More Rogoff: Painful Austerity, Market Shockwaves

Woodblock print by Utagawa Hiroshige

As a follow-up to yesterday's post here are more details of the remarks by Kenneth Rogoff at the Tokyo forum.  According to Bloomberg, Rogoff said after the speech that the U.S. is likely to tighten monetary policy before cutting government spending, sending “shockwaves” through financial markets.

He does not see the U.S. as coming to grips with its budget deficit immediately. “The U.S. is in a state of paralysis in its fiscal policy,” he said. The IMF has forecast that by 2011 gross borrowings will amount to the equivalent of 99.5 percent of annual economic output for the U.S., 94.1 percent for the U.K., and 204.3 percent for Japan.

Rogoff said that investors around the world will eventually demand higher interest rates to lend to countries that have heavy debt loads, including the U.S. In his scenario, the U.S. government will delay any efforts to contain the deficit until Treasury yields reach around 6 percent to 7 percent. Fiscal discipline won't be imposed until soaring bond yields trigger “very painful” tax increases and spending cuts, he said.

“When they start tightening monetary policy even a little bit, it’s going to send shockwaves through the system.”

“Clearly the dollar is going to go down against the emerging markets -- there’s going to be concern about inflation and the debt.” He said that currently the dollar is being propped up by concerns about the euro zone's ability to withstand the deteriorating finances of member nations like Greece.

Oddly, in the audio of his remarks, Rogoff argued that the "main event" is over and that the situation is "not that bad" now, despite a deep recession and long recovery. His data indicate that stock prices recover remarkably well following a deep financial crisis and return to their former peak within two or three years. Rogoff did hedge this view, however, saying that government debt will be a huge problem, and it will be challenging to extricate from stimulation.

In Europe, he expects Greece will eventually be bailed out by the IMF rather than the European Union. Although he expects the EU to provide a bridge loan, he believes that it won't be enough in the long run. “The more they suck in Greece, the lower the euro goes, because it’s not a viable plan.”

As mentioned yesterday, Rogoff is co-author with Carmen M. Reinhart of the book This Time Is Different, a study of eight centuries of financial crises.

Rogoff: Several Countries to Default, U.S. to Cut Spending

     Thomas Hart Benton, Score Another for the Subs



In an earlier post this blog discussed This Time Is Different by Carmen M. Reinhart of the University of Maryland and Kenneth S. Rogoff of Harvard University, who gleaned a number of general lessons from eight centuries of financial crises.

This blog has also discussed several pundits, including Bill Gross and Bill Mauldin, who both extrapolated from Reinhart and Rogoff's work to form their own conclusions about the course the present financial crisis.

Now, Rogoff has spoken out and said that ballooning public debt is likely to force several countries to default and the U.S. to slash spending.

Speaking at a forum in Tokyo Rogoff said that after a major financial crisis the world usually sees "a bunch of sovereign defaults, say in a few years. I predict we will again." Without predicting who would default, he did say that European countries such as Greece and Portugal will “have a lot of troubles.” He also said that Japanese fiscal policy is “out of control.”

Another of the outcomes predicted by Rogoff is higher interest rates.

In his view, the rich, developed nations will be able to cope with the crisis without defaulting, but will pay a price. Although it is hard to call the timing, “In rich countries -- Germany, the United States and maybe Japan -- we are going to see slow growth. They will tighten their belts when the problem hits with interest rates. They will deal with it.”

In addition to co-authoring This Time Is Different, Rogoff is a former chief economist at the International Monetary Fund and a member of the Group of Thirty, a panel of central bankers, finance officials and academics headed by former Federal Reserve chairman Paul Volcker.  With a complex system such as global finance, it seems prudent to include historical precenents when contemplating how the debt crisis may play itself out.

Inevitable Collapse

Jean Antoine Watteau, Gilles, 1718.



Today I would like to comment on recent reports issued by Societe General's Albert Edwards, a former colleague of Jean Marie Eveillard and James Montier, other value-minded strategists who have moved on to other organizations.  Because Edwards seems to be perpetually on the extremely pessimistic side, his reports should perhaps be received with a degree of critical caution.  After all, we should be examining every side of the debate over global indebtedness, and not dwell exclusively on pessimistic views.

On the other hand, Edwards is of interest precisely because he is extreme.  He cites debt-to-GDP statistics as pointing toward extreme market events.  Others have cited similar statistics and suggest that debt growth cannot continue, and some have been quite blunt, albeit without being quite as direct about the consequences as Edwards is.  When you strip away some of Edwards's alarming language, you find that, lurking underneath, there remains a worrying and deteriorating situation for the world's advanced nations.

Competitive Devaluation Looms

Lacking the Societe Generale reports themselves, we will have to rely on quotes from two articles by Tyler Durden in the Zero Hedge blog.  The first of these is pretty well summed up in its title: Timing The Exit As Competitve Devaluation Looms; Is The Euro 25% Overvalued? More Thoughts From Albert Edwards. 

