Wednesday, July 27, 2011
"Those whose duty it was to watch over the safety of the country lived simultaneously in two different worlds of thought. There was the actual visible world with its peaceful activities and cosmopolitan aims; and there was a hypothetical world, a world 'beneath the threshold,' as it were, a world at one moment utterly fantastic, at the next seeming about to leap into reality-- a world of monstrous shadows moving in convulsive combinations through vistas of fathomless catastrophe." -Winston Churchill, "The World Crisis; Volume I, 1911-1914"
I saw a poll yesterday which indicated that Americans are roughly evenly split on whether or not a US sovereign default would be a major catastrophe. This is pretty shocking to me because it seems transparently obvious that this would be a major catastrophe for which most of the world is vastly unprepared. So here is a litany of events that will cascade if and when the US halts payments to creditors.
1.) America will be shut out of the international capital markets for some period of time. If you are known to willingly default, then people stop lending you money.
2.) An instant MASSIVE recession. Though many people have a vague idea that the deficit is large they do not quite fully understand the degree to which the government services they enjoy are debt financed or just how large a fraction of the economy those services have become. Hmm... I wonder how big that is... lets have a look at it on the official budget document (check supplemental table S-1 on page 171) So here are the facts: in 2011 the government will take in $2.174 trillion and spend $3.819 trillion leaving a deficit of $1.645 trillion. That is to say that this year of the services the government is providing, it is borrowing 43% of it or for every dollar the government took in taxes, it borrowed another 75 cents and then spent it. Another way to think of it is that this deficit is about 10% of GDP which is to say that one out of every ten dollars in the economy this year was funded by federal borrowing. Does that sound like a lot? It sure as hell is. This is why the Tea Party is so freaked out, we really are in a deep hole. Is this the right way out? Probably not. Because once we default all that borrowing will come to a screeching halt and we will have a contraction in the economy of roughy 10% of GDP at high speed.
For some perspective on this remember the “great recession” of 2007-2009? During that time the economy shrank by about 12%. Now imagine a similar level of economic chaos happening IN A DAY. That's what we're looking at.
3.) Holders of US Treasury securities will begin to sell them. The US Treasury market is the largest single asset class in the world. This means that organizations that have to save a large amount of money hold a lot of them. Specifically Central Banks who peg their currencies to the US dollar have MASSIVE holdings of Treasuries. They also have a mandate to not lose money another reason they have been in Treasuries, until now they have been thought of as virtually risk free. Once the US chooses to default those holders will be tempted to begin to liquidate their holdings. It won't be an easy decision because even after the US Treasury begins to default the value of these bonds will not go to zero. This is because everyone knows that the US will at some point want to try to borrow money again. In order to do that they are going to have to have some kind of settlement with the holders of the pre-default bonds for some nominal amount of money. The large holders of the bonds will, if they can statutorily, hold on to the bonds because they'll have a lot of negotiating power with the US government. The problem is, as people sell them, the large holders will have to take larger and larger losses and may decide themselves to sell. One particular problem they will face is that almost immediately they will have to take large losses because a trick of the CDS settlement process.
4.) CDS are “Credit Default Swaps.” These are basically debt insurance policies and just as you can buy them to insure the risks you have of a company defaulting you can do the same for a sovereign. Let's say I sell you a $1 million CDS on IBM and then IBM goes bankrupt. I'll have to pay you the difference between what he lenders are able to recover of their original loans through liquidating the assets of IBM and the $1 million. So lets say that after selling all the real estate and type writers the creditors get 20 cents on the dollar, I owe you $800,000.
So, when an issuer on which a CDS has been written defaults there is a mechanized process by which all the people who owe insurance payments pay all those who are owed payments. At the center of this process is a large auction. This is because it takes too long to figure out how much money is going to be recovered in a liquidation. So what ISDA, the group responsible for settling CDS does is it hosts a massive bond auction to arrive at the markets best guess as to what the recovery value should be and then uses that price to benchmark who owes what to whom.
