Diatribes of Jay

This is a blog of essays on public policy. It shuns ideology and applies facts, logic and math to economic, social and political problems. It has a subject-matter index, a list of recent posts, and permalinks at the ends of posts. Comments are moderated and may take time to appear. Note: Profile updated 4/7/12

05 July 2011

Flirting with the Devil


The most astonishing thing about our current national predicament is how stupid our leaders in Congress are. On seeing a bus bearing down on us at high speed, most of us would jump back on the curb. We wouldn’t stand pat and think, “I’m in a crosswalk, for God’s sake. It can’t hit me!”

That sort of instinct is pretty basic to survival, isn’t it? But right now, our members of Congress and much of the public either can’t see the bus coming or are pretending it’s not there.

Today, July 5, 2011, our financial markets have reopened. We now have precisely twenty business days until August 2nd—the day when, if we don’t increase the legislative limit on our national debt, the shit will really hit the fan.

During this period, it seems, our pols will continue to posture and bluff. Fox zombies will continue to cheer Boehner and McConnell and their attempt at legislative extortion. The President’s supporters will urge him to hang tough and hold out for revenue and tax increases, if only on the very rich.

Meanwhile, the clock will be ticking. The people who can predict consequences (or think they can) and do so for a living will be hard at work. They will be placing big bets and distorting our already ill economy beyond recognition.

How do I know this? Because I’ll be doing it, too. Actually, I’ve already started.

I’m not rich. But I’m not about to lose the comfortable retirement that cost me over 45 years of sweat to clueless extortionists like Boehner and McConnell. So I’ll do what I have to do to protect myself, as will virtually everyone who has the faintest understanding of finance.

So here’s what will happen, starting today (and some of it already has):

1. The government won’t be able to finance itself until the crisis ends. Extending the debt limit is a matter of law only. There is also the minor matter of finance. However much debt the law may allow the US Treasury to sell, people have to be willing to buy it. Who’s going to do that?

The Fed’s program of purchasing our own government bonds, known affectionately as “Quantitative Easing II” or “QE2,” ended on June 30. Right now, no one can be sure if Congress will extend the debt limit and, if so, when. Would you lend Uncle Sam your money under these circumstances? If you ran a bank and did so, you might well be breaching your fiduciary duty to your shareholders.

The government was already having trouble selling bonds and notes as early as last week. (See 1 and 2.) Do you think it will have an easier time starting today? It’s unlikely that our government will be able to sell enough securities to finance its operations until this particular episode of Republican extortion comes to an end.

2. Interest rates will start to rise immediately. Why have interest rates stayed so low for so long? The Fed, by buying huge quantities of Treasury notes and bonds at rock-bottom rates, kept them low. Now it has stopped doing that.

As far back as anyone can remember, Treasury notes, bills and bonds seemed risk free. No one ever dreamed that Uncle Sam might default or be unable to pay his debts like, say, Argentina, Mexico or Thailand. So Treasury securities built a risk “floor” for investors. They became the “gold standard” for security—the measure of every other form of debt because they were presumed risk free.

But now, of course, they aren’t. Whether or not Uncle Sam actually defaults, this serious GOP attempt at extortion undermines the basic assumptions of credit markets for most of our nation’s history. The closer we get to August 2 without a budget deal, the greater hit those basic assumptions will take. And if (as now seems likely) Congress just kicks the can down the road, those old assumptions will be off the table for the foreseeable future.

In other words, the very threat of default implicit in the GOP’s extortion attempt already has changed bond dealers’ thinking irrevocably, worldwide and forever.

If markets were entirely rational, investors today might switch from US government bonds to corporate bonds. After all, our corporations are sitting on between $1.6 and $ 2 trillion in cash and recent high profits. Unlike Uncle Sam, they are unlikely to default, at least in the near future.

But there are three reasons why markets can’t do that, let alone in a mere twenty days. First, most Treasury securities have longer maturities than twenty days. Unless their holders want to sell them at a loss (which increases for later maturity dates), they have no choice but to hold them to maturity. Second, many other securities use Treasury securities as a benchmark: the presumed risk-free investment. In some cases they have built this basis into their very terms. For example, some securities use the interest rates paid on Treasuries as a basis for computing the “floating” interest rate they pay. Third, the markets simply can’t react that fast because of the huge amounts of money involved, the wide dispersal of Treasuries among people and institutions, and the varying degrees of belief that a meltdown still might be avoided.

So what does this mean? A few corporations with clever management and strong balance sheets might be able to sell their own bonds at below-Treasury rates during the next twenty days. But interest rates on Treasuries, everything based on Treasury rates, and almost everything else will rise. That means that existing bond prices will go down as corporations and (if it can) the Treasury issue bonds at prevailing higher interest rates.

