Uncle Sam Leveraging Up: De-leveraging? Not the US government
By Tony Allison, October 27, 2008
Best of luck to the 44th, and next, President of the United States. He will need it. After a brief post-election celebration, the enormity of the problems facing the next administration will begin to sink in.
As our government deals with an unprecedented global financial crisis, the frantic de-leveraging of the financial system continues everywhere, except in Washington. In order to save the system, the US government has been shifting the burden of risk from the speculators to the savers, from the hedge funds and money center banks to the taxpayers. The mistakes of the few are now the burden of the many.
Too much debt, too much risk
The problems emanated from too much debt, and too much risk, and now the US taxpayer (and their heirs) is the proud recipient of trillions more. As if the average taxpayer didn’t have enough debt on his/her own balance sheet. Now our representatives in Washington have upped the ante, enormously. The Treasury, Federal Reserve and Congress are creating trillions in new debt that must be serviced, or defaulted on in future years. Conversely, the hope is that many of the “assets” purchased by the government at a discount will one day be sold at a profit. One can only hope.
Source: Federal Reserve Board
A tidal wave of debt coming
Next year’s federal budget deficit should easily reach $1 trillion and may be closer to $2 trillion, counting the convenient off-budget items such as the wars in Iraq and Afghanistan. In our $14 trillion economy (soon to be smaller), a $2 trillion deficit would be 14% of GDP! In historic terms 6% was considered a crisis level. Unfortunately, the Fed is in a corner and will aggressively act to save the global financial system from collapse. The Fed will thus do whatever it takes, printing or borrowing untold trillions more in the coming months and years. Solving a debt crisis that took over two decades to create with a tidal wave of more debt is not likely to resolve the situation in a tidy manner. It will, however, prolong the pain.
On top of a list of pressing foreign issues and flashpoints to be addressed, the new president will arrive in the White House to find the faith and trust in the financial system under fire and the economy already into what appears to be a nasty recession.
With a lengthy and costly agenda of campaign promises, the president must pause and consider how to pay for it. The US government borrows over $2 billion a day from foreigners already to keep the lights on. There will be calls on all sides for a new and overdue “fiscal responsibility” and a need to “live within our means.” With a full-blown financial crisis, a deep recession, and war in two foreign countries, the next president may wish he had stayed in the Senate.
A more dependent nation this time
Compared to the Great Depression of the 1930’s and even the deep recession of 1973-1974, our government unfortunately has a few distinct disadvantages this time. In the two prior periods, the US was energy independent, a creditor nation, a manufacturing-based economy and its citizens had a fairly high personal savings rate. Today, leverage is working against us. We are the world’s largest debtor nation, dependent for 70% of our energy needs, a consumer-based economy whose citizens are saddled with high debt levels and a negative savings rate. Other than that, we are in pretty good shape.
On the plus side we have the world’s strongest military and the reserve currency. As long as we can print unlimited amounts of currency and foreign nations must accept them to keep the wheels of commerce turning, then the US can stay afloat. Unfortunately, our creditors are getting increasingly tired of holding trillions of Federal Reserve notes that have lost purchasing power, and look to lose a lot more with our printing presses heading into hyperdrive. A currency crisis looms as another potential disaster awaiting our next president.
The next “New Deal”
With the next administration will come pleas for the next New Deal. Free market ideals are likely to be buried under calls for the US government to bail out America, and to an extent, the western world. The only problem is we are not the wealthy power-house of yesteryear. Nonetheless, the “new” New Deal is likely coming, to be “financed” with debt upon debt, with future obligations to be borne by those yet born.
Leverage is a useful tool when used in moderation. But moderation has left town long ago. As the hedge funds and others frantically de-leverage, Uncle Sam leverages up.
Dollar strength may be temporary
A Reuters article published last week in Beijing highlighted the growing discontent of China with the dollar in global commerce.
“The United States has plundered global wealth by exploiting the dollar's dominance, and the world urgently needs other currencies to take its place, a leading Chinese state newspaper said on Friday.
