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CDS Pricing in Increasing Treasury Default Risk

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We have noted that Treasuries (and the dollar) are the remaining bubbles, although some doubts are starting to surface on the Treasury front. Paul Amery at Prudent Bear gives a good recap:

The tectonic plates underlying the whole superstructure of debt have started to shift.

On the surface nothing remarkable is happening – the 30 year US Treasury bond yield recently hit an all-time low of 3.88%, as investors sought a safe haven during equity market turbulence. Yet while nominal bond yields have declined, the credit risk component of US Treasuries has been on an increasing trend since last year. According to data provided by CMA DataVision, the credit specialists, the 10-year credit default swap spread – a form of insurance contract against issuer default – has risen steadily – from 1.6 basis points (0.016%) in July 2007, to 16 basis points in March 2008, to 30 basis points in September, to over 40 basis points on October 27 – see the chart below for the spread history so far this year. In other words the cost of insuring against a US government default has risen by 25 times in little over a year. Similar trends have been evident in the UK and German government bond markets.

This has perplexed, and even amused, some market observers. How, they ask, could a private sector contract against default be expected to pay out in the case of a US government default – which would be the equivalent of a nuclear explosion in the financial markets? So what’s the point of buying such a contract?

Moreover, how could the US government ever renege on its debts? After all, it supplies the world’s reserve currency, and the Federal Reserve Chairman reminded us a few years ago of the US authorities’ ability to print money in unlimited quantities. Any “default” would at least be through the time-tested mechanism of inflation and currency devaluation, according to this view.

On the other hand a longer-term examination of debt markets reminds us that, throughout human history, regular default is the rule than the exception. And while sovereign defaults on external, foreign-currency debt are most common, Carmen Reinhart and Kenneth Rogoff demonstrated in a paper released earlier this year that defaults on domestic debt have happened far more often than might have been expected, particularly in times of severe economic duress.

In both the US and UK, budget deficits are poised to explode….the really big impact is coming from the rescue packages being thrown at the financial sector. Morgan Stanley recently estimated that the 2009 fiscal deficit in the US would reach 12.5%, over double the previous record of 6%, set in 1983…

When measured as a percentage of GDP, the US national debt is expected to pass 70% next year, which, though much higher than recent years, is still short of the record 122% registered in 1946, at the end of the Second World War. Some observers point to this comparison as an argument for the sustainability of the current position.

Yet others argue that government debt must be seen in the context of, and as part of, the overall debt burden on the economy. With the US private debt to GDP ratio at levels never seen before – close to 300%, according to Steve Keen, the Australian economist – the question is surely whether the whole debt pyramid can avoid crashing down via a violent and uncontrollable chain of defaults, dragging the government bond market down with it. If this seems far-fetched, it helps to remember that the Latin root of the word credit comes from credere – to believe, but also to trust. For large sections of the private sector bond market, it is precisely that trust which has disappeared over the last year and a half. To suggest that such “credit revulsion”, to use an old term, might spread to governments’ debt obligations is surely not beyond the realms of possibility

Signs of strain in the US Treasury market are already there, despite the current low yields. Recent auctions have shown poor bid-to-cover ratios, and long tails (the difference between the average accepted yield, and highest yield), both signs of shallow demand. Delivery failures in the secondary market have also hit record levels, a sign of poor liquidity. Market observers should keep a close eye on the progress of future auctions, particularly as the issuance schedule picks up.

How can investors take cover if concerns over government solvency spread? For the early part of any credit-related decline in bond prices, there are obvious hedges, such as credit default swaps, short Treasury bond futures positions and inverse Treasury ETFs. But ultimately a US debt default would have cataclysmic consequences for the financial economy, bankrupting the entire system. So the ultimate safe haven is in the precious metals, which would rapidly regain monetary status in such a scenario.

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78 comments

  1. foesskewered

    However much that warrants an OMG, am resisting uttering that.

    The part about private insurance against government default was well made, hmm, perhaps a sign of the cannibalism rife in present markets?

    Hesitate to wonder how Mr Buffett is doing in his muni bond insurance business?

  2. River

    …’But ultimately a US debt default would have cataclysmic consequences for the financial economy, bankrupting the entire system. So the ultimate safe haven is in the precious metals, which would rapidly regain monetary status in such a scenario.’

    Governments, always and everywhere, have destroyed the purchasing power of fiat currencies. If US administrations since LBJ have not purposely destroyed the dollar, then they have done a remarkable job without trying.