As for current conditions, Edwards intreprets leading indicators as signaling that China and other emerging markets have topped out, and that the U.S. and other advanced economies are soon to follow.  He does not follow the interpretation of many others, that rises in economic indicators signal more positive surprises. 

He thinks that the Euro is too strong and inflation too low given the prospect an impending European slowdown, and the the dollar/Euro exchange rate should fall by 25%.  "The end game for the Ice Age was always competitive devaluation and the US and UK have embraced this strategy to revive growth and export their own domestically generated deflationary impulses."  Now it's the Euro that needs to devalue.  At least he doesn't see the U.S. as being prone to longer-term stagnation to the extent that demographically-challenged Japan is, given that "the US demographic outlook shows a continued expansion of the working age population through this century."


The Breakup of the Eurozone

Edwards's view of the ultimate outcome of the debt situation is summed up in the title of a related post:  Albert Edwards: At 500% Net Liabilities To GDP, It Is Too Late To Prevent The Collapse Of The G-7; Greece Is Irrelevant, We Are All Now Insolvent.  Starting with Europe, he believes that the debt problems of Portugal, Ireland, Greece, and Spain (the PIGS) will bring about "the inevitable break-up of the eurozone."   This is because "the root problem for the PIGS is lack of competitiveness within the eurozone," brought on by "years of inappropriately low interest rates."  The resultant inflation, double digit current acount deficits, and weak growth mean that "the PIGS public sector deficit will inevitably remain large."

Ivan Aivazovsky, The Shipwreck, 1871

Pressure to reduce these budget deficits by tightening fiscal policy "will not be tolerated by the electorates in these countries. Unlike Japan or the US, Europe has an unfortunate tendency towards civil unrest when subjected to extreme economic pain."   The breakup of the eurozone will then follow from "another of Europe's unfortunate tendencies -- the emergence of small extreme parties to take advantage of any unrest."

No Way Out But Default

As we know by now, the U.S. and U.K. also face the prospect of especially stern fiscal policies to reign in their budget deficits, which Edwards quantifies as "structural (cyclically adjusted) general government deficits of almost 10% of GDP (according to the OECD)."   He becomes particularly pessimistic when he looks at government debt including unfunded liabilities, for which "most governments are already insolvent with debt to GDP ratios closer to 500% of GDP instead of around 100% for most G7 countries . It is too late."  Moving on to individual countries, "Greek total net liabilities (on and off balance sheet) to GDP are 800%! EU: at 470%, the US, at over 500%. There is no way out but default."

Is It Really This Severe?

This range of liabilities-to-GDP sounds severe, but how severe is it really?  We have to consider differences between "official" debt accounts (on balance sheet) and total net liabilities, which include unfunded liabilities (off balance sheet).  We are of course familiar with the problems that private firms have encountered when suddenly faced with the unexpected need to pay for unfunded off balance sheet liabilities, such as those hidden in special vehicles or counterparty liabilities. 

However, in this case we are talking about government liabilities.  We are also talking about future liabilities, generally those owed to citizens, on the basis of promises and expectations about entitlements.  Such entitlements include, of course, promises like Medicare, Medicaid, and Social Security.  We do not know how such promises may be amended in the future, nor the ability of the taxpayers or the willingness of creditors to fund those promises.  We do not know how much the citizenry may amend its expectations, nor the political will of the leadership to enforce fiscal discipline. Such future unfunded liabilities are therefore uncertain in magnitude and, to some extent, fungible.

Equally important, we don't know how well the U.S. and other nations will be able to grow their economies.  Growth seems scarce in the developed world, and growth is necessary to raise government revenue.

Other Statistics, Other Opinions

This blog has recently discussed a number of viewpoints about the debt situation and has cited the supporting statistics such as debt-to-GDP ratios.  For example, Bill Gross includes the U.S. in the "Ring of Fire", his name for the set of advanced countries that are at risk of exceeding a 90% ratio of public debt to GDP.  That is the point at which he considers a country at risk of suffering a 1% decrement in its economic growth rate.  Gross does not say in his public statements what he thinks the chances are that the process will lead to a U.S. default or runaway inflation, but he does think that the situation bodes poorly for U.S. fixed income.

A different metric is the ability to make interest payments on debt.  Former U.S. Comptroller General David Walker recently said:  "Within 12 years…the largest item in the federal budget will be interest payments on the national debt."  As interest payments squeeze out other budget items, something will have to give, and at some point in the next few years a choice will be made between default and fiscal austerity.  Speaking at the same forum on fiscal reform, Federal Reserve Bank of Kansas City president Thomas Hoenig said that having the Fed print more money to purchase the mounting debt would lead to an inflation-induced financial crisis.

How Will It Play Out Politically?

In the case of Greece, we are now seeing an immediate reaction and the potential of confrontation over the need for fiscal discipline.  Who knows?  Perhaps Edwards has a point about the potential for extreme political reactions and fissures appearing with the EU. 

