession as the financial markets melt down.

The reason is simple: we can no longer negotiate - we engage in tests of will.

Perhaps more importantly, we have a large number of powerful people convinced we can default without major consequences.

I am reminded of that as I listen to those Republicans who claim that a small default on payment of principle and interest to creditors would not roil credit and equity markets.  Indeed, 17 Republican Senators have sent a letter to Treasury Secretary Tim Geithner saying that if a default on sovereign debt payments occurs, it is all Geithner’s fault.  The “reasoning” for this statement is the fact that the Treasury takes in much more money than is needed to pay outstanding debt on time and in full, so it’s Geithner’s responsibility to make sure that happens.What they don’t say is that a government services disruption of an unprecedented nature would then occur—after all, if Treasury pays the debt cost, it has to cut spending somewhere else.  And in a cash-in/cash-out system, only hundreds of thousands of layoffs and the issuance of IOUs to contractors, among other chaotic choices, would satisfy that “stubborn fact of life.”Apparently, the belief that no one in the United States would notice such layoffs, and the resulting economic disruption, is held as an article of faith by folks who ought to know better.In a separate letter, 23 GOP Senators wrote to President Obama calling upon him to create a budget plan that would assume no increase in the government’s ability to borrow.And, Stanley Druckenmiller reprises his 1995-96 role in a budget/debt debate by once again contending that a short term default wouldn’t disturb markets if a major deficit reduction plan emerged.(If I were 24 years old, seven feet tall, with a superior hook shot and athletic ability, I would be the center for the Los Angeles Lakers.  That is about as relevant as Druckenmiller’s hypothetical discussion of markets’ reactions to something that isn’t going to happen.)When politicians talk about politics, it is wise to listen.  They do it for a livelihood and if they are wrong, they lose their jobs.  Just like butchers and back surgery, however, don’t listen to politicians with little or no experience in modern financial engineering when they predict market behavior.Listen to market participants, who will lose their jobs if they are wrong.Or watch the rising costs of Credit Default Swaps (CDS) in the marketplace.  Without getting too technical, when those costs rise, it means that markets are losing faith in a form of financial product—in many cases, national sovereign debt.  The CDS market forecast the late and unlamented financial meltdown of three years ago before almost any other market mechanism.According to the Depository Trust and Clearing Corporation, which gathers information about global CDS, global traders and investors have increased their purchase of this form of insurance, doubling the level of such insurance on American sovereign debt in 12 months.So, who you gonna believe—the markets or the politicians?Here are a couple of ways to make that decision:*ask the next Senator you see about the Credit Default Swap situation;*ask the next Congressman you run across at a fund-raiser about the size of the global derivatives market;*ask the next Washington, D.C. politician you meet how many swaps and derivatives contracts he or she has personally arranged.Then, ask a Wall Street fixed-income trader the relationship between United States sovereign debt issuance and the global markets in these arcane financial instruments.  Finally, ask this trader for the legal and market implications of failures of counterparties to be able to perform as contractually obligated because the United States defaulted “just for a little while” on its debt payments.And, the coup de grace, just ask anyone if they think it is wise to test a theory about marketplace behavior when failure of that test could severely undermine the confidence of markets all over the world about the reliability and judgment of United States policymakers.A theory gaining ground on Capitol Hill posits that with all the turmoil in North Africa, the Middle East, in Japan, and with wars in Iraq, Afghanistan, and Libya, American Treasury securities will continue to be the first choice with global investors who want to protect their capital.  That’s like saying that we should foul our own nest because others’ nests are even worse. [More]
I think many assume there is a script somewhere and the actors are just peaking the dramatic tension. I do not. I think we are being led by badly misinformed, power-motivated politicians who would just as soon push the economy back into recession on the gamble it would be blamed on their opponent.
Because we really don't know how this failure would play out, there seems to be a curious sense of "Let's find out!" floating around DC-wannabees. After all, if it goes very badly there will be plenty of mud to be splashed on everyone, and perhaps more of it will stick to the other guy. If you are currently out of power, there could be a "What do we have to lose?" mentality.
At any rate, between now and August, barring any surprising breakthrough,  we will fumble for a position that could at least let us get this crop sold for a profit. After all, current prices aren't bad.
If I think of any other measures I'll share them. And hope I am wrong.


Anonymous said...

Sounds like Illinois politicians are running Washington! Not paying your bills timely is an Illinois trick. The government needs to cancel some subscriptions, drop cable TV and grow a garden and buy only used cars. We need frugal across the board.

Chuck said...

I could pun on politicians who aren't concerned about defaulting on their principles.

But don't you think the blogger you quote should at least use the correct word (principal, not principle) if he's going to comment on financial matters?

John Phipps said...


Good catch, but you could spend all day pointing out similar blog errors.

Responding with complete thoughts and semi-readable prose is just about the most you can expect from someone who is posting several times a day in the heat of battle.

Besides the presence of hotlinks outweighs the polish of multi-edited writing.

Just my experience talking - I know some of my posts make me cringe when I re-read them, but I hope some of my logic gets through.

Brian said...

Credit markets are obviously sanguine over the any possibility of default - just look at the price of treasuries. Are you saying the market is wrong and you are right?
This is a fight over reducing spending, reductions which make US debt more sound in the long run. Markets fear fiscal profligacy, and tacitly cheer citizens who are sick of gov't debt. A technical default that resulted from getting the fiscal house in order would be a boon to our creditors.
I am not saying there wouldn't be turmoil, or that the politicians shouldn't soberly work this out ahead of time. But the battle here is between the short term potential default and the long term potential default.

John Phipps said...


I am puzzled by financial markets as well, but I also believe that they will not react gradually, but in quantum leaps and lightning speed. In short I think they will start pricing in more risk. And we won't see it coming. This is a pretty weak explanation, I'll admit.

Keep in mind, that investors have very few choices with the global economy losing steam. Even if you think there is risk in bonds due to default, where do you put money? Especially BIG money?

Technical default is a deceptive term implying lesser consequences, a belief I do not share.

Finally, we have a long-term debt problem and an immediate growth/employment problem. I think we are attacking them in reverse order with the risk of a second and much deeper recession which we would exacerbated massive premature government spending cuts such as we have seen at the state level.

Anonymous said...

What the markets will eventually react to this summer is the irrational and irresponsible behavior being displayed by Congress. Yeats had it right with his phrase:"The best lack all conviction, while the worst
are full of passionate intensity." When responsible people won't step up and serve in government, Ignorance and zealotry fill the void.