    This might be a good time to purchase some hurricane supplies…even if you live in a part of the country that is not threatened by hurricanes.

  3. Richard Kline

    I am skeptical that the markets will be able to absorb the volume of debt issuance that the US Treasury is about to unleash upon the world. The ‘market solution’ to that problem, of course, is price declines to get yields well up . . . which past a certain point will have a highly negative impact upon existing, low-yield debt. What I suspect is that we will get a tipping point on the latter debt where it’s market value implodes, and big chunks are dumped at distressed re-sale prices. The effect of that can ‘simulate’ a default event even if the US of course promises to pay “in full” in its deteriorating $s, since the dollar can expect to be dragged into devaluation conditions in such a scenario even if it has already been devaluated in the interim.

    Continuing to issue massive amounts of further debt when there is already so much $ denominated debt in the global financial system as to seriously raise the question of inability to pay is, what’s a good word?, suicidal. What I see to this point in policy from DC is that The Powers That Be have learned _nothing_ from the last thirty years. All this talk about ‘stimulus’: That’s a mispronunciation for the word ‘debt’ when what we really have is a revenue problem in the context of an insolvent banking system. “Debt is the solution,” yeah, a three per cent solution in a hypo, until the debtor is in dissolution.

    When such a dissolution comes, if it comes, it won’t be a shift into gold, at least outside the US: it will be a shift into sounder debt denominated in other currencies. The thing which will avoid that outcome is for the US to get its debt and revenue into some semblance of strategic engagement. But I think we will have to fail before we try that option.

  4. ruetheday

    The two paragraphs under the graph (i.e., the opposing view) have it right.

    The US government is not going to outright default on its debt. Not going to happen. Ever. Inflation and devaluation will be the mechanisms for ameliorating the debts. As to the claim that the historical record shows defaults to be the rule, I’m betting close evaluation of those records will show only countries with large external debts denominated in a currency other than their own.

    Finally, the idea that private CDS debt contracts would somehow be honored in the event of a US government default is preposterous.

  5. Murph

    Does anyone have any references where one might learn more about the counterparty-problem which the author identifies – i.e. why buy a CDS against US Default as nobody could ever pay on it… ?

    Who is selling these CDS’s and how do they claim that they’ll make good ?

  6. Matt Dubuque

    The current fad among American commentators (who, it seems, are universally long metals) is to predict that after a short bout of deflation (which they had earlier claimed was impossible) inflation will shortly return in a very nasty fashion and their purchase of precious metals will be soon rewarded. All it takes is a little patience.

    What the Americans don’t seem to understand is that deflation is EVERY bit as pernicious as inflation and its effects are long lasting.

    But I won’t go on at length here. Telling an American that they will lose money on precious metals is generally a complete waste of time.

    It’s a religious thing for them.

    From an anthropological perspective, it’s interesting.

    From a historical perspective, it’s tragic.

    Matt Dubuque

  7. mft

    Richard Kline: “Continuing to issue massive amounts of further debt … suicidal”.

    Under deflationary conditions massive public spending is the only way forward, otherwise we’re headed for a downward spiral in world trade and collapsing levels of production as in the early 1930s. The great danger is fiscal conservatism applied now under inapproriate conditions.

    You are right that this cannot be accomplished by countries acting on their own, especially not by the USA alone, because of the risk of currency chaos. We badly need a global plan for big spending spread around all the main currencies, combined with exchange rate stabilisation measures.

    And, of course, the spending has to be targetted so that it works. For the immediate short term, low-income sectors of the population should get immediate cash, because they will spend, not save; for medium term we need global investment in the energy revolution.

    And the banks should be nationalized, in a confiscatory fashion – equity wipe-out and debt to equity conversion. We might be able to afford that.

  8. Gregor

    A functional default would occur when the Auctions and Rollovers started to fail, from a lack of buyers. At that point, I would expect foreign CB monetization of US Treasuries to advance to a new stage. I think they would print solely for the purpose of taking up the surplus supply, from the failed auctions. The failed auctions might not trigger the contractual terms of the CDs, but, as you say, the implications would be quite broad were we to reach that stage, rendering the disposition of CDs as rather minor in the grand scheme of things.

    Of course, I think price-sensitive buyers will have been exiting the US treasury market long before this begins to unfold:
    http://gregor.us/crisis/debt-ology/

  9. DownSouth

    mft said…

    “And, of course, the spending has to be targetted so that it works. For the immediate short term, low-income sectors of the population should get immediate cash, because they will spend, not save; for medium term we need global investment in the energy revolution.”