Scene from Nosferatu (F. W. Murnau, 1922)

In the U.S., however, the outcome is far, far from obvious.  Some want to continue stimulus, and others demand immediate fiscal discipline to avoid eventual insolvency and default.  The debate is vociferous and, unfortunately, there is every appearance of a stalemate persisting in Congress.

Edwards has no such uncertainties about the political process:  "The trouble is that, as the private sector debt unwinds, there is no political appetite to allow GDP to decline to its "correct" level as this would involve a depression. So burgeoning public sector deficits and Quantitative Easing are required to maintain the fig-leaf of continued prosperity."

Edwards also has no such uncertainties about the outcome.  According to him, "there really is no way out that does not trigger a major market-moving upheaval."

Payback Time

I agree with Edwards about what has happened to get us here:  "Ultimately economic prosperity over the past decade has been a sham: a totally unsustainable Ponzi scheme built on a mountain of private sector debt. GDP has simply been brought forward from the future and now it's payback time. "

But I just don't have his one-sided conviction about the future.  He sees the inevitability of collapse.  I believe that there are too many uncertainties to say.  Maybe the U.S. will just cut back on entitlements, people will suffer, and the country will muddle through and emerge a shell of its former self.  There is no way to know the outcome more precisely.  Not at present.

However, as governments run into budget problems, it does seem likely that people will run from one asset to another as their perceptions of safety change over time.  In the very near future, it seems likely that people will continue to flee to the dollar.  At some point another alternative may appear, and maybe that event is what we need to watch for.

Prediction is a perilous business, and Edwards mentions that his former colleague, James Montier, derides the notion of investing on the basis of forecasts as they inevitably prove so inaccurate.  Agreeing that prediction of markets and economies goes beyond prudence, I will avoid agreeing with anyone how the debt crisis will play out.

But something extreme is going to happen.  At a recent forum on budget reform, Former director of the Congressional Budget Office, Rudolph Penner warned:  "The American people today are not remotely prepared for the changes that are necessary."  This is something that I can agree with.  If political stalemate continues, and the debt situation deteriorates, Americans may be stunned by the magnitude of the changes about to take place.


Thure de Thulstrup, The anarchist riot in Chicago : a dynamite bomb exploding among the police. From: Harper's weekly. Vol. 30 , no. 1534 (May 15, 1886)

The Sea of Fog

Caspar David Friedrich, Wanderer above the Sea of Fog, 1818.

The prevalent view about US debt problems, at least as I interpret recent guru predictions, is that a rendezvous with disaster lies a number of years in the future, say 5 to 10 years.   The most visible media gurus -- Taleb, Roubini, Faber -- appear to expect the process to culminate in the free printing of dollars accompanied by rampant inflation and a worthless dollar before the U.S. defaults on its debt.  More immediately, many are predicting rising bond yields this year as the Treasury struggles to fund the growing federal debt. 

These are not the only viewpoints being presented in the investment community, however.  Also, what will be the nature of the path that the world economy traverses in the next few years, default or not?

An interesting scenario is that the immediate future will bring deflation rather than inflation, accompanied by low interest rates and a strong dollar.  Longer term, perhaps stretching over years, interest rates may rise, as government bailouts and debt loads increase in scale.  Given the importance of the debt question, and uncertainty about the way forward, I decided to give space to deflation-oriented viewpoints today.

David Malpass:  Rolling Recovery

Having read a few sensible things from David Malpass of Encima Global, I decided to look further into his concept of a "rolling recovery".  Despite his unintuitive conclusions, he agrees with the commonly held view that the U.S. in on the road to debt disaster and must take immediate steps to rein in federal spending. In a recent Forbes article titled "The High Cost of the U.S. Budget" he and Eric Singer wrote that the administration's budget puts the country on a path to danger in just a few years' time:

When a country goes past owing 100% of its nominal GDP in publicly held debt, as this budget schedules us to do by 2020, there is danger.

Although he does not predict the outcome, Malpass sees the path to 2020 as punctuated by occasional emergencies of varying magnitudes, a process that he calls a "rolling recovery".  That's the long term.  As for this year, his "Economic Outlook for 2010" predicts that the wind-down of emergency stimulus will affect asset prices like this:

Currencies should strengthen relative to commodities as emergency stimulus stands down.

Emergency stimulus has distorted both sides of the inflation/deflation barbell trade – commodities, bonds and foreign stocks all up big, esp. in dollar terms. They should soften or retrace as stimulus slows.

His February 11 letter at Encima Global, "Rolling Debt Crises -- Where They Lead", expects the global economic recovery to gain strength but be "marked by rolling debt crises – Iceland, GM, Dubai, Greece, California. Stronger sovereigns will extend debt guarantees and subsidies to some but not all of the distressed debtors."   The result will be crises for those who cannot be sustained but a gradual process of recovery for the world as a whole:

The trend to government umbrellas is unsustainable, but I think the upward bias in global output and consumption -- including innovation, hard work, and tens of millions of Chinese, Indians and others moving from subsistence agriculture to the cash economy – is strong enough to push the problems into the future.