Historically this has not been the case in a sovereign default. What would happen is that the large holders would hold on and try to negotiate the best terms possible from the defaulting government. This happened in Russia in 1998 and again in Argentina in 2001 the bonds might trade but thinly and most effort was focused on the negotiations. But now, ISDA arranges a massive auction which would force all holders of US Treasuries to instantly realize their losses. Remember also that at the same time as this auction is being held the Peoples Bank of China and the Saudi Arabian monetary authority are going to have to decide whether or not to sell their holdings. And then here is ISDA hosting a nice auction, or liquidity event for them. Needless to say this could get ugly. It is hard to imagine a world in which there is a US sovereign default, then an auction with mildly well capitalized vulture funds on the buy side and the largest central banks on the other. Something tells me prices will go down, a lot. When the PBOC et all blow out of their treasuries they'll probably be blowing out of their dollars as well. So we would have a simultaneous dollar crash and interest rate spike. This would be, shall we say, manifestly not helpful for coming out of a 10% recession.
5.) The most interesting aspect of this for me is that it would basically destroy the modern framework of theoretical finance. In the way that the law of gravitation is central to the modern understanding of physics, the Capital Asset Pricing Model or CAPM is central to an understanding of modern finance. Basically the CAPM says that all asset in the world are related to each other through their expected rates of return and the variance, or risk, associated with that return. The idea is that returns and risk should be positively correlated, that is to say the more risky something is the higher the return. This is enforced by the daily actions of markets. If I have two assets which have the same return but one is more risky than the other I'll sell the risky one and buy more of the less risky one. This action will push down the price of the risky asset and thus increase its return. I'll stop doing this once the return is high enough for me to be willing to take on that risk.
6.) In this way all assets are related to all others and all of this assumes that, at the base of it, there is a risk free rate. That is a rate of return on which there is zero variance. Once you have that rate you know a great deal more about the relative attractiveness of all the assets with non-zero variance. For the entire existence of the theory the markets have used the US Treasury rate as a proxy for that anchor risk free rate and have priced all, and I mean ALL, other risk assets at a spread to that risk free rate. This made sense because after all the United States has hundreds of years of continuous Constitutional Governance, is surrounded by oceans or nations it dominates militarily, has thousands of nuclear weapons and has legal taxing power over the most productive economy in the history of the world. Sounds pretty risk free to me, except for one small thing. It can CHOOSE to default. If it does it would be the financial equivalent of altering the gravitational constant. The theory which links all asset classes to one another will have had its bedrock assumption thrown out the window and will have to reconstitute itself.
That process will begin with sudden massive repricing of all the risk assets in the world as people realize that the world is actually much more dangerous than they had been thinking for the preceding fifty years or so. This will start slowly and will build at huge speed in parallel with the CDS auction/fire of Treasuries which will jack interest rates in the US to the moon, the collapse of the dollar which will jack commodity prices to the moon, and simultaneous with the 10% of GDP recession induced by the sudden withdrawal of US government spending.
It is, in short, the end of the world.
Tuesday, July 26, 2011
In order to see into the mind of the men who are behind the brinksmanship over the debt ceiling it is instructive to read the editorial that Ron Paul wrote to on Bloomberg on Thursday. Ron Paul is a Republican and a libertarian who is a presidential candidate so his views are important. Among his more controversial views are the ideas that both heroin and prostitution should be legal. Whether you agree with these views or not I think they are consistent with his views of the effects of the consequences of a breach of the debt ceiling: that is to say they begin with a deceptively simple premise but struggle under close analysis.
Ron Paul is one of the leading conservatives pressing for a voluntary default through a Congressional refusal to rasie the statutory debt limit. His overall view is that such a default would be painful but not catastrophic and would, in the long term, be healthy because by withdrawing access to capital markets the government would be forced to live within its means. He would prefer this to happen sooner rather than later. It seems to me from his editorial that his views are based on a false analogy, a clear lack of understanding of the mechanics of a fiat monetary system, the role of the Central Bank, and the degree to which a default would resolve our problems by becoming some kind of deus ex machina which would instill the discipline that he and his colleagues, and ultimately we the voters, have so far been unable to muster.
Paul begins his editorial by claiming that default by the US government is a common occurrence and each time it has not been followed by a major calamity. The three examples he mentions are as follows: first when Roosevelt revalued the dollar against gold and forbade transactions in gold in 1934. The second is when congress stopped silver redemption of the dollar in 1968, and the last was the “Nixon Shock” when Nixon halted gold the convertibility of dollars into gold at the rate fixed via the Bretton Woods Accords. As should be obvious to anyone with an economics background, none of these events constituted a formal default. They were all currency devaluations. They were steps on the road from a monetary system tied to gold to a “fiat” system, one in which the values of currencies were determined by the “faith” of markets.