    Even though I agree completely with what you say, what are the chances of this actually happening?

    I am of the belief that the Friedman Circus still hasn’t rolled out of town, that it is still, ideologically and politically, very much in control. (The fact that Robert Rubin is one of Obama’s top advisors is scarry as hell.) And as long as this is the case, is it not unreasonable to expect things to play out much as they did in Mexico in 1994? Here’s how Carlos Fuentes describes it:


    Mexico needed—and did not get—policies encouraging investment in activities that would further employment, wages, growth, and savings. Instead, the Salinas reforms provoked a flood of speculative, unregulated capital that did not go into productive areas. Like flight capital in any other emerging market, it stayed in Mexico as long as it was profitable to stay and fled as soon as dark clouds started accumulating in the sky…

    Never had Mexico received as much foreign investment as it did during the Salinas years: almost $59 billion between January 1989 and September 1994, but of that economic sum, almost 85 percent was speculative flight capital.

    [When the foreign capital began to flee and the crisis began the] neoliberal model espoused by the Salinas administration responded by fighting inflation, balancing the budget, inspiring confidence in Mexico, attracting investment, concentrating wealth in a few competitive firms and individuals, and hoping that the trickle-down would take effect. But the hope was undermined by evidence that the economy was not growing, that fighting inflation had become a fetish, that excessive foreign spending was not compensated for by increasing local production, that real growth was hindered by one of the lowest savings rates in the world, and, finally, that flight capital had become unmanageable.

  10. Anonymous

    Are Credit Default Swaps still being written? If so, why? Some have argued that all CDS should be declared null in void. Instead of destroying the source of our problems, we send mountains of money to the people affected by the problem. We are treating this like a natural disaster. All I can conclude is that going after the source of the problem is, for some reason, Off Limits.

  11. Lee's Dhaba

    Nice catch-22; if the US defaults and you ensure with CDS then you get paid in…the defaulting currency. How nice!

    As CDS rates climb, why is gold falling off a cliff; this seems contradictory given the last line of your post.

  12. Lee's Dhaba

    Nice catch-22; if the US defaults and you ensure with CDS then you get paid in…the defaulting currency. How nice!

    As CDS rates climb, why is gold falling off a cliff; this seems contradictory given the last line of your post.

  13. mft

    I’ve looked at the paper by Reinhart and Rogoff now, and there are really very few domestic currency defaults that would resemble the US case. I think the only ones are the British, who on one occasion unilaterally reduced the coupon and on another (after WWII) converted war debt into perpetuals.

    Unilateral coupon reductions are a real option for the future, and from the policy standpoint I think we just have to accept this as a risk and go ahead anyway and issue debt to cover the kind of spending that’s needed to get us out of this mess. However it works out, it’s going to hurt both investors and the employed.

    By the way, murph, I don’t understand cds either, really. But so far as I can tell, when spreads rise sellers of protection try to cover their extra risk by buying protection themselves, thus passing on the extra risk. In the end, all the risk is distributed as increments in a very wide market. That at any rate is what allegedly happened with Lehmann. Seems to work. Perhaps an expert could comment.

    If the US cut its coupon unilaterally by 1%, I think it would make the Chinese very unhappy, and might have foreign policy consequences, but I don’t think the world financial system would come tumbling down. After all, Nixon went off gold, and the USA survived that.

  14. mft

    downsouth:

    You may be right, and I’m p…… in the wind, but I prefer to think that where there’s life, there’s hope.

  15. Anonymous

    The ultimate safe haven is in food because even homeless people have to eat. Might want to get a gun and some ammo then start practicing now. This is going to be unavoidable 1-3 years out.

  16. baychev

    i doubt that failure to pay will be a default trigger. the more likely way is money devaluation. this is how benny thinks: throw money out the helicopter but do not EVER let money keep their value even for a day!

    with a global slowdown we are destined to see what richard kline pointed out: the gov’t will have to pay HUGE interest yields on treasuries if it is to borrow. do not forget that most foreign reserves are already in treasuries so those holders will pay a hefty deflation tax. their appetite for further dollar denominated debt will disappear at the very moment. i expect financing arrangements either in foreign currency or commodity backed arrangement so the US gov’t does not renege on its debt again.

    mft,
    there are 2 types of government spending: productive and unproductive. the US gov’t is spending way too much on unproductive (military, unfunded social benefits, corruption etc.). read more about it here:
    http://mises.org/story/3169

  17. baychev

    i sense alot of socialism on this forum today. the gov’t should nationalize banks, disburse cash to the poor, spend on this and that etc.

    people,
    understand that the government is not an enterprise: it takes taxes from everyone and redistributes while it creates non productive employment for the incapable to work in the private sector. by borrowing, the gov’t just pushes further ahead in time future tax hikes or a default.
    even in lovely socialist france the congress just upped the pension age to 70 years. this is the tax for the liberal socail benefits: 5 extra years labor.

