Open Thread: The US Debt Crisis

As with the previous such post, this thread will primarily serve as a meeting ground where S/O readers can discuss the impending US fiscal crisis. As usual, I try to provide some context and avenues for discussion:

1. On August 2nd, give or take a few days, the US Treasury will run out of money. Some commitments will have to be broken. As this article explains, first in line will be Treasury bond holders; frankly, the US sovereign reputation is so valuable that it will not want to risk it at almost any cost. Nor does either party want to see SS recipients, veterans, and soldiers not getting their salary. Once these are accounted for, little else will remain (the US borrows $1.40 for every dollar it now spends). If a deal isn’t reached, there will be massive furloughs and a shutdown of most non-“essential” government functions.

2. Though the current deficit of 10%+ of GDP is patently unsustainable, the immediate drop in spending the failure to raise the debt limit will represent will instantly plunge the US into deep recession (if not depression, if sustained; i.e. a cumulative GDP drop of more than 10%). The economy is very weak, with recent revisions showing the post-2007 drop in output to have been deeper than thought, and the subsequent recovery much weaker. With consumer spending hurt by deleveraging and high commodity prices; it is only being propped up by government stimulus.

3. The political ramifications. This is a risky bet on the Republicans’ part; whereas the Obama administration would have otherwise got the blame for a sluggish recovery, their perceived role in triggering a deep recession will erase that (nor can we take for granted that Republicans are able to logically perceive this; their Tea Party wing in particular has heavy ideological blinkers). In any case, it was the Republicans who got the blame for the previous government shutdown in 1995.

I went counter-consensus in the immediate aftermath of the Osama bin Laden killing by betting on a Republican win in 2012. This was on favorable odds, with all the commentators crowing that Obama has a victory locked up. Now I’m not sure this was such a good move. As of now, this is ALSO increasingly counter-consensus; in the last few days, many people have began to say Obama’s chances of winning are slipping. I disagree. The Republicans are volunteering themselves as free targets for the blame games that make up Presidential campaigns. If they go through and shut down government, then Obama will seize the opportunity to blame them.

4. So, in the end, what will happen? I think there is a high chance that the US will not go into formal default (that is practically impossible, for now) and that there will be a compromise, if not by August 2nd then within two or three weeks. But if the Republicans remain obstinate, then its back to deep recession.

5. The WSJ on what Russia thinks: Oil-Rich Russia Calm Ahead of U.S. Debt Deadline. I basically agree with it.

6. As in 2008, China will remain largely unaffected – even if the US slips into a deep recession. As I argued in my post on Top 10 Sinophobe Myths, the idea that China depends in any real way on manufacturing exports doesn’t hold water.

7. The PMI indicators show that large parts of Europe are slipping into zero growth or outright recession. But Germany remains solid, and Russia seems to be picking up its pace.

As soon as the US debt limit crisis is papered over, the focus will shift back to Europe. Italy’s budget deficit is small (relatively, anyway), but its debt to GDP ratio is huge and the average maturity of its bonds is only about five years. And needless to say, Italy is no Greece. That said, Europe’s overall fiscal position is better than that of the US, Japan, Britain (which is, despite a 13% of GDP budget deficit, becoming a mini safe haven) so the recent moves towards a German-controlled “eurobond” has diminished the risks of contagion.

STRATFOR provides food for thought with Germany’s Choice: Part 2.

8. Where can investors go? In the past few days, we’ve had the bizarre sight of investors, frightened by the rising turbulence and concerns about low growth, scurrying into the “safe haven” of US Treasuries; issued by the same institution that will not have money to pay the bills in a few days! Well, what can I say… Investors aren’t rational creatures. And it does illustrate the massive reputational advantage still held by the US… a reputational advantage that brings it massive benefits (very low interest rates, most of the international trade in commodities being denominated in its currency, etc) that its more rational politicians will be very unwilling to squander.

Nonetheless, this doesn’t change the fact that no matter how this debt limit issue is going to be resolved in the coming days and weeks, in the longer term US hegemony is unsustainable. That is because its fiscal position is unsustainable, and it is unsustainable because its political system is fundamentally dysfunctional. The Republicans want cuts in spending, but not enough to wipe out the deficit (since some influential lobbies like the MIC, Big Oil, agriculture, etc. are to be protected); the Democrats want to keep entitlements spending and military spending largely as is but increase revenues, but the Republicans are unwilling to raise taxes an iota, not even on natural resource companies and high income earners. It is an idiot’s limbo whose only foreseeable resolution is through a debt trap / default or massive inflation.

The only thing the current antics are doing is, by giving cause to doubt the creditworthiness of the US (previously unthinkable), the politicians are merely bringing forward the day of reckoning.

9. Whither commodities? It will basically be a race between these two forces:

  • Recession – and hence falling demand – in the fiscally bankrupt Western nations.
  • Stagnant oil supplies (or the onset on rapid decline); rising demand from China to fill any gap left by falling consumption in the West; and investors fleeing from stock-markets and indebted government-issued papers for commodities, where the long-term trend is now certainly for prices to go up.

Which one will win out in the next few months? I don’t have a fucking clue. If I did, I’d be out there gambling on the commodity markets.

One thing I would (still) recommend doing is investing in US credit default swaps; even if the debt limit crisis is amicably resolved, it is still a great long-term play.

us-cds

10. One final article: Emerging markets could be the new safe haven for investors.

It is bizarre that Russia, a country with almost zero debt and a tiny budget deficit, or China, or dozens of other fiscally sustainable countries are rated much worse (and have higher CDS spreads on their bonds) than a country like the US or the UK. Arguably even Argentina is a less risky investment at this point.

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