3. Money-market funds may lose money or get frozen. Most people think of money-market funds as bank accounts. They’re not. They’re mutual funds, similar in many ways to stock funds and regulated similarly. The FDIC does not insure them against default. The SIPC only insures them against fraud or malfeasance by securities firms and brokers, but not against a loss in value, especially not an unprecedented loss due to Uncle Sam’s default. And anyway, even if they were insured, who would honor the insurance with Uncle Sam in default?

Money-market funds reinvest your money in short-term notes, bills and bonds of corporations, municipal and local governments, state governments, the federal government and its agencies, and foreign governments. Traditionally, they have invested most heavily in Treasury and other US government securities, which are easy to handle and were once thought to be most secure.

To find out how much your own money-market fund has invested in Uncle Sam, you can look at its prospectus. In some cases, you can get useful information from the fund’s own Website or from independent research firms like Morningstar. If you look carefully, and if your funds are like the options available to me and my wife, you’ll find that most funds have from 7% to over 40% exposure to Uncle Sam. All that investment, of course, is at risk of a US default.

You have to be careful in drawing conclusions, however. Typical money-market funds invest in short-term instruments with maturities of seven to 120 days. They constantly “turn over” their investments as old ones expire. For the last several months, smart managers have been scrambling to liquidate investments in Uncle Sam and avoid the risk of an extortionate default. In this scramble, reports of funds’ investments get quickly out of date. If you don’t have a list of this month’s investments, what you have is probably outdated.

But one thing is clear. If there is a default, fund with large investments in Uncle Sam will be caught with their pants down. They might have to incur substantial losses on their investments, which means they will “break the buck.” Or, more probably (and if their governing documents permit), they will declare an emergency and limit cash withdrawals until the default and its aftermath have settled down.

It’s unlikely that Uncle Sam would default on any instrument for more than a month or two. The consequences of a longer default would be so globally catastrophic that even Boehner and McConnell would be able to see them by then.

But if you expect to need the money in your money-market fund soon, and if your fund is heavily invested in Uncle Sam, you’d best start moving it out now. An FDIC-insured account in a highly profitable bank would be the best place to park it temporarily.

Even right now, much is churning underneath the surface of a reported $1.00 net asset value for money-market mutual funds. Funds are scrambling to reduce their exposure to Uncle Sam as their investments mature. That scrambling will increase in size and tempo as August 2 approaches (unless and until there is a debt deal), distorting the market for short-term securities and the safety of money-market mutual funds in a frenzy of risk-avoidance.

4. Capital will flee America. Our national economy is the world’s most sophisticated and complex. As the Crash of 2008 showed, it is beyond the comprehension of even the most brilliant economists and bankers who spend their lives studying it and profiting from it. To idiots like Boehner and McConnell, it is a complete mystery, deeper than the cosmos or the origins of life, about which they no doubt spend equal time thinking.

Now, when such idiots threaten to throw a monkey wrench of extortion into such a delicate mechanism, what do you think smart people will do? They will get their money as far away from the endangered machine run by mad mechanics as quickly as they can.

Without a very quick debt settlement, I predict that the next twenty days will see the greatest short-term outflow of capital in the history of our Republic. Money will flee Treasury bills, notes and bonds, whenever they mature or can be sold. But money will also flee instruments whose terms or interest rates are based on Uncle Sam’s securities, just for fear of the confusion and uncertainty that a default would sow.

Ironically, our erstwhile enemies China and Russia will probably stand by us. They know that any precipitate sale by them would only bring on a global economic collapse faster. And they don’t have any better place to park their huge investments in us in so short a time.

But private money is an entirely different story. If you don’t think that private money that can escape the threat of imminent chaos by pressing a button on a computer will do so, you had better think again.

Really nervous private money may even flee good stocks. Our excellent corporations are in no immediate danger, even from a US default, because they are sitting on piles of cash. But nervous investors might abandon them for safer venues abroad, with lower volatility. There’s nothing like financial markets in distress to provoke vestigial herd instincts in Homo sapiens.

5. The dollar will fall. As money flees Treasuries and Uncle Sam can’t finance his short-term needs, the dollar will fall.

That process already has started. Troubles in Greece and the EU have masked it by making the Euro fall also. So some people haven’t yet noticed, because the Euro is the foreign currency to which most people compare the dollar. But the yen and renminbi (yuan) have been rising steadily, despite Japan’s still-recent catastrophes. These changes will accelerate during the next twenty days, destabilizing international finance and increasing market volatility worldwide.