Malpass's scenario is that big bail-outs will produce different outcomes in the short-run and the long-run:

... expanding the too-big-to-fail umbrella – will be pro-growth in the short run.

In the longer-run, however, the process moves even more of the global economy away from market principles. This gradually undercuts the capital allocation process.

He expects growth in the U.S. this year, but the growth in government debt will have a price:

Bond yields should rise in the U.S. and Europe when as it becomes clearer that the trend is toward guarantees and bailouts, not bankruptcy. Insurance against deflation (part of the value of Treasuries and bunds) is less valuable if Germany chooses to guarantee Greece.

In the longer run, however, governments can only take on so much debt, and they will have to draw the line between those who can be supported and those who cannot:

Governments will try to draw the line between which countries and companies can win their protection and which can’t. The U.S. has many large banks that are too-big-to-fail, but thousands of smaller ones that can be digested by the FDIC and are outside the umbrella. I expect a similar sorting process for municipalities and small countries in Europe.

So, he does not predict immediate debt doom, but a longer-term malaise:

Cyclical and secular growth helps float distressed debt for a while. Guarantees save other debt. It probably works in the short run, but the longer-term result is bigger government, a poorer allocation of capital around the world, and slower long-term growth.

Hugh Hendry: Japanese Malaise

Hugh Hendry of Eclectica is hugely optimistic about the dollar and U.S. Treasuries.  Zero Hedge reported this strategy as Hendry stated it at the recent Russian Summit of hedge fund leaders: "I am hugely intellectually bullish on Treasuries. I am long."  The most contrary part of his strategy is that it is long-term.

He admits that this is against the majority views: (1) that the end of QE will result in higher bond yields, and (2) that a successful reflation of the economy would produce inflation:

I fear the end of QE, the money funds are making on the [curve], I am aware of the issuance, I am aware that the States is going to have to sell $2.5 trillion of this stuff. ... I think there is a lesson in Japan.

The precedent of Japan suggest that if you allow leverage in your society to breach a certain level, let's call it 200 or 230% of GDP, then what happens is monetary policy doesn't work, fiscal policy doesn't work. ... prices are falling and look set to fall further.

Hendry gives more of his reasoning about a strong dollar and strong Treasuries in the Eclectica November 2009 letter, which is probably best read at at this address.  He believes that dollar devaluation has already happened and hence won't contribute to future inflation.  The dollar is not going to decline versus major competitor currencies:

I keep hearing that a dollar devaluation would help matters. I agree; it has. Let me say it again; we have already had the devaluation. That is what the last five years were all about. Now with China rebuilt, and the trade deficit in full retreat (note the -47% contribution from net exports to China's GDP growth in the first 9 months of this year), there are less dollar bills being exported overseas to ungrateful recipients. ... Is it really inconceivable that the dollar could now strengthen?

Regarding US Treasuries, he agrees with those who say that they offer poor long-term prospects:

... not an adequate return for lending your money to the profligate United States for 30 years.  I agree wholeheartedly. ... I do not propose that anyone adopt a buy-and-hold policy for the next thirty years in bonds. However, a nominal rate of 4.5% might prove very profitable over the coming year should breakeven inflation expectations head south again.

So, he may well switch positions at some time, but for now he thinks that the U.S. domestic market will take up the slack in demand from overseas:

... a lower Chinese trade surplus will eliminate a very large source of Treasury buyers at a time of burgeoning supply. ...  However, it is our contention that US savings are heading north over the months and years to come. And an America that saves is an America that does not run a current account deficit. It is an American that can finance its own spending domestically.

As a consequence the Chinese surplus is set to fall further and ... their demand for Treasuries will continue to shrink. Now this is potentially a huge headache owing to the massive projected American budget deficits for this year and next ....

Many observers might disagree with Hendry and argue that U.S. consumer is too highly leveraged to do much saving of any kind, and that institutional investors cannot take up all of the slack.  However, Hendry seems to think that the risk of default will force policy decisions that keep rates low:

Now remember I have been describing a positive macro scenario: a world in which low interest rates make the debt load manageable and that we muddle through with lower growth rates in nominal GDP. ... my opponents (see Ferguson et al.) believe that government bond yields are going much higher. ... It is my contention that the leverage of the economy is only tenable if interest rates stay low ...

He says, even if things get bad and bond rates rise, the problems will first appear in other nations' sovereign debt.  He proposes Japan as the major domino to fall first:

But first, it may require the spectacle of seeing Japan implode and so we have been actively positioning the Fund to profit from such a scenario. As many of you know, the fiscal situation in Japan is rapidly rising out of control. ... the ratio of public debt to GDP is guaranteed to rise further. It is currently 196% of GDP with the IMF estimating that it will rise to 234% by 2014.

