How is the rest of the world (ROW) viewing America’s fiscal problems?
Here is Germany’s Der Speigel,
The US has more in common with heavily indebted southern European countries than it might like to admit. And if the country doesn’t reach agreement on deficit reduction measures soon, the similarities could become impossible to ignore. The fiscal cliff looms in the near future, and its not just the US that is under threat.
…Americans are now facing a different, much more real horror scenario: In just a few weeks time, thousands of children could be denied vaccinations, federally funded school programs could screech to a halt, adults may be forced to forego HIV tests and subsidized housing vouchers would dry up. Even the work of air-traffic controllers, the FBI, border officials and the military could be drastically curtailed. That and more is looming just over the horizon according to the White House if the country is allowed to plunge off the “fiscal cliff” at the beginning of next year.
The author is very astute in recognizing that if markets lose confidence, the U.S. is too big to bail,
US politicians, no doubt, would not be fond of hearing their country compared to Greece. After all, the heavily indebted euro-zone country was used during the presidential campaign as a caricature for the horrors of European-style socialism. But their current finances are not dissimilar, with one difference being that the US can’t count on outside help as the Greeks have received.
We hear a lot these days, “no problem, the Fed is there to backstop U.S. sovereign debt. The U.S. has an independent central bank and will just print money to finance the government if it gets in trouble.”
No words can express how much this scares the bejesus out of us.
We’ve been in and worked with many countries where markets have lost confidence in the sovereign’s ability to pay and rollover maturing local currency debt. The central bank then had to make a decision. Should it inflict the pain on the poor and middle class by monetizing maturities causing hyperinflation (Bulgaria 1996/97); or stuff the sovereign creditors by defaulting and restructuring existing debt (Russia 1998)?
David Tepper, the great hedge fund manager, learned an expensive lesson in Russia in late 1990′s, saying it was one of his worst investment decisions,
In 1998, as the Russian government was having troubles with its increasing debt level, he saw an opportunity by reasoning that while Russia might devalue its currency it would not default on its debt. Of course, Russia went on to shock the global markets by defaulting in the same year. This misguided trade cost Appaloosa 30%.
Quantitative easing has created a dangerous complacency, in our opinion, not to mention a huge bubble with potential disastrous consequences. That is, a belief in the central banks’ ability to solve all that ails an economy, including fiscal imbalances, excess debt, and falling asset prices. The Germans seem to truly grasp and understand this.
Distorted interest rates
But aren’t U.S. Treasury yields signaling little or no credit risk for the U.S. government?
We have a few observations.
First, the Federal Reserve has totally distorted the price signal of interest rates via QE and has become one, if not, the largest buyer of U.S. government bonds. The Fed is a nonmarket buyer and is not motivated by returns and yield.
Second, we sense that many of the marginal market buyers are cowboys and use long dated Treasury securities as a trading vehicle to game duration and economic cycles, front run the Fed, and as a temporary tail risk safe haven. We doubt many, if any, of these buyers plan to stick around to maturity. Thus, trying to discern any clear signals about longer term credit risk or inflation expectations from current rates is futile.
Global economy and markets in a parallel universe
In addition, we believe the yield on longer dated U.S. treasury securities is the most important price in the world, which all other investment yields are priced and benchmarked. If then the global benchmark is distorted, are not all investment returns distorted?
Quantitative easing, in our opinion, has catapulted financial markets and the global economy into a parallel universe. If aggregate demand, for example, is once again driven by asset price inflation as it was in 1990′s stock market bubble and the 2003-07 housing bubble, is there any hope the private sector will meaningfully expand capacity?
Twice burned by bursting bubbles, corporations and small businesses now see through the veil of demand induced by negative real interest rates and asset price inflation. No wonder they’re hoarding cash and not hiring.
Greek 4.84 percent 10-year yields
Third, Greece 10-year government bonds were yielding 4.84 percent in November 2009. All clear ahead, no credit problems, right?
How the market was so wrong. Less than three years later these bonds were effectively in default and restructured into securities with significant haircuts. When it comes to sovereign risk, we heed the words of the great 49er quarterback, Joe Montana, “confidence is a very fragile thing.”
Nobody knows when, what, where and how that tipping point which cause markets to lose confidence in a sovereign borrower is triggered. It may be next week, next decade, or possibly, but not probable, never.
We do know, however, what Hebert Stein stated so eloquently, “if something cannot go on forever, it will stop.”
And, of course, let us not forget the words of the late, great MIT economist, Rudi Dornbush
In economics, things take longer to happen than you think they will, and then they happen faster than you thought they could.
We concede the argument there is no current alternative to the U.S. dollar as a reserve currency. Dangerous justification for complacency, however, Spiegel writes,
Should politicians not agree to a credible plan for reducing US debt, it could ultimately harm the credibility of the dollar as a reserve currency
Greece is the Word
Finally, Spiegel sums up the perspective of foreign investors,
Greece’s economic problems and the resulting austerity packages it has passed have plunged the country into five straight years of recession. Germany, Europe and the world are hoping that the same fate is not in store for the US.
We could be wrong, but really think we’re right. Get it done, Washington!