Christopher Pang
President Obama, you only have so much space for manoeuvre!
The financial system today is very much similar to a game of musical chairs, where the slowest person to move at the end of the music will find himself without a chair. It is time to act now before it is too late. The clock is ticking as Democrats and Republicans are rushing to find a bipartisan solution to overcome America’s fiscal crisis.
There are only 2 options:
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A legitimate default by announcing to the rest of the world they can no longer repay their debt and to stop paying their bills for social security, defense spending, withdraw their troops from all over the world, sell their public assets to repay their debt and raise taxes.
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A illegitimate default by raising the debt ceiling and carry on the reckless fiscal spending using money created out of thin air from the Federal Reserve
Unfortunately, the USA is in a state beyond redemption. With over 14 trillion of debt and more than 60 trillion in unfunded liabilities in the form of Social Security and Medicare, which country(s) in the world has the capacity to lend USA this sum of money to finance all these government programs? It is also highly unlikely that these politicians will select option 1 and stop handing out Social Security payments and providing Medicare to millions of voters deciding their reelection into office in 2012.
Therefore the likelihood of option 2 being selected is more probable than option 1. Being overoptimistic with tax revenue forecasting to offset the deficit is one of the most commonly used political ploys. Former President George W. Bush administration had forecasted a budget surplus of over $1 trillion in his first term. However, due to “unforeseen economic and technical re-estimations”, the eventual result was a deficit of over $850 billion. So what makes Obama so sure that even with this debt ceiling increase and further spending, the economy would recover and generate enough tax revenue to bring down the deficit?
What USA is doing in option 2 is akin to a person spending the entire credit limit on his credit cards then telling his bankers to increase his limit because his economic situation will improve once he finds a new job with higher income.
The only thing we can learn about history is that history always repeats itself and that most politicians will never do the right things for the people. Since 1962, the debt ceiling has been raised a total of 74 times. During President George W. Bush era, the debt ceiling was raised a total of 7 times.
When Barack Obama was a US Senator in 2006, he told Congress:
He voted against the raising of the debt ceiling then. I think that it’s important to understand the vantage point of a senator versus the vantage point of a president. When you’re a senator, traditionally what’s happened is, this is always a lousy vote. Nobody likes to be tagged as having increased the debt limit – for the United States by a trillion dollars.
The most obvious conclusion anyone can draw from the contrasting comments from Obama as a Democrat senator under a Republican presidency and as a Democrat President is that politicians will always vote for their own political agenda. The recent shifting of Obama’s position was even more apparent that he would do so in order to be reelected.
Whether the debt ceiling is raised or not is inconsequential to how this would play out eventually. The devaluation of the dollar will cause investors of treasuries to flee and seek safety in other currencies and also commodities that traditionally hedge against inflation, i.e. gold and silver. The credit ratings agencies have also started pay more attention to the U.S. deficit and how they are going to pay it down.
If the credit rating of U.S. takes a downgrade, it would shift the entire yield curve upwards and the fed fund rate is not likely to be able to sustain at 0.25% as real interest rates are already negative without factoring in the credit risk. Mortgages delinquencies would rise accordingly and housing prices would tumble further. The financial industry would be affected most greatly with the spike in interest rates as interest margin narrows and foreclosures affect their profitability.
The previous change to the Mark to Market accounting treatment had prevented further losses on the books of the TBTF (Too Big to Fail) banks during the economic crisis in 2008. The situation this time would be different from how it played out in 2008. As markets around the world declined, people flee into treasuries, on the assumption that it was a risk free asset. Today treasuries are no longer risk free. U.S. is merely funding longer term liabilities with shorter term treasuries by raising the debt ceiling. Even if default risk was avoided this way, inflation risk would be severe in the longer term. The outlook for treasuries is highly negative.
If the credit rating agencies do not downgrade U.S.’s credit rating because of political pressure, it would just enable U.S. to kick the can down the road but the markets would eventually price the default/inflation risk in sooner or later. Creditors that dump treasuries ahead of other creditors would gain a first mover advantage by capturing bulk of the value of treasuries before the dollar devaluation process begins. The earlier any creditor nation realizes this, the more it would be able to purchase with the same amount of dollars.
The investment strategy for any retail investor in this doomsday scenario is to get out of all existing debt with floating rate payments(mortgage repayments would rise with interest rate rising), sell assets(mortgages) financed by long term borrowings(Net Present Value of the asset will decline as interest rates rise) and invest part of the portfolio into commodities such as gold and silver as hedges against inflationary pressures. Alternatively he can enter into long term fixed rate loans or short treasuries/long term debt.
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Photo courtesy of the White House.
