Friday, March 14, 2008

Debt, Austerity and Iraq

The United States is in the middle of a major debt crisis that has both illiquidity and insolvency components. Illiquidity means some loans/bonds are unable to be paid off on time due to merely cash flow issues and thus can be worked out so that the NPV of the loan can be fully paid off at some point in the future. The collataral and cash flows will eventually be there, just not right now. Insolvency involves loans whose NPV will never be paid off. The borrower lacks any reasonable projection of being able to pay off their debts. The solution here is some type of shared pain agreement where the borrower pays what they can while taking a hit on their credit rating and the lender seizes the underlying collateral, and takes a loss on the difference between the loan amount and the collateral value.

Right now almost all of the carnage is occurring in the private markets, and the pain is going to be sharp and prolonged. However the pain and the costs of cleaning up are slowly moving away from the private markets and toward a public bail-out of the dumb decisions that have been made. The Term Securities Lending Facility where the Federal Reserve gives out very liquid and valuable US Treasuries in exchange for AAA rated (yeah right) mortgage backed securities for 28 days and the re-rolls them over is the first step of the public bail-out (the use of the Federal Home Loan Banks was a covert step of a bail-out). The Federal Reserve takes lipsticked pigs wallowing in MBS slop and calls it the equivilant of the full faith and credit of the US government.

I am assuming that this bail-out will continue and grow in size and scope for the near future. No one wants to account for the highly probable losses that should be massively marked-down. Instead being able to transfer assets to the Fed and allowing the Fed to by the crypt of zombie debt allows companies to ignore reality for a while longer. And that is attractive when your bonus structure is based on a pleasant reality at the end of the quarter.

So we could have a situation where a really nasty private sector debt crisis transforms itself into a really nasty public-private debt crisis. And here is where things could get really interesting, as the recent model for resolving national public debt crisi is for categorization (what's okay, what's illiquid, and what is insolvent), international bridge loans to carry over the okay and illiquid debt to better days, harsh liquididation of the insolvent debt, export led policies to generate more foreign currency, and severe austerity on the public budget which means cutting back almost everything except debt service.

There are a couple of big differences between this low probability, high cost scenario I am spinning right now and most traditional debt crisis resolved by the Washington Consensus prescription. The most important is that the US debt is denominated in US dollars; massive inflation is a viable option of avoiding some forms of policy pain. The other is that the groups with money to bail the US out are the mercantilist/Bretton Woods II countries (OPEC, China etc) and their strings being attached to any package are most likely different than the strings the US would attach.

Paul Krugman notes the interconnected relaionships of issue and policy space, and how the creeping bail-out will significant crimp option space of the next President:

I used to think that the major issues facing the next president would be how to get out of Iraq and what to do about health care. At this point, however, I suspect that the biggest problem for the next administration will be figuring out which parts of the financial system to bail out, how to pay the cleanup bills and how to explain what it’s doing to an angry public.

If the US government embarks upon a significant bail-out of significant elements of the US financial sector, it will need massive injections of foreign capital. Most foreign capital that is willing to come into the US is not profit maximizing capital at this time; instead it is either risk averse capital or politically controlled capital. If the US is able to attract a massive lump of capital then few choices will need to be made. However if there are problems, austerity will be imposed to free up additional cash.

The Pain Caucus is much weaker today than it was five years ago or twenty years ago, so Baby Boomer retirement programs are relatively safe. The other big pool of cash floating around in the government is the defense budget and the biggest discretionary portion of that budget is Iraq. $200 billion per year is some serious money. There are already large pre-exisiting political groups (most of the Democratic Party) that thinks this is a damn dumb idea for one reason or another already, and as we move forward more people will be screaming for relief. The ability to propose non-trade-off solutions will decrease.

A debt crisis could provide very convienent political cover to withdraw from Iraq and save $150 billion per year in expenditures (some money will be spent to maintain 'containment forces', and other funds will be used to pork out the supplier's districts). And pulling out of Iraq could be one of the strings attached to any implicit or explicit foreign bail-out.

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