From the post Civil War resumption of payments in gold in 1871 until the end of the Bretton Woods international monetary system in 1972 the US dollar was convertible into gold or silver at a fixed ratio though that ratio was periodically subject to change. In the early 1930s after the stock market crash precipitated the systemic collapse of the US banking system America entered a deflationary spiral. Because the dollar was pegged to gold the Federal Reserve lacked the tools that Ben Bernanke has used to prevent a similar deflationary spiral in the aftermath of the real-estate/Lehman collapse. Changing the rate at which the dollar was convertible into gold was a primitive form of "quantitative easing" it basically created more dollars relative to gold.
After the second world war, in order to help the rebuild the economies of the anti-Soviet alliance we had assembled we established a global fixed exchange rate regime called the Bretton Woods Accords. This was a system of fixed exchange rates and capital controls. Bretton Woods effectively pegged the currencies of every country in the world to the dollar and pegged the dollar to gold. At the time the US was 45% of global GDP and the largest trading partner of every major industrial country, as a result at the start of the system it was a trivial matter for the US to function as the anchor. By the late 1960s the rest of the world had recovered, the global trading system as I have outlined in another post had recovered and advanced to levels never before seen. The Bretton Woods arrangements which had originally served to buttress the global free trading system began to hobble it, particularly its anchor, the United States. America had been fighting the Vietnam War and had embarked on a series of costly social programs which resulted in high levels of money creation which made the maintenance of the gold peg extremely difficult. Gold and silver began to pour out of the country. In 1968 the government stopped redeeming dollars in silver at a fixed rate. It threatened but did not destroy the Bretton Woods System because that was pegged to gold. Then in 1971 Nixon fully halted gold convertibility of the dollar which set the stage for the dissolution of the global regime of capital controls and fixed exchange rates. This in turn paved the way for the global fiat monetary system we have today. Keep in mind that though the government no longer pegged the dollar to gold, the whole time if continued to borrow, and repay, all its lenders in US dollars which were legal tender for all debts public and private in the United States.
So as you can see, all these episodes are the systematic detachment of the US dollar from the gold standard and are therefore devaluations. Ron Paul conflates them defaults. From a narrow perspective this is true. Let's say for the sake of argument that you were a hedge fund founded the year of the American Centennial in 1876. Let's further imagine that your strategy was that you would borrow gold, take that gold change it into dollars and then lend it to the US government thinking to yourself that, since the dollar was convertible into gold if anything went wrong you would simply sell your Treasuries, change your dollars for gold at the fixed rate and then pay back whoever had lent you the gold. If you had that strategy on in 1934, 1968, or 1971 you may well agree with Ron Paul that the US government had defaulted on you. After all, they were paying you back in dollars but those dollars were worth far less in gold terms than they had been when you originally borrowed the gold. You got smoked.
The question to ask, however, is how many people were in that position and did it damage the credibility of the Federal Government? Well, considering that the financial power of the age, Great Britain, had abandoned the gold standard in 1931 there was virtually no one in that position and given that in Bretton Woods all the worlds currencies were pegged to the dollar which was then pegged to gold, literally no US Treasury investor on Earth was in a position to be harmed by the US abandoning the gold standard. Yes, it was a devaluation of the dollar in gold terms and so if you were a holder of US Treasuries benchmarked to gold you would consider the US to have defaulted. But, since 1945 the dollar itself has been the reserve currency of the world it is pretty hard to think of the abandonment of the gold standard as a default. It was not accompanied by a reduction in the credit rating of the US or even of a mild disruption of the American ability to access global capital markets. Ron Paul's problem is that he looks at these devaluations and conflates them with default. He then draws the conclusion that since these defaults were not do bad that a straight up default would not be so bad either. Of course, as you can see, from start to finish these were not defaults and therefore Paul's logic is deeply, deeply flawed and massively underestimates the chaos which would result in a straight up de jure default on US Government obligations.
In his next two sections entitled “Unlimited Spending” and “Boom and Bust.” In them he makes the claim that once the US was off the gold standard it was free to borrow as much as it liked limited only by demand for Treasuries. He also concludes that the Federal Reserve is responsible for the business cycle through its control of interest rates. These assertions also have a tenuous connection at best to the historical record.
