January 18, 2012
Since the EU Crisis went into overdrive in 2010, EU politicians have largely resorted to political posturing rather than implementing any actual financial solutions to the EU’s debt and banking crisis.
To clarify that statement, we view a “real solution” as one that A) cleared bad debts from the system, B) brought debt levels down to manageable levels, and C) got the troubled country’s economy back on track.
By way of example, real solutions would involve outright debt defaults, bank failures, and very likely one or more countries leaving the Euro. However, no major EU leader ever seriously promotes any of these ideas because doing so would akin to committing political suicide as the rest of the political class would blame them for what followed.
As a result, EU politicians continue to kick the can down the road with half-measures such as austerity measures in exchange for bailouts. The end result is that nothing is ever solved as those in charge of the decisions that matter have no incentives to actually do anything beneficial for their countries’ economies. See Greece whose economy has completely imploded to the point that children are being admitted to hospitals every week for malnutrition… and it will still have a Debt to GDP of 120% in 2022!
It is now obvious that US politicians have seen this work well for their European counterparts (nothing gets fixed, not tough choices have to be made and almost no one gets kicked out of office), and are now adopting this strategy on this side of the pond.
Consider the fiscal cliff issue, which our political leaders discussed endlessly for over a month, only to then pass a “deal” which both raised taxes AND failed to cut the deficit or debt.
Again, nothing solved, but plenty of posturing and blame.
Expect more of this. Today, the top story for the US is gun control even though we will officially breach the debt ceiling in roughly one month’s time. The last time we did this the US lost one of its AAA ratings from a credit agency and the markets imploded wiping out over a trillion dollars in household wealth in a matter of days.
This time around, things will be far worse if nothing is solved. If the US loses another AAA rating, then the financial markets could face systemic risk. The reason for this is that US Treasuries are one of the senior most forms of collateral used by the banks to backstop the $600+ trillion derivatives market.
As any trader who trades on margin can tell you, when the value of your collateral is called into question, those on the other side of the trade come looking for you to put up more capital on your trades. This can result in assets being sold en masse (similar to what happened after Lehman failed) and things can get very ugly very fast.
Another consequence of the US losing another AAA rating would be a potential spike in interest rates as a result of us having a lower credit rating. A 100 basis point move higher in interest rates means the US paying another $100+ billion in interest payments on its debt. The US is slated to pay some $300+ billion in interest payments in 2013. This amount could explode higher if interest rates rose.
We already have a Debt to GDP ratio of over 100%. Our deficit to GDP is nearly 10%. These are Greece type levels. And while the US has several advantages Greece does not (it produces the reserve currency of the world and is also the largest economy), the bond markets can be very unforgiving of fiscal profligacy.
But US politicians don’t care. They know that the US economy is a disaster and will be getting worse. The issue for them is not fixing this, but shifting the blame for what’s coming onto the other party.
Bottomline: the US debt situation is not going to be brought under control. We’ll either breach the debt ceiling or pass some hurried bill to raise it. Neither of these will help our credit rating or our fiscal issues.
Buckle up, 2013 is going to be an “interesting” year.