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Mark's Market Blog

7-30-11: US Default Part II?

By Mark Lawrence

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Seeing as how Harry Potter #7 part II did so well at the box office, Congress decided this week to have US Default Part II. At the time of this writing, it appears there is a compromise, "A sugar-coated Satan sandwich," as Rep. Emanuel Cleaver (D-MO) calls it. Markets fell about 5% this week as Nero fiddled and Rome threatened to burn. Clearly on Monday markets will be tentative to see how the votes go, then shoot up or down, depending on the votes.

S&P 500 February 7 2011 to July 29 2011

Central Falls, Rhode Island is about to declare bankruptcy as their pension pay outs exceed their revenue. Their union is considering voluntary give backs. We'll be hearing a lot more stories like this in the coming months.

What's the big deal about the debt ceiling negotiations? Frankly, I don't know. In my opinion, this is all grandstanding, staking out positions for the coming elections. It's certainly not about substance. What we're arguing about here is less than 3% of the budget. This year's budget numbers, according to the White House, are receipts of $2.17T, spending of $3.82T, and a deficit of $1.65T. Let's multiply those numbers by 2 and then consider "trillions" to be "tens of thousands" to put this into a typical family context. Our family is earning $43,400 this year. Our family is spending $76,400 this year. We're adding $33,000 to our credit card debt. And we're nearly getting divorced arguing about how to cut our spending by $2,200 - about 3% of our total spending, about 7% of our new credit card debt. Our family needs to take on another job and raise our income to something perhaps in the $50k - $55k level, we need to cut our spending by about $25,000, and we're almost getting divorced over $2,200. Seriously, the prognosis for our family is quite poor. The only consolation I can offer is that our neighbors to the east, the Europeans, are even closer to bankruptcy than we are, and our neighbors to the west, the Asians, are spending more than half their money building poorly engineered and non-permitted buildings on their property and it's starting to look like a major fire hazard. That's it for good news: if the US family can avoid immediate divorce, we'll likely be the last intact family on the planet.

The conservatives are completely split - tea party republicans want no increase to the debt limit at all. Without an increase in the debt limit, government spending would have to cut in half pretty much overnight. If there is a debt limit increase, it will be voted for by most democrats and a few republicans, and will therefore be a plan looking more like the Reid plan, perhaps with a few changes to attract republicans. My take: there's just too much pressure on Washington for them to fail to act. A compromise will be found and passed with mostly democratic votes and a few republicans. The bill will not be passed in time to meet the artificial August 2 deadline, but in plenty of time to stave off default. S&P (read: David Beers, Jerk of the Year) will downgrade our debt. This will have no more effect than their 10 year long program of downgrading Japan's debt. Personally, I would like to see federal expenditures severely cut back, starting with the elimination of agricultural subsidies, a cap on the capital gains exclusion, the elimination of the Depts of Energy and Education, cut the DOD budget by 40% or more, and make major progress on lowering medicare payments, especially to drug companies. However I don't see why this needs to include threatening the world's financial system - with how China is throwing around construction money on failing projects and Europe is failing to deal with their sovereign debt, I think the world's financial system is close enough to the edge without our help.

What if Congress fails to act? Obama and his Trained Attack Puppy Geithner still have options. Here's a few:

  1. Obama can invoke the 14th amendment and raise the debt limit on his own. My read of the 14th amendment tells me that he will most likely lose the constitutional crisis and impeachment that will certainly follow, so I doubt this.
  2. Geithner can call up the mint, who works for him, and instruct them, "I need a special coin minted out of platinum and gold, face value $1 trillion, and I need it in 48 hours." Then he can take his coin across the street to Bernanke and say, "Hi, I'm buying back $1 trillion of your treasuries." Just that fast we're $1 trillion under the debt limit.
  3. Geithner can instruct the mint to print up $5 trillion in $100 bills, and then tell China, France, Germany, "Hi, I'm buying back all your treasuries. Have a nice day." and just that fast we've gotten rid of a third of our debt.
  4. Obama can instruct all the departments working for him, "Effective immediately, your budget is cut in half." Immediately the US budget is balanced and we don't need to sell more debt.