The front-page commentary in the overseas edition of the People's Daily said that Asian and European countries should banish the U.S. dollar from their direct trade relations for a start, relying only on their own currencies.
A meeting between Asian and European leaders, starting on Friday in Beijing, presented the perfect opportunity to begin building a new international financial order, the newspaper said.”
Taiwan questioning US credit quality
A recent Barron’s article titled “Taiwan dumps Freddie, Fannie. And Uncle Sam?” suggests that even America’s allies are beginning to question its credit worthiness.
"After Mao drove the Nationalists off the Mainland in 1949, the cry went up among U.S. conservatives, "Who lost China?"
Now Washington might well worry about who lost Taiwan as a major investor in U.S. agency securities as the Republic of China has openly questioned their credit quality -- even after the federal government has committed hundreds of billions of dollars to bail out mortgage giants Fannie Mae and Freddie Mac.
Beyond that, Washington might well worry that other nations also no longer view its agencies -- and now, by extension, the very credit of the United States of America -- beyond question.
Taiwan's financial regulators reportedly have ordered that nation's insurance companies to pare their holdings of the debt and mortgage-backed securities of Fannie Mae, Freddie Mac and Ginnie Mae securities, according to a report on the Internet site of Asian Investor magazine.
Such an order would be a stunning rebuke to Washington, coming a little more than a month after the federal government effectively nationalized the mortgage giants. Fannie and Freddie last month were placed into conservatorships with the Treasury standing ready to inject up to $100 billion through purchases of preferred shares in the government sponsored enterprises.”
Foreign ownership of US bonds
If foreign nervousness over US credit issues ever gets to the “throw in the towel” stage, then the bond bubble will not just deflate, but likely blow sky high. The chart below illustrates our dependence on foreign ownership of US treasuries and our financial fate in the hands of others.
Dollar alternatives
European central banks may just think twice about selling their gold reserves into this market. The Chinese, among others, would likely start buying it and holding it for the next millennium or so. The Chinese think in terms of centuries, not next quarter’s results.
Margin-call selling rules the markets for now. Value and fundamentals mean little when trillions of dollars of securities must be sold to unwind massively-leveraged bets gone wrong. When things finally stabilize and the world begins to realize the mind-numbing extent of the leverage now taken on by the US government, the race out of dollars will begin. Gold should be a major beneficiary.
Nothing significant ever gets done in Washington without a crisis to provide political cover. Perhaps the next president, while dealing with this complex crisis, will have the “cover” to actually make a difference. More importantly, this crisis will have a profound effect on every American and the American culture. The Age of Frugality is upon us. The hope is that beyond the pain we will emerge a stronger, more stable society.
Today’s Markets
U.S. stocks on Monday were slammed again at the close to end sharply lower after multiple fits and starts, with a September rebound in new-home sales failing to stem ongoing fears of a worldwide recession.
The Dow fell 203.18, or 2.42 percent, to 8,175.77 after earlier rising 220 points. Broader stock indicators showed even more sizable losses. The Standard & Poor's 500 index fell 27.85, or 3.18 percent, to 848.92, and the Nasdaq composite index fell 46.13, or 2.97 percent, to 1,505.90.
Crude-oil futures ended Monday's volatile trading down for a second session, closing at their lowest level in 17 months on worries that slower economic growth will reduce energy demand. Crude for December delivery fell 93 cents, or 1.4%, to end at $63.22 a barrel on the New York Mercantile Exchange, the lowest closing level since May, 2007. It fell to $61.30 earlier. Crude slumped 11% last week.
Gold futures reversed earlier losses Monday and closed up 1.7% as investors speculated that the precious metal has been oversold. Prices have fallen in 10 out of the past 12 sessions as investors scrambled to liquidate their gold positions to meet margin calls in other markets.
Wishing you a good evening,
Tony Allison
© 2008 Tony Allsion
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