First of all, as we can see in the European periphery, there is indeed a point at which, even in a fiat monetary system, the bondholders will pull the plug on a sovereign borrower. Thus a fiat monetary system is not the blank check he claims. While it is true that the capacity of the US government to borrow is limited only by the willingness of investors to buy treasuries the US had a far far higher debt to GDP ratio in 1946 when we were still on the gold standard. For that matter the highest debt to GDP ratio in the history of the world that did not result in default (Great Britain, 1814, 225% of GDP) also occurred under a gold standard. So fiat money did not create the capacity for governments to borrow titanic sums. As far as speculative bubbles being the creation of central banks he might want to look over the history of the Dutch tulipomania which occurred in the absence of a central bank or the panics of 1857, 1869, 1873, 1893, or 1907 all of which occurred before the Federal Reserve Act to see that this is quite simply not the case.
Then comes his section on “Hard Decisons” and here the mistake Paul makes is a simple one of accounting, though it spectacular consequences. “It isn't too late to return to fiscal sanity,” he says, “we could start by canceling out the debt held by the Federal Reserve, which would clear $1.6 trillion under the debt ceiling.” This is simply ludicrous. Something to remember about The Federal Reserve Bank is that it is, as the name implies, a bank. This means it has a balance sheet. On one side of that balance sheet are the assets of the bank, among them $1.6 trillion in US Treasury securities, ordinarily considered risk free. Also on that side are another $1.3 trillion of other assets for total assets of $2.9 trillion. On the liability side there are $2.8 trillion in liabilities including $1.6 trillion worth of deposits from the nations commercial banks which they are required to hold at the Fed in order to ensure their safety and soundness and a mere $25 billion in equity. So guess that happens if you force the fed to write down $1.6 trillion in US Treasury securities because you have “cancelled them out.” You create a $1.6 trillion hole in the Fed's balance sheet which would, in effect, make the Federal Reserve Bank insolvent. THus it would be unable to redeem the $1.6 trillion in deposits back to the banking system and therefore transmit that insolvency to the entire banking system and from there to the real economy. This, of course, would be a major economic fiasco. Thus either the Fed would have to print $1.6 trillion, which I am sure Ron Paul does not envision with this plan, or the government would be forced to recapitalize the Fed to the tune of $1.6 trillion. Does the government have $1.6 trillion? No. It would have to borrow it, and we're right back where we started. I find it somewhat shocking that A.) Bloomberg printed this, and B.) there are people who think of it as a realistic possibility.
So Pauls theory is essentially that we have defaulted a lot in the past, that these defaults were not fatal, and that if we default today it will, in the short term, limit the access of the government to credit markets and therefore force the government to live within its means. Therefore, he concludes, default is the best option. This is of course absolutely insane, a straight up de jure default by the US would not only shut the US out international capital markets, but it would also obliterate the global fiat monetary system as well as force a massive repricing lower of every risk asset on Earth. Think of it in these terms, the post Lehman recession was two consecutive quarters of -6% GDP growth. The deficit is currently 12% of GDP, so a default which shut the US out of capital markets would be the equivalent of having all the financial turmoil for the fourth quarter of 2008 and the first quarter of 2009... in a day.
The other half of the problem with Ron Paul, is that though he is entirely wrong with his prescription for what ails the US, he is not wrong about the diagnosis. It is true that the net liabilities of US government entities at all levels are in the hundreds of trillions. It is true that no amount of “taxing the rich” will come close to financing them. It is true that the most likely outcome is serial inflations and defaults. Because these things are true he seems to have some credibility, indeed he is one of the few in Congress who grasp just how deep the problem is. Unfortunately, he is like Karl Marx, he has correctly identified the problem but his solution is destined to failure and catastrophe. He intends to rely on the bondholders to instill the discipline that he and his colleagues do not possess. But this is why we elect people like Paul to serve us in Washington. The right thing to do is to have the voters decide how much pain gets taken, by whom and at what speed. People like Ron Paul who would prefer to throw their hands in the air, and let the panicking bondholders decide those things are abdicating the very responsibility they have been granted by their constituents.
It is a crime against the country and the Constitutional order they feign to revere.
Monday, July 25, 2011
So the circus in Washington has made me decide to restart my blog.