... we have been active buyers of corporate debt default swaps. We find it remarkable that one can insure highly leveraged utilities at 23bps despite their considerable yen debt.

Gary Shilling: Still Bearish, Still Right

Shilling has been bearish and on the side of deflation for so long that I hesitate to mention him, but he deserves credit for recommending this profitable asset allocation for a long time.  In one of his recent Forbes columns he cited the pinched consumer and an expectation of a rising savings rate both as reasons to continue liking Treasuries, and he added a recommendation for growing dividend stocks in the staples sector.

Caspar David Friedrich, The Sea of Ice, 1823-24.

Like a Meteor Streaming in the Wind

Him the Almighty Power
Hurld headlong flaming
                  from th' Ethereal Skie
With hideous ruine and combustion down
To bottomless perdition, there to dwell
In Adamantine Chains and penal Fire,
Who durst defie th' Omnipotent to Arms.

John Milton, Paradise Lost, Book I



Don't try to defy the capital markets.  Added to the likes of Marc Faber, Nissim Taleb, and Nouriel Roubini, we now have predictions of U.S. hyperinflation and/or debt default from Niall Ferguson, the Harvard economics professor and author of The Ascent of Money. 

Niall Ferguson

As reported in Zero Hedge, Ferguson took note of an environment that he thinks will remain positive for the dollar for a number of months: 

For the world’s biggest economy, the US, the day of reckoning still seems reassuringly remote. The worse things get in the eurozone, the more the US dollar rallies as nervous investors park their cash in the “safe haven” of American government debt. This effect may persist for some months, just as the dollar and Treasuries rallied in the depths of the banking panic in late 2008.

As we know, however, the situation is deteriorating:

Even according to the White House’s new budget projections, the gross federal debt in public hands will exceed 100 per cent of GDP in just two years’ time. This year, like last year, the federal deficit will be around 10 per cent of GDP. The long-run projections of the Congressional Budget Office suggest that the US will never again run a balanced budget. That’s right, never.

Because those are long run projections, it seems that Ferguson is talking about fiscal trends that may take years to play out.  These are the kinds of trends discussed in a book that I have written about often here, This Time Is Different, a study of eight centuries of financial crisis by Carmen Reinhart and Kenneth Rogoff.  The current fiscal situation looks likes it fits the pattern.  Higher bond yields have so far been avoided through the purchase of Treasury securities by the Federal Reserve and the Peoples Republic of China, but that situation is about to change:

Explosions of public debt hurt economies in the following way, as numerous empirical studies have shown. By raising fears of default and/or currency depreciation ahead of actual inflation, they push up real interest rates. Higher real rates, in turn, act as drag on growth, especially when the private sector is also heavily indebted – as is the case in most western economies, not least the US.

Ferguson argues that GDP growth and inflation will lead to a situation in which the debt load will eventually become unsupportable.

But now the Fed is phasing out such purchases and is expected to wind up quantitative easing. Meanwhile, the Chinese have sharply reduced their purchases of Treasuries from around 47 per cent of new issuance in 2006 to 20 per cent in 2008 to an estimated 5 per cent last year. Small wonder Morgan Stanley assumes that 10-year yields will rise from around 3.5 per cent to 5.5 per cent this year. On a gross federal debt fast approaching $1,500bn, that implies up to $300bn of extra interest payments – and you get up there pretty quickly with the average maturity of the debt now below 50 months.

The Elite Will "Preserve" the System

Ever the optimist, Zero Hedge commented "our political and financial leaders will do everything in their power, even sacrifice the population, to prevent the collapse of the system."  There are lots of indirect ways of sacrificing the population fiscally and monetarily, but a direct way would be to confiscate 401k accounts in order to support Treasury securities.  To do this, as some speculate, the contents of 401k accounts would be forcibly converted into annunities.  Annuities backed by what?  Why, by Treasuries, which a bankrupt federal government would have in unending abundance.  After punishing savers with low interest rates, and saddling everyone with a monstrous national debt, why not?

Marc Faber

While discussing catastrophic predictions, we might as well hear from a cheery "Dr Doom" interview on CNBC, U.S.-Europe Will All Default on Their Debt: Marc Faber.  He said, in fact, that the governments of every developed economy will eventually "all have to print money before they default", citing as reasons for his prediction both unfunded future liabilities and current debt-to-GDP ratios.  The U.S. will reach this state "within ten years."

Faber isn't totally pessimistic, because he is "relatively optimistic" about stocks going up, and he referred to stocks and gold as two as the best safe havens.

Afterword

In Paradise Lost the "meteor streaming in the wind" is the glittering ensign of the fallen angels, Satan's unrepentant pride.  Perhaps in its pride America too will remain fiscally unrepentant and defy the markets until they hurl the dollar down to hideous ruin and combustion.