  18. Richard Kline

    So mft, no and yes. Stimulus applied in the textbook formula is misconceived in the present environment, and will fail. Or at best, it will lead to Japanese style ‘oxygen depleted’ conditions for five to ten years and _then_ we get the crunch.

    Everything happens in a context; that’s a truism, but in this case context is king. I have no problem with stimulus as a concept, or in proper context as a method. I’m all for infrastructure investment in this country, properly targeted and conceived (which it won’t be because it never is, but let’s let that pass for now.) Macroeconomists treat the factors involved like buttons and dials on a mechanism; run the right formula, properly set the buttons and monitor the dials, and hey presto, MONEY!. —But the machine is not a constant configuration. It changes is pieces over time; it changes its settings over time, it changes its wear and loadbearing capacity over time. It changes these things in ways that abstracted textbook models simply do not engage with; we have to see the context for what it is, and reason through what the context actually is.

    Stimulus can really can work at times. Now, no. Why? Most of the ‘consuming classes’ in the US are locked into bad numbers with the wrong trajectories. The middle class has seen its wages stagnate for ten years, and decline in real terms. The working class has seen its wages plummet in real terms for a generation. Both have been encouraged and situationally coerced into resorting to debt to make up the shortfall to maintain expected levels of consumption, levels expected by themselves and by macroeconomic operationalists. Any one time, or two-three year dollop of lolly to either or both classes simply encourages them to push money out _into the same context of failure_, a context where there incomes continue to decline and debts continue to increase, slow or fast but inexorably and unsustainably. What really happens with that stimulus in this context is that consumption is simply sucked back into the parasitical FIRE machine, with its loans and cards and baubles and tax discrimination: that’s the point, dope the hamsters so they start running round in their wire wheels again. Start paying on those top of the market, out of the money mortgages again. Spend on those 12% plastic ball and chains, which when money velocity goes up will likewise be jacked back to 19.5% in no time. Push _more_ income into your 401k, “To recoup your losses (and make my bonus, sucker).” Take a second blow-wage, no-bene job to buy that flat panel screen to listen to hard right vidiots tell you what a good old boy you are again. While management screws you for every nickel they can carve out and makes their bonus speculating on derivatives with the cash flow and pension funds. Those few of us out here too proud to join the ranks of the suckerocracy living on debt and television are encouraged to put our stiff necks to use in the yoke of the bandwagon for Candidate TweedleMcDum or Obamadee, Who Will Make It All Better by mailing a three figure Stupid Prize to us after the election. Then again, let’s _not_.

    What the 90% of the population in the US which is not going to retire comfortably on money rent needs from this crisis is a rise in their wages and a reduction in their costs. We don’t need one shot stimulus, we need real wage increases. Those wage increases will have to come out of the fat pie chart of equity speculators and management. What we need is the parasitical insurance industry which has inserted itself into the health system for _no value added_ but all profits there netted to them cut OUT by single payer and full demographic distributed costs. We need the profiteers OUT of educational financing, and while we’re at it we might find out and do something about those higher educational costs which know no limits or rationality. We need a progressive tax rate on the mega wealth and corporations which funds the government, so that those sectors are put on notice that if they want to be wealthy they will have to innovate and actually invest in productive operations rather than speculate and buy political parties to protect their gains. We need appropriate retirement pensions, which we the people at all levels are going to have to pay for, natch, which means real increases in deductions and hence real deductions in immediate consumption.

    And what, pray, does a short term stimulus do to accomplish any of that? Nothing: in fact worse than nothing. Short term stimulus only papers over the need for broad structural changes in consumption, savings, planning, and investment in this country, by all parties starting with the working class. This isn’t about just taking money from the top to fund beer binges by the proles, it’s about creating real investment, wage levels in line with consumption _plus_ debt, and a system that works rather than just projects its eventual failure a few years or a generation down the time line. Economies which consume more than they produce should fail, and we needn’t worry about it, really, because they assuredly will. Ours has; it’s time we changed The Plan.

