“Where Are We Now?” is my fiftieth blog post. The purpose of a political and economic blog is to “connect the dots” looking for coherent patterns. This post will attempt to do just that, warning you that the emerging pattern is disturbing.
Slow Motion Depressions
Policy makers in Washington and other western capitals are recently smug. They proclaim that, through coordinated monetary and fiscal response, we have averted the Second Great Depression. More bluntly, all we have done is throw a lot of money at the problem through unprecedented monetary easing and a fiscal policy of bailouts and stimulus bills. The core financial issue remains: western countries and the US in particular have too much debt and insufficient income to service that debt. Depressions have their own timetable. In my opinion, government intervention has only slowed the timetable, but definitely has not averted the event.
The Magic Act
Politicians and central bankers are a bit like magicians. While an observer is firmly focused on the right hand we miss the left hand’s activities, which are hiding in plain sight. Just look at current economic and financial trends:
- Increasing Risk of Sovereign Debt Default – In late 2009 a problem arose with the financial solvency of Dubai. Much like the subprime crisis in the US, financial pundits assured the public that the Dubai default was minor and self contained. Yesterday, credit protection for Dubai rose to a record high exceeding the November peak. See Dubai CDS Hits 652, Ploughs Through November Highs As Gold Jumps. Greece too is on the verge of sovereign debt default and is seeking a European Union bailout. Portugal, Ireland, Italy and Spain are reportedly in dire financial trouble as well. The United States, Japan and United Kingdom are not immune from talk of default.
- Crisis at the State Level – The Center for Budget and Politics has projected 48 of 50 states will have budget deficits. Cumulatively, the Center estimates an $180b shortfall for this fiscal year. All states with the exception of Vermont have a balanced budget requirement. Some assistance to the states has been proffered through the American Recovery and Reinvestment Act, but it is questionable whether this aid can continue. See Recession Continues to Batter State Budgets; State Responses Could Slow Recovery. It is more likely that states will follow the lead of newly elected Republican Governor Chris Christie. Recognizing that the state is on the edge of bankruptcy, Christie has declared a fiscal “state of emergency” and intends to slash $2.2b from the budget. See Chris Christie Declares Fiscal ‘State of Emergency,’ Paving Way for NJ Spending Cuts. The crisis in municipal finance portends trouble in the municipal bond markets. The unsuspecting public has purchased municipals in search of yield and instead may receive an unpleasant surprise.
- National Fiscal Irresponsibility – President Obama signed into law a $1.9t increase in the debt ceiling, raising it to $14.2t. As the administration has predicted deficits out to 2020, this ceiling will rise each and every year. Also, it does not include the Christmas Eve bailout of Fannie Mae and Freddie Mac which provided “unlimited financial assistance” to these two entities. We will likely exceed our previous limit of $400b on financial assistance under emergency bailout provisions. See US Promises Unlimited Financial Assistance to Fannie Mae and Freddie Mac. Moreover, how can we continue to finance these deficits without an increase in interest rates? However, such an increase in interest rates could put the US in a “doom loop,” as interest payments become the dominant budget line item crowding out other federal spending programs.
- China – Recently China has made a number of financial moves that do not bode well for the US and world economy. First, China has ordered its currency managers to withdraw from any US dollar denominated risk assets, such as corporate bonds, equities and only invest in US guaranteed assets. Second, it has raised its reserve requirements on its own banks to dampen an over-inflated domestic real estate market. Speculation in Chinese real estate has reached the point that Jim Chanos, a respected investor, predicts an economic collapse. See Jim Chanos: China Bubble Ready to Burst. Given the size of our deficits, the US desperately needs China to continue purchasing US government securities. The world needs China as a growth engine to continue world trade and prevent a second leg of the recession.
Harbingers of the Economic Unraveling
Before the next phase of an economic crisis there are often clues to impending problems. Some harbingers to consider:
- Junk Bonds – The Greek crisis has spurred investors to sell junk bonds, highly risky assets, at the fastest rate since 2005. As a result credit spreads are widening between treasury and higher risk corporate bonds. See Junk Bond Spreads Widening: A Canary in the Coal Mine.
- Problems in a Treasury Auction – Last week’s US 30-year Treasury bond auction was considered a failure. Indirect bids, that is, foreign buyers, dried up and the government had to offer a yield of 4.72% compared to an expected yield of 4.687%. See Dismal $16b 30 Year Auction
- Credit Card Problems – Capital One, a major credit card issuer, reports that in January delinquencies rose and that expected unrecoverable loans have risen to 10.41% from 10.14% in December. See Capital One: Credit -Card Delinquencies Rose in January.
- State and Municipal Finance –In its upcoming July 1 fiscal year budget, California expects a $20b shortfall. Illinois has a $61b pension shortfall, and is borrowing to make contributions. Harrisburg, Pennsylvania, is contemplating a March 1 bankruptcy filing. These stories are the proverbial tip of the municipal finance debt iceberg. See Illinois Pension Fund $61b Underwater; State Borrows Money for 2010 Contribution; California $20b in the Hole Again.
Reality
Till now the policy direction of the Obama administration and other western leaders has been to “extend and pretend:” we will ignore economic realities by permitting banks to suspend “mark to market accounting” and we will send various administration spokesmen to spread the fairy dust of “green shoots” to pacify an anxious public. Essentially, we have an economic policy of faith and hope that willfully ignores reality. Economics does respond to the laws of mathematics. Like a termite that silently eats away the wooden supports of a house, excessive debt has eaten away the structure of the world economy. There will be more troubled countries like Dubai and states like California before this Depression has run its course.
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