Beneath Lilacs

This post could be titled "The New Economy" or "The Perversity of Rent Seeking Behavior", but I prefer a title that brings to mind an image of sitting under blooming lilacs and contemplating how much more pleasant life would be if generations of politicians hadn't thrown our futures away with a ruinous public debt.

The Work of Nations

In 1991, before he had become President Clinton's Secretary of Labor, Robert Reich published The Work of Nations, in which he described an increasingly globalized world and the the impact that this world was having on society and the workforce.  At a time before these changes were quite as widespread as they are today, Dr. Reich described how information technology and global wage arbitrage enabled global wage arbitrage, enabling workers in emerging nations to compete with workers in the more advanced economies.  As Dr. Reich predicted, wage arbitrage brought about a convergence of wages across borders, within different job categories, and a stratification of wages according to the scarcity and demand for each type of labor, within national borders.  One outcome of this process was to increase the divergence in economic outcomes across the labor force within the developed nations.  It was well established even before the time of Reich's writing that the less skilled, less educated members of the advanced societies were suffering lower wages and lower employment because of international competition and increasing mechanical and information productivity.

Roll Back the Enlightenment

Economic statistics demonstrate a long-term trend to greater inequality in American society, with a widening gap between rich and poor. Wealth is being concentrated into fewer and fewer hands, and the rising debt loads of the past thirty years or so have greatly depleted the wealth and the ranks of the middle classes.  This increasing inequality may look like nothing more than the inevitable results of greater global competition, greater financial complexity, or the folly of overconsumption, but there are yet other forces at work that threaten to continue the trend toward inequality and to drive it to barbaric extremes. 

In an interview in 2008 the economist Michael Hudson said:  "The economy has polarized to the point where the wealthiest 10 percent now own 85 percent of the nation’s wealth. Never before have the bottom 90 percent been so highly indebted, so dependent on the wealthy. From their point of view, their power has exceeded that of any time in which economic statistics have been kept."

About the wealthiest members of our society Hudson said:  "You have to realize that what they’re trying to do is to roll back the Enlightenment, roll back the moral philosophy and social values of classical political economy and its culmination in Progressive Era legislation, as well as the New Deal institutions."

He feels that the move is a deliberate attempt to transform society fundamentally to their advantage, no matter the consequences to everyone else: "So what you find to be a violation of traditional values is a re-assertion of pre-industrial, feudal values. The economy is being set back on the road to debt peonage. The Road to Serfdom is not government sponsorship of economic progress and rising living standards, it’s the dismantling of government, the dissolution of regulatory agencies, to create a new feudal-type elite."

By the way, there is more than one "Road to Serfdom".  Hayek's book of that title described one, undeniable route, which is the socialist state.  Hudson's interview describes another route, which is feudal domination by a conservative, exclusivist elite.  Both routes lead surely to serfdom and must be defended against.

New Feudalism

Although "rolling back the Enlightenment" sounds like an extreme view, there are identifiable forces working on the world to transform the economic and social system in a pre-industrial direction, as discussed in an article by Parag Khanna last year in Foreign Policy.  In "The Next Big Thing: Neomedievalism,"  Khanna pointed out a seeming incongruity, that globalized financial systems have spread economic crisis around the world at a time when increased corporate and local concentration of power may be dragging us all back to a more localized, feudal condition.  He called this state of affairs "a new Middle Ages".

The argument begins with the observation that:  "The state isn't a universally representative phenomenon today, if it ever was. Already, billions of people live in imperial conglomerates such as the European Union, the Greater Chinese Co-Prosperity Sphere, and the emerging North American Union, where state capitalism has become the norm. But at least half the United Nations’ membership, about 100 countries, can hardly be considered responsible sovereigns. Billions live unsure of who their true rulers are, whether local feudal lords or distant corporate executives."

Given the weak positions of many nation states, "This diffuse, fractured world will be run more by cities and city-states than countries. ... Today, just 40 city-regions account for two thirds of the world economy and 90 percent of its innovation. ... Add in sovereign wealth funds and private military contractors, and you have the agile geopolitical units of a neomedieval world. Even during this global financial crisis, multinational corporations heavily populate the list of the world's largest economic entities ..."

We wonder if America will be dominated increasingly by feudal elites, corporations, or new transnational organizations.  Or maybe this is the wrong analogy with the Middle Ages, which saw some remarkable progress in many spheres of European life, and which were perhaps even more remarkable in other parts of the world.  The medieval world in Europe was one of city-states, local military strongmen, and the loose international network of the church. In contrast, China developed national commerce under the Sung dynasty, and then a universal (if foreign ruled) state under the Mongol Yuan dynasty.

A Predatory Financial Sector

In the western world, government's role in finance has been shrinking for hundreds of years as new financial enterprises and instruments have been developed -- banks, bonds, insurance, stock markets, bonds, futures contracts, etc.  Economies and governments benefited as new financial institutions directed capital flows to where they were needed.

Any system can be perverted, however, and in recent decades financial activity has comprised a growing percentage of gross product -- but with no corresponding contribution to economic efficiency or growth.  Heaven knows, economic stability has certainly been sacrificed to financial interests.

The Rent Seekers

The financial sector and the elite clientele that it serves have been looking for new ways to maintain and increase their wealth.  This includes influencing legislators and bureaucrats to pave the way for more effective rent-seeking behavior.  In economics, rent seeking is the capturing of "economic rent" (income) by means other than economic transactions or the creation of economic value added.  That is, rent seeking requires manipulating the rules of the economy or exploiting special relationships, e.g., getting the government to regulate commerce in a way that effectively confers a monopoly advantage.  Other examples would be getting control of public resources or charging "fees" rather than usurious rates of interest.


As "real" economic activity wanes (from foreign competition or economic depression), you can be sure than rent seeking behavior will increase among the privileged.  They have to maintain their life styles, after all, and poor peons can't afford the lobbyists and corporate attorneys.  The growing role of government in financial affairs, in the wake of the credit bust, is sure to provide even more fertile grounds for nefarious rent seeking.

You can be sure that this does not bode well for new "real" economic activity.  People are always trying to get something for nothing.

My Brother Is Coming with Many Fremen Warriors

The intent has been to confine this post to known trends and to obstain from conspiracy theory, but you will of course have to consider for yourself whether this story is realistic or other-worldly.  Should it say beneath lilacs or Bene Tleilax? 

List of graphics:

Photograph of lilacs
Harry Sternberg, Bethlehem Steel in Moonlight, 1937
Jean-Honore Fragonard, The Reader, c. 1770-1772
Page from Les Tres Riches Heures du Duc de Berry
Otto Dix, Machine Gunners Advancing, from Der Krieg, 1924
Close up of Alia in Dune (David Lynch, 1984).

U.S. Credit Rating at Risk

El Greco, The Annunciation

As I Was Saying ...

I just wrote a post warning that the U.S. debt is at risk of becoming unsustainable.  Immediately after, along came a news story warning that the crisis may be even closer than we imagined.  Zero Hedge reports "Moody's Sees US Rating Under Pressure After $3.8 Trillion Budget", and they quote the report:

The ratios of general government debt to GDP and to revenue are deteriorating sharply, and after the crisis they are likely to be higher than the ratios of other Aaa-rated countries.

If the current upward trend in government debt were to continue and become irreversible, the rating could come under downward pressure. The trend and the outlook would be more important than any particular level of debt.

The italics are mine.  As Zero Hedge asks:  "IF it becomes irreversible?"

Dollar No Longer the Safe Refuge?

The article says that, if trends continue, the U.S. ratios of debt to GDP and debt to revenue will be HIGHER than the ratios of other Aaa-rated countries.   Many people have been counting on the U.S. being in no worse position than other advanced economies, and they have been allocating assets as if the dollar will remain strong relative to the Euro, Yen, Pound, etc.  Maybe that is not a good assumption.  Those are flawed currencies, but the dollar is flawed too.  Maybe Treasuries will tank as rates rise on the sovereign debt of all these indebted countries.

MSN Money added this tidbit:  "Unless further measures are taken to reduce the budget deficit further or the economy rebounds more vigorously than expected, the federal financial picture as presented in the projections for the next decade will at some point put pressure on the Aaa government bond rating."  This means, that in the absence of an economic miracle, we can expect (a) deflationary pressures from higher taxes and lower expenditures, (b) higher deficits, or (c) a ratings downgrade of the U.S.  Or maybe all of these.

An Actor?  We Move on the Word of an Actor?

That's what Martin Sheen (as General Lee) said in Gettysburg, after receiving a scouting report on the Army of the Potomac.  We all know that the credit rating organizations are corrupt liars, and no one believes them anymore.  They proved that they will do anything, utter any lie to make a buck.  If one of those sycophants comes this close to impugning the credit rating of the U.S., there must be a real problem with our credit.  You would be justified to complain that this crisis has been obvious for so long that it isn't news anymore.

When and What to Do

Whenever a ratings agency issues a more directly worded warning, you can be sure that the Treasury market and the dollar will tank immediately.  When it gets so bad that a Treasury auction finally fails, it will be too late to act.

What to do about it?  Short Treasuries?  Buy gold and foreign currencies?  I lean more toward stockpiling guns, food, and ammo.

When to act?  It seems a little early to act against the dollar, given the problems of Europe, Japan, and the U.K., whose problems are likely to benefit the dollar.  With weak economies weighted down by heavy debt loads, it also seems early to short Treasuries.  When the day will come is hard to tell.

The U.S. Budget Deficit

Walker Evans: Truck and Sign, 1930. 

Walker Evans Archive, The Metropolitan Museum of Art.

