Sunday, December 21, 2008

The Debts of The Spenders: Obama's 3 Choices

Which Is Most Likely?

A) Default on Federal Debt (Treasury market)

B) Restructure Debt (Bankruptcy/Bretton Woods 2)

C) Conversion

I will go through each option to explore the pros and cons.

A) Default - This is the apocalypse scenario favored by goldbugs.

Under a default scenario, the US federal government will default on its external debt obligations.

While the authorities can wipe out US debt in a single stroke the consequences are catastrophic. Looting and mass riots are the symptoms on the domestic front. Internationally the collapse of the dollar will mean even more widespread chaos in emerging markets and ripple effects among the remaining G7. The largest creditor nations will also face hyperinflation as their contractual debt claims would be wiped out. Nations that depend on US foreign aid in order to function will become suddenly isolated (Israel and Taiwan).

Winners: Agriculture, Energy, Guns, Canned Food, Gold (short term), US Taxpayer
Losers: Everything except the above

B) Debt Restructure (Bankruptcy) - Bretton Woods 2. An international consortium of G7 and powerful emerging market nations will form the parameters of a new world order.

A new currency would replace the dollar. This "New Dollar" would be backed by the full faith and credit of the new world order instead of the US government.

Treasury holders will lose most of their holdings although sovereign (international government) creditors would be given options, warrants, or some form of IOU that places them in a senior position to other debt holders. Institutional holders of Treasuries would be next in line. Finally the retail holders of Treasuries and state government debt would be wiped out. Make no mistake. This is an attempt to preserve the status quo but the price will be high.

Winners: US Govt, emerging markets, large foreign governments, agriculture, energy, corporate (FIXED INTEREST) bonds, non-Western Banking Cartel
Losers: Cash, inflation bugs, retail US govt debt holders (treasuries and munis), corporate CALLABLE (variable) bonds, US Taxpayer, Western Banking Cartel

C) Conversion: All existing US government obligations will be converted into EXTREMELY long term, low, fixed interest loans. Treasuries would be smoothed out to 50 and even 100 year maturities. The Federal Reserve would buy home mortgages outright from the banks and then offer the homeowner rates as low as 1-3%. This is basically a Japanese "Lost Decade" taken to extremes - global slowdown that will last 30-40 years minimally.

Note - This option is ONLY AVAILABLE TO THE US. There can be only one quantitative easing beast in the world and that is the US government. Other nations that try to emulate this model will be only partially successful.

The UK, EU nations, Japan, and maybe even China WILL try to copy the low interest, long term rates and be partially successful in doing so at the institutional level through DOLLAR DENOMINATED credit swaps run by the Fed or a new government agency.
But, they will still have to offer higher interest rates on their debt refinancing because there simply are not enough institutional or retail buyers to soak up all the new bond issuances.

Winners: US Fed govt, Western banking cartel, US State govts, US corporate bonds (fixed interest), agriculture, energy
Losers: Agency Debt holders, Corporate (variable) bonds, foreign govt bonds, commodity dependent emerging markets (Russia, OPEC, Latin American banana republics), smaller manufacturing based emerging markets (Vietnam, Taiwan, S. Korea), US Taxpayer

Conclusion: Out of the 3 options above, I believe US authorities are leaning towards #3 since it is the solution that best preserves the status quo. However, the conversion policy runs a VERY HIGH risk of triggering mass social unrest in less stable, foreign governments - particularly the commodity dependent emerging markets such as Russia, OPEC states, and virtually all of Latin America.


Anonymous said...

Fascinating article! Would like to read about the geopolitical practicalities of navigating between 2) and 3). Does China have a say in avoiding 3)? Will the US threaten 3) to get 2)? Is there path between 2) and 3) that works for all parties? China does have a long-term horizon if they can survive the near-term turmoil so a defacto 2) is politically possible.

In Debt We Trust said...

These options are not mutually exclusive except for #1. World governments are doing their best to avoid #1 at all costs.

#2 and #3 can be blended together as a way of representing China's interests.

Please note that #2 and #3 are also dependent on maintaining public any cost.

The Greek riots currently unfolding are examples of the dangers that can occur when a population is pushed to its limits from corruption, unemployment, and social marginalization. We can be sure that US authorities will authorize any means to stop dissent ranging from subversion all the way to outright force.

Anonymous said...

Those are some odd choices, and you left out the most obvious one:

4) Print.

The rest of the world is locked in a mutual death dance with the US. The longer the trade imbalances continue the more likely the situation will unwind in a disorderly fashion. But in the short term the current setup works. Sustained moderate inflation (6-8%) would grind down the US's debt without the system seizing up. At the same time it would force a rebalancing of trade. Foreigners - especially the Chinese - won't like it, but they can't stop exporting to the US overnight, thus they can't retaliate by dumping their US assets in bulk.

It would also have the advantage of grinding down the real value of the mountain of debt Americans have piled up internally. Yes, savers would be punished, but we're all going to get punished to some degree so we might as well choose the smoothest path out.

There really is no need for a BW3 as long as everyone actually lets their currencies float, instead of fixing or constraining them artificially - which was an important cause of the current problem.

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