Our Hero, David Beers, JotY, will likely demote the US from AAA rating to AA. Please hold on a moment, I have to find some boots so that I may quake in them. The big question here is, will anyone care? He demoted Japan's bonds several years ago and nothing happened: their rates stayed low, people kept buying them, basically he was roundly ignored. What will happen when he downgrades US debt? Little or nothing. No one seriously believes the US will be a substantial default risk for the rest of this decade, and we're nearly the only game in town: everyone else with AAA ratings put together is still only about 2/3 as big as the US. And of the remaining AAA countries, clearly the UK and France are in worse shape than we are, and Germany is questionable.

AAA bond market

A German high government official has accused China of substantially increasing food shortages and starvation in Africa. This is because China has been buying up African farm land, in preparation to stave off their own predictable food shortages. China of course immediately denied it. I think this is amusing: there will come a day, soon, when Chinese are trying to get truck loads of grain from their African farmland to the African ports, and to get there they are going to have to run a gauntlet of African troupes armed with cheap Chinese AK-47s. The Chinese are going to be very dismayed when they learn that the African troupes, due to a couple decades of non-stop civil wars, are actually pretty decent with their weapons.

We're told that China's economy will surpass the US economy in perhaps 15 years, and India will be close behind them. I don't believe this for a minute, for three reasons: 1) Both of these economies are based on having literally billions of unskilled and uneducated people who are willing to work cheap. In the modern world, there are fewer and fewer products that you can make competitively with cheap labor. Most require computer guided machines, robots, and highly skilled workers to program and maintain the machines. As cheap labor gets less and less valuable, as is already happening in China, these people will find themselves out of work just as 17 million poorly educated Americans are out of work. Having tasted a short life in the (relative) middle class, they're going to be very upset when they get laid off. 2) US growth was enabled by the nearly free and unlimited energy available in the last century. This century energy is getting very expensive very quickly due to demand increasing much faster than supply. 3) On top of all that, as more and more Indians and Chinese enter the middle class, their demand for water and food will grow, again faster than supply can keep up. The US had 200m people last century, and we could feed them with the output of Kansas, Nebraska, Illinois, Ohio. China and India have 2,400m people this century, no great lakes, no prairie / grain belt states, and rivers fed by disappearing glaciers.

Oil Demand, Developing v. Modern World, 1996 to 2015

Nearly 50% of Spain's youth are unemployed, the self-named "Indignados." Many of these people continue to protest the government, camping out near the capital buildings, having little else to do. Now police are starting to clear the campgrounds, as apparently the government is tiring of this embarrassment. Tear gas manufacturers are seeing unprecedented demand for their products. So far there has been no violence, but the parallels with Egypt several months ago are difficult to miss.

Europe mostly goes on vacation for the month of August. Unfortunately for them, bond traders don't. Interest rates on Spanish and Italian debt dropped a bit immediately after the last announced final, major, this-will-fix-it-for-sure bailout, but are on the rise again. Both countries are currently north of 5.5% on 10 year bonds. As I've written before, when that gets over 6% there's no turning back. I expect another serious crisis in the Euro area this year, indeed most likely this summer, that is before October 1st. Europe will be faced with an existential crisis: become the United States of Europe, with one central government and substantial loss of power to individual states, or have their banking system collapse under the weight of $18T in sovereign debt, much of which is bad. I don't see any significant chance of a US of E in the next few months: try to imagine the Germans agreeing to a government where the majority votes are held by people in bankrupt countries. While you're at it, try to imagine the US and Canada agreeing to a new government covering North and Central America where Mexicans, Guatemalans, Nicaraguans have the same votes we do. So I'm projecting another Lehman moment this year - that is to say, something as bad or worse as what happened to the US in late 2008. If I'm right, hold onto your butts: we're going on Mr.Toad's Wild Ride.

How can you watch for this? I'll certainly let you know when rates hit 6% for Italy and Spain. After that, at literally any minute markets could go into full fledged panic. I'm talking here about the Dow or S&P 500 index losing 25% to 40% of their value in a matter of weeks. I'd thought that the next crash would hold off until 2012, I'd be able to predict it in my Mark's Bold Predictions blog at the end of the year. I no longer think that. What can you do? I don't recommend you short markets, this is very dangerous. I'm very unconvinced that gold will hold its value, people are going to be liquidating everything. I do expect the dollar to do relatively well, and likely so will the Swiss franc. More later as things develop. Or don't. Maybe This Time Is Different.

Since we're seeing this big argument about the National Debt, I've decided to include these great graphs I found at

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