6. Financial gambling will increase in amount, scope and frenzy. What has motivated the explosion of financial “innovation” in recent years, including mortgage-backed securities, credit-default swaps, collateralized debt obligations, and other so-called “derivatives”? Hasn’t it been the desire and belief (however unjustified) that financial gambling can avoid or reduce the risk of unforeseen or unforeseeable events and their economic effects?

Financial gambling responds to risk as party goers respond to free food. And what is the biggest, most uncertain and most gnawing risk today? The risk of a US extortion-default, of course.

Already the prospect of August 2, plus the complete inability of news media and pundits to predict how it will come out, have created a veritable new industry of financial gambling.

That industry will not wind down after August 2. It might if the impossible happened. For example, gambling might subside if Congress produced an agreement to reduce the national debt by $ 4 to $6 trillion dollars in the next ten years, and to do it with sensible, wide-ranging cuts and reasonable increases in revenue, including increased tax rates.

But as the GOP have threatened over and over again, that’s not going to happen. Already there is serious talk of kicking the can down the road, thereby prolonging the agony of uncertainty and risk at least for another eighteen months, until the 2012 elections, and perhaps even beyond that.

So you can be sure that, for the next eighteen months at least, financial gambling on the political uncertainty in the United States will be a growth industry. The gambling will draw increasing interest and attention away from real industry, infrastructure improvement, and education. It will therefore suck the oxygen out of any effort to arrest our national decline. And it will, as in 2008 and always, make a few people fabulously rich at a vastly increased risk of another derivatives-led financial catastrophe like the Crash of 2008.

* * *


These are just a few of the worst short-term consequences of the extortion by default now under way. They will all begin to rear their ugly heads this week. In the absence of a quick resolution, they will seriously impact our economy, our recovery, and the willingness of foreigners to invest in our increasingly irrational and precarious society.

The closer we get to August 2 without a debt-ceiling extension, the worse all these effects will get. If we actually default, they will all get precipitously and instantaneously worse and will remain so for the foreseeable future.

And I haven’t even mentioned the longer-term consequences of a near-default, especially one that just kicks the can down the road. But there are many. They include: (1) increased inflation at home, due to rising interest rates and a falling dollar (which makes foreign goods more expensive here—including all those Wal-Mart products from China); (2) long-term increases in US interest rates, as foreigners no longer view US securities as risk-free investments and therefore demand higher returns to compensate for their now-demonstrated risk; (3) a stronger and ultimately successful push to decouple oil prices from the dollar, which will exacerbate oil-price inflation here at home (and at precisely the time that a global supply shortfall threatens to push prices up steadily and strongly); and (4) a general capital flight from the United States to foreign countries with greater political stability, less market volatility, faster GDP growth, and more sensible government generally.

All this recalls a story from the Manhattan Project, which invented the world’s first atomic bomb. At that time, we didn’t know much about radiation and its effect on people. We did believe that a critical mass of fissile material, such as plutonium, would produce an atomic explosion if assembled or compressed with explosive force.

So one worker in the Project experimented with bringing subcritical masses of plutonium closer and closer together, quietly on his lab bench, to see what would happen. As they drew near to a critical mass, the smaller pieces produced a strange blue glow and palpable heat. The researcher, fascinated by these phenomena, became first member of the Project to die from radiation poisoning.

Both this Manhattan-project story and our extortion by default are tales of people unable to predict consequences. Like Uncle Sam’s mere near-default, a nuclear event below the level of an atomic explosion can be dangerous—even fatal—in unforeseen ways. Let’s all hope our economy doesn’t have to die like that hapless researcher to prove the point.

Update: Brooks on GOP Extremism

A mere hour after publishing the foregoing post, on which I’d been working for several days, I read David Brooks’ column today. In it, he castigated the GOP for failing to grab a very generous, concession-laden compromise on debt offered by the President. His title, “The Mother of All No-Brainers,” says it all.

I’ve mostly stopped reading Brooks lately. Once reasonable and centrist, he’s moved hard to the right along with the party whose indefensible actions he increasingly tries (vainly) to defend.

But his title caught my eye, as did this excerpt:
A thousand impartial experts may tell [the GOP extremists] that a default on the debt would have calamitous effects, far worse than raising tax revenues a bit. But the members of this movement refuse to believe it.
With that, I fully agree. I do not agree with Brooks that a no-tax-increase compromise will ultimately be good for our country or its people. But his column is nevertheless worth reading, if only to confirm how far from the moorings of reason, compromise and moderation the extreme right wing has ripped the GOP.

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