So I've been following the debt ceiling talks very closely and I have just finished reading the transcripts of the television addresses of Obama and Boehner.
Where we are is this: the Democrats and the Republicans are miles apart and are not even negotiating. Instead they are trading barbs on twitter and blaming each other on national television. From the legislative perspective each party is crafting a separate bill in the chamber in which it has a majority and attempt to brute force it through the other chamber. This is very much a non-trivial matter. The Republicans might filibuster the Democratic bill in the Senate which would mean that they can't even get it to the House. This would give the GOP the advantage in that their bill might be the only game in town which would put additional pressure on the Senate and Obama to pass it. In my opinion, the bills are substantially different and are both primarily motivated by the political interests of their authors and are an attempt to frame the opposite party as unreasonable rather than to try to compromise.
The House bill recognizes the failure of the GOP to make progress on trimming the deficit and seeks to buy more time. Their bill contains a $1 trillion increase in the debt ceiling matched with the $1 trillion in spending cuts that were the least controversial in the recently failed negotiations. This is paired with a requirement to appoint a commission which will be tasked with finding another $1.6 trillion in cuts to both discretionary and entitlement programs as well as revenue increases through reform of the tax code. Only once the additional $1.6 spending cuts have been identified will the government raise the debt ceiling an additional $1.6 trillion. Some kind of deal would have to be reached relatively shortly because the government will blow through the $1 trillion borrowing limit in less than a year.
The plan of the Democratic Senators is to raise the debt ceiling by a full $2.6 trillion by pairing it with $2.6 trillion in spending cuts and no revenue increases. The Reid plan draws all of the $2.6 in spending reductions from discretionary programs and does not envision any changes to Social Security and Medicare. Of the $2.6 trillion $1 trillion is from the wind down of the wars in Afghanistan and Iraq and $400 billion is from “interest savings” though it is not at all clear to me how it possible for the government to save $400 billion by altering the term structure and interest rate profile of the debt especially considering that interest rates are pretty close to their theoretical minimum today and, given inflation, you could argue that they are in fact negative. Thus interest expense has nowhere to go but up. I don't think this really bothered the Reid staffers who put it together because they were primarily interested in getting to the $2.6 trillion number as fast as they can.
Both of these plans are ingeniously designed to make the other party look as though it is reneging on its original commitment. The Republican plan is actually the policy that Obama partially implemented earlier in the year when he appointed a commission to study the deficit. The trouble with that was that Obama then dissolved the commission without implementing any of its suggestions, or proposing any deficit reduction legislation whatsoever. Instead he left it to the House Republicans, a decision he almost certainly regrets. The Republicans will claim that they are just implementing Obama's original policy but with a hard deadline connected to the debt ceiling. The Democratic plan optically looks like what the Republicans asked for originally: $2.6 trillion in spending cuts with no revenue increases. Of course $1 trillion of those cuts come from reductions in defense expenditures which are already not projected to occur and $400 billion is in interest savings which will, as a practical matter be virtually impossible to capture. So the headline number of $2.6 trillion contains $1.4 trillion is in cuts that are not really cuts so in terms of actual effect its much closer to the current $1 trillion plan the GOP has put forward.
So basically both parties are offering to trim around $1 trillion in spending over ten years. The main difference is the timing of the next debt ceiling increase, the Republicans want it before the next election and the Democrats want it after the next election. It is pretty simple to understand why. Many of the Republican Congressmen elected in 2010 were given a mandate to cut spending. If they want to win reelection in 2012 they need to show that they have done this. It is obvious that the current impasse will not produce meaningful spending cuts so they need another chance to produce an agreement before the 2012 elections. The Democrats of course do not want this to become a major issue during the presidential election because what will be happening then is that Obama will not only be squaring off against the Republicans in Congress but also against Republican Presidential candidates who will all have strong opinions on what should be done with the debt ceiling but with no responsibility for actually doing anything. This would weaken him both as a candidate and as a negotiator, a position he will certainly seek to avoid.
So this is where we find ourselves with less around a week to go until the deficit ceiling needs to be raised. Two parties framing legislation designed to favor them in 2012 and, in the event that they fail to pass the legislation they each have the ability to claim that the other side reneged on its original strategy for narrowing the deficit. Meanwhile the government continues to borrow $3.8 billion dollars a day and the debt ceiling approaches.