Tuesday, July 5, 2011

Danger in Debt Ceiling Deal?

Before I delve into the debt ceiling deal, I want to apologize to those who misread my last comment on 400 years of tyranny as "anti-American." When you write your thoughts in a blog, it's easy to get carried away and even though I have problems with the wars in Iraq and Afghanistan and the pathological greed on Wall Street, it's not the fault of regular, hard working Americans, most of whom loathe Wall Street and corporate greed.

My comment was more to say that the world expects better from the US. When my grandfather left Greece at the age of 20, moved to Cedar Rapids, Iowa and volunteered to fight alongside American soldiers in the first World War, he didn't flinch. He was proud of being part of the US army, fighting for something he believed in. When he died, the US government kept sending a pension to my grandmother in Crete and she was extremely grateful. When my uncle left Crete and settled in New Jersey to become one of the first surgeons to perform laparoscopic surgery at John F. Kennedy Hospital, he was proud to be American and extremely loyal to his country. He died last year after battling colon cancer but in his later years, he was disenchanted and disgusted with US policy and the lack of leadership which he saw across the political spectrum.

That's my preamble to the ongoing and raging debate on the US debt ceiling. I consider this to be a purely political issue, but others will construe it as a make or break economic issue (it isn't, only serves their political agenda to paint it that way). Bill Schneider, a professor of public policy at George Mason University, wrote an excellent opinion piece for Politico which reflects my thinking, The danger in the debt ceiling deal:

The danger in the debt limit negotiations is not that the two sides will not make a deal. It’s that they will. Specifically, that they will reach the kind of agreement Republicans are demanding — which would cut more than $1 trillion in government borrowing over the next 10 years.

Any deal of that magnitude would have a devastating effect on the nation’s economic recovery. And make the deficit situation worse. Economic activity would slow and government revenues fall even further.

Democrats and Republicans are arguing over the correct balance between spending cuts and tax increases. Republicans insist that all the savings come from spending cuts. Democrats are willing to accept some cuts but insist that the deal be “balanced” with new tax revenues.

What they are both missing is that the exact mix doesn’t matter. What matters is how much money is taken out of the economy at a time when economic growth is desperately needed. Economic growth is necessary for any deficit-reduction plan to succeed.

Ronald Reagan knew that. Reagan said in his 1985 State of the Union speech, “The best way to reduce deficits is through economic growth.” That is because big spending cuts and tax increases are politically impossible.

On the other hand, growth will not be sufficient. The debt problem has become so large that we can’t grow our way out of it without further sacrifice. Some spending cuts and tax increases will be necessary. But growth will have to be a major part of the solution, just as it was in the late 1990s.

Right now, big spending cuts will damage the recovery. So will tax increases. Bill Clinton understands that point. “I hope they make a mini-deal,” the former president said in a recent interview at the Aspen Ideas Festival. “I don’t think you can agree to some mega-deal on their [Republican] terms.”

What makes the most sense, and what Clinton recommended, is a delayed deal. “What I’d like to see them do is agree on the outlines of a 10-year plan and agree not to start either the revenue hikes or the spending cuts until we’ve got this recovery underway,” Clinton said in an interview with ABC News last month.

The problem is political. All we need to do right away is get through the Aug. 2 deadline for raising the debt ceiling. The United States is the only country in the world where a political decision must be made to do that.

It’s never easy because it’s never a popular thing to do. To the American people, raising the debt limit defies common sense. If the government has maxed out on its credit card, it seems foolish to raise the credit limit.

President Barack Obama tried to get around that argument at his news conference, when he argued that raising the debt limit applies to money that the government has already spent. “These are bills that Congress ran up,” Obama said. “The money has been spent. The obligations have been made… . This is not a situation where Congress is going to say, OK, we won’t buy this car or we won’t take this vacation. They took the vacation. They bought the car.”

Raising the debt limit is a problem but not exactly a crisis. Jobs are a crisis. “If we defaulted on the debt once for a few days,” said Clinton, speaking at a fiscal summit in Washington in May, “it might not be calamitous.” Later, his spokesman said that Clinton had “inadvertently misspoken.” But had he?

Early this year, Treasury Secretary Timothy Geithner warned that failing to raise the debt ceiling would have “catastrophic economic consequences that would last for decades.” That may have been an exaggeration. No one really knows.

But one consequence does seem likely. Obama called attention to it at his news conference. “If capital markets suddenly decide,” Obama said, “you know what, the U.S. government doesn’t pay its bills so we’re going to start pulling our money out, and the U.S. Treasury has to start raising interest rates in order to attract more money to pay off our bills, that means higher interest rates for businesses. That means higher interest rates for consumers.”

Not to mention higher interest rates for the government to pay off the national debt.

It is important to raise the debt limit to avoid that consequence. But not by caving in to Republican demands for a mega-deal — which would have far worse consequences. That’s why Clinton urged Obama not to blink under Republican pressure. “The White House could blink,” Clinton said at Aspen. “I hope that won’t happen. I don’t think they should blink.”

Clinton revealed his own priority when he told ABC News, “All that matters is putting the country back to work. We put the country back to work and prepare for the new century, the rest of this will take care of itself.”

A recovery-choking deficit deal would be the worst possible thing for the country right now. How can we keep that from happening? The answer is gridlock. If it prevents bad things from happening, gridlock can be good.

I agree, gridlock can be good, and President Clinton is right to warn President Obama not to cave in under Republican pressure. Moreover, I let a senior pension fund manager know that the "debt ceiling crisis" is exactly what the big global macro hedge funds and prop desks want because it creates more uncertainty and volatility. He responded:

What I am really worried about is the likelihood of very pro-cyclical fiscal tightening (i.e. tightening when the economy is weak). The US economy is currently EXTREMELY vulnerable and I can’t imagine a worst possible time to cut spending and try to make a big dent in the deficit. Greece and some other European countries are doing just that, but it is basically a matter of life and death and if they want to stay in the Union, they have no choice. They are, in effect, facing a lenders’ strike. The US, on the other hand, is able to borrow and there are plenty of willing lenders. It is, to boot, extremely solvent.

Sharp fiscal tightening now would constitute a grave self-inflicted wound. It makes no sense, but I understand it is a touchstone issue from a political point of view. Most senior members of Congress and the Administration know this, Republicans and Democrats, but the rank-and-file don’t, and they appear to be in control of the national discourse, amplified through the megaphone of indentured media: whether it’s the Tea Party blogs and Fox on the one hand, or the rabid left-leaning counter-Republican outlets, the whole debate is extremely polarized and demagogical. I don’t see a lot of responsible behavior in Washington, but even less so on the internet and the media.

The debt ceiling and default are probably not key issues for hedge funds either. My strategy as a hedge fund would revolve more around knowing which way the economy is headed, and how hard the Federal government is going to push it up or down. At the end of the day, the big issues will not be addressed until AFTER November 2012. There are plenty of lenders of last resort with deep pockets and the US is not Greece, Ireland, Portugal or, for that matter, the UK or Japan. The play is a lot more on credit spreads and equities, in my opinion. And maybe, to a lesser extent, on the dollar…

I understand that many will dismiss these views as pure "Keynesian dogma," but that's only because they follow another religion from the Chicago School of "Free Market" Economics. I think these people are genuinely concerned about debt, but their myopic obsession based on a now debunked economic theory is clouding their judgment. The real crisis now isn't the debt ceiling, it's about jobs and lack of leadership on that front. The sooner we get people back to work at good jobs with a good pension, the better off the US and the developed world will be.

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