The federal budget deficit is larger than thought, and it is becoming a national-security threat.

The National Security Threat

The Wall Street Journal reports that the Federal government will borrow one of every three dollars it spends this year.  The problem is that U.S. citizens cannot lend the money, because they save so little.  Much of the money will have to be borrowed from foreign countries.

"We've reached a point now where there's an intimate link between our solvency and our national security," says Richard Haass, president of the Council on Foreign Relations and a senior national-security adviser in both the first and second Bush presidencies. "What's so discouraging is that our domestic politics don't seem to be up to the challenge. And the whole world is watching."

The Journal listed four ways that such a severe budget deficit threatens America's national security:

• It makes America vulnerable to foreign pressures.  Because half of America's debt is in the hand of foreigners, a foreign central bank could put pressure on the U.S.
• By accepting vendor financing from China, we are conferring a lot of financial leverage to them in particular.
• Long-term national-security budgets are put at risk.  Debt service will crowd the defense budget.
• The American model is being undermined before the rest of the world.

To this list I would add the following ways that the growing national debt harms national security:

• America is saving so little that it is not able to invest in the human resources, plant and equipment, etc. needed to increase productivity and build a competitive position in a modernizing world.
• The U.S. will become less socially stable as debt service crowds out social programs.  Citizens will become desperate, angry, and more prone to take extreme solutions.
• The resulting brittleness of U.S. systems will amplify the impact of any future terrorist attacks, resource scarcity, environmental change, inflation, war, or other adverse events.

The last bullet could be expanded into a number of issues.  Living standards will decline because the Federal budget will be unable to afford the social safety net that US citizens have already paid for and are depending on: Social Security, Medicare, Medicaid.  Support for already stretched cities and states will wither.  Essential city and state services (roads, schools, police, fire, etc.) will have to be sacrificed.  Benefits for the unemployed will be cut.  Increased tax loads will discourage businesses, increase unemployment, and squeeze impoverished citizens even harder.  As America sinks, its disappointed citizens will see other areas of the world gain improving living conditions.  They will see "progress" fail in the U.S. and succeed elsewhere.

Otto Dix, Stormtroops Advancing under Gas, etching and aquatint, 1924.

Growing Deficit Estimates

In "White House to Paint Grim Fiscal Picture" Reuters reports that the budget deficit is larger than previously believed.  According to the White House's Office of Management and Budget, the deficit for the current fiscal year will be significantly higher than the $1.35 trillion figure forecast by the nonpartisan Congressional Budget Office last week.

Despite the President's proposal of a three-year freeze on some domestic programs to save $20 billion next year and $250 billion over the coming decade, that will not be enough to get deficits down permanently to the 3 percent of gross domestic product that most economists consider sustainable.  Deficits will still average roughly 4.5 percent of GDP over the coming decade, according to the White House estimate.  That's not all.

What happened to the entitlement problem that we have been expecting for some time?  It's still coming.  Deficits are expected to rise again toward the end of the decade due to the increasing cost of retirement and healthcare programs as the "baby boom" generation retires.  If we cannot bring the current deficit problems under control, we will be utterly swamped when the deficit is hit by the coming wave of baby boomer retirements.

Where to put the blame?  Despite the criticism of President Obama and his administration, most of the fiscal mess has been inherited from the previous administration of Republican George W. Bush, who cut taxes and created an expensive prescription drug-benefit while pursuing wars in Iraq and Afghanistan.

Blame also falls on Bush for the shortfall in tax revenues to fund the budget.  It was his administration whose monetary policies provided the loose money for the housing bubble, and it was his administration whose laissez regulatory policies failed to rein in the investment banks and mortgage companies.  The shortfall in revenues during the resulting depression is putting cities, states, and the Federal government further in the red.

Unsustainable Debt Levels

Bert Dohmen wrote a sobering piece last month in Forbes about "Trillions of Troubles Ahead" for U.S. debt.  He quotes his colleague Rob Arnott that "at all levels, federal, state, local and GSEs, the total public debt is now at 141% of GDP. That puts the United States in some elite company--only Japan, Lebanon and Zimbabwe are higher."

In adddition, household debt is 99% of GDP and corporate debt is 317% of GDP ("not even counting off-balance-sheet swaps and derivatives") -- both being the highest in the world.  Adding those to government debt at all levels, "our total debt is 557% of GDP."

Dohmen warns:  "The interest on the debt will consume all the tax revenues of the country in the not-too-distant future. Then there will be no way out but to create more debt in order to finance the old debt."

The article likens the situation of the U.S. to Japan, which has the highest debt-to-GDP level (227%) of any industrialized country.  Japan's recession has lasted for 19 years now and the stock market is down 75% from the 1990 high.  As bad as things have been for Japan, they could get worse.  Japan's demographics will make it more dependent on foreign creditors in the future, and Fitch has warned about a potential downgrade of Japan's debt.  This is not a good precedent for spendthrifts like the U.S.