    Deflation is a real potential, I don’t deny that. But the kind of debt issuance and stimulation we are seeing now is _not_ about staving off deflation. It is about saving the wealth of the top stakeholders of the FIRE wealth extraction system by paying excessive rates for their appropriately deflating assets and equity. This debt issuance is about charging the public of next winter and next Admin for the costs of saving the skin on the tender behinds of the speculative class. I would rather be talking about implementing and appropriate systemic redesign than howling at this kind of theft and greed, but this kind of theft and greed has to be halted to accomplish the former. So let’s drop a spanner in the misconceived neoliberal stimulus dribble and see the systemic failure we have boxed ourselves into for what it is—and change it.

    And further, mft, the British experience on sovereign debt is directly comparable, and much what I expect. We will likely have a ‘negotiated’ coupon reduction when and if it comes to that, rather than an outright repudiation of obligations.

    And Gregor, the thing to watch, I think, are the rollovers. When and as these slow, the vote of no confidence has been taken. I didn’t say that in my first post, but it has been in my mind for some long time.

  19. Stuart

    “So the ultimate safe haven is in the precious metals, which would rapidly regain monetary status in such a scenario”

    And now we know why the supply of physical gold and silver has been drawn down to next to nothing available. People are not unaware of the coming debt default as they know more than well if this was the case on a personal level what the end result would be. Default or Print are the only two options for Govt. The public IMO sees this coming hence the run on supplies of physical gold and silver even though exchange prices fail to reflect this demand. It would be similar to gas stations everywhere reporting gas shortages, no gas at all in many cases yet gas prices are falling. We can thank the paper contract holders for creating this disconnect. Paper contracts for gold are not the same as physical gold. This disconnect ultimately breaks the exchange as they default and holders of short contracts cease to exist while the exchanges are exposed for merely being a forum that has tolerated naked shorting of metals for years.

  20. Stuart

    Also to add, the matter of US debt default is not one of “IF” the default will happen for when one factors in the amount of unfunded liabilities (Social Security, medicare, etc) with a current NPV of $62 Trillion per David Walker, well, debate over default becomes redundant. Selective default and pure monetization is the outcome. In the meantime, continuing treasury funding requirements are crowding out all markets until the treasury market itself fails to attract sufficient funds…this is what we’re talking about and what is happening and why markets are failing. The Treasury market “The beast” is hungry and it’s caretakers want it to be fed.

  21. a

    “even in lovely socialist france the congress just upped the pension age to 70 years”

    It did not. The Assemblee nationale passed a bill that said a company cannot force an employee to retire at 65 against his will.

    As to the CDS price on U.S. debt, there are credit default events short of total repudiation of debt, events which fall short of Armageddon.

    And eventually, yes, it’s entirely possible that certain banks (or private individuals) will be seen as more secure than governments. One might even say that this is the norm throughout history.

  22. john bougearel

    RK – u ar right to point out that for the US to get its debt into a sounder relationship with our revenue, the US will have to default or “fail before we try that option.” The fools that be on the hill have never shown a capacity to be pro-active in prevention or avoiding negative outcomes. Their lack of capacity to be pro-active is a signal of failure within the political system to legislate policies that would ensure economic soundness.

    Nothing ever seems politically feasible until an entire collapse of the economic system comes along. And then when the inevitable crash comes, they only enact measures that are politically expedient without regard for their economic viability and soundness. Thereby they leave their constituents holding the bag. We are the bagholder’s. In the greater fool theory, we are their patsy’s.

    mft – I had never heard of unilateral coupon reductions, this introduces a new type of risk I was unaware of, thanks for the heads up

  23. tompain

    I would certainly sell CDS protection against US default if I could. There is no conceivable way the US will default when it can instead simply inflate the debt to nothingness in real terms. Those who are concerned about deflation should understand that it may occur over a short period of time, but over a longer horizon if the government wants and needs to destroy the real value of the dollar it has unlimited ability to do so. Unlimited. No matter how strong the deflationary forces are, they cannot possibly offset the ability to devalue a currency simply by printing more of it. That is why there has NEVER been an extended period of deflation since we went off the gold standard.

    You can be more confident that inflation is coming than you were that house prices were going to decline.

  24. tompain

    mft, how can it possibly be wise to confiscate all the equity in the banking system. One result will be that you will never be able to privately capitalize a bank again. A further result would be massive capital flight from this country as investors wonder industry’s shareholders will be robbed next. It’s absurd to call for such a thing unless you also are calling for the end of capitalism.

  25. john bougearel

    It is important to note the massive bear market rally in the dollar, it has risen more than 25% off its lows. Even with the dollar rally, it is still badly beaten up and at the lower end of its historical range.

    But consider what happens to the dollar in a massively deflating world and it continues to rise further still: the cost of all goods and commodities plunge increasing the purchasing power(what is left of it anyways) of the US consumer.

    The dollar and yen are the lone bulls in our deflationary world, and this stands to reason as the Great Inflation Unwind continues. During the deflationary spiral Matt Dubuque is 100% right, gold investments will be dead money. What we are experiencing is a massive deflationary bubble.

    This will also keep the bubble in US treasuries intact for the foreseeable future perhaps for the next 1 to 3 years. Until real business spending and investment resumes, until manufacturing activity bottoms and then picks up, until job creation resumes, until consumer spending stops declining and begins to pick up again, deflation will rule the day. Under these conditions, the dollar will rally and ten year yields will plummet towards 2.5% roughly.

    In short, the best hedging scenario against a dying consumer is to be long the dollar. Long the Dollar, short the consumer.

    And oddly enough, the deflationary spiral (resulting from a consumer that can not be possibly be recapped or made whole by Uncle Sam signals) will push the trajectory of long term treasury yields lower. The cost of servicing the up and coming multi-trillion deficit will at least in part be partially offset by lower interest rates.

    Remember the discount rate fluctuated between 0.5% and 1% between 1937 to 1948, when the national debt stood at a record 122% of GDP.

  26. Anonymous

    I have been buying and holding physical gold since the late 1960s. I am amazed that the physical dealers continue to deliver rounds and bars (all be it 4-5 weeks delayed) when precious metals are in high demand and the spot market is disconnected from demand.

    One bullion dealer advised me that their orders are running between 200-300 per day, up from a few orders a couple of years ago. Meaning more than a couple of people are taking out some precious insurance.

  27. mft

    Richard Kline: “Short term stimulus only papers over the need for broad structural changes in consumption”.

    Sure. But for Gods’s sake, let’s paper it over, if that helps us prevent a Second Great Depression. I think many of the things you mention about the serious structural problems in the US economy are well known to be true, but we have to act now, and then deal with the structural issues.

    The biggest problem as I see it is that Bernanke has shot all the Fed’s ammunition. I don’t mean the floods of liquidity, that was ok, I mean the reduced interest rates. He should have kept his powder dry, so that when the economy bottoms, he can fire it up again. Now he’s got nothing left.

    And, by the way, there is an underlying problem IN PERCEPTION: the US ruling elite see the economy as primarily a financial construct, only secondarily as a real process of production. So people like Bernanke think that if they just jiggle around with the monetary levers long enough, they can solve any problem.

  28. SlimCarlos

    @ Yves:

    >> But ultimately a US debt default would have cataclysmic consequences for the financial economy, bankrupting the entire system.

    Yes, devaluation would have "cataclysmic consequences" for the financial economy, but it would be a boon for everyone else. And it is everyone else we should now be worried about.

    You have said yourself that the mortgage sector needs a program of "loan mods." Your rationale here is that certain loans can't get paid back anyway and a haircut on behalf of the creditor is better than foreclosure. I agree. But the mortgage sector is hardly unique; rather, it is symtomatic of the economy of the whole. A subprime borrower in Cleveland with an AMR reset is no different than, say, the Federal Government, (who, in passing, is also about to get an ARM reset.) So why can't we seem to extend this principle of "load mods" to the economy as a whole? What's good for the goose is good for the gander, no?

    Western economies saw too much lent for too few productive purposes and now it can’t be paid back. The more time we spend twiddling thumbs, the more damage that is done to the real (productive) segments of the economy, the less capable we are of servicing the debt. The feedback loop is not working in our favour. Devaluation: more, faster, please.

    This is a good thing, Yves. Indeed, it is the only thing that will prevent the economy from becoming a smouldering chunk of charcol. FDR did it. Why can’t we?

  29. mft

    tom pain, I hope you don’t think it’s ok for the taxpayer to be robbed to keep the banks alive, because that seems to be the alternative to confiscating the banks. I think the effect of such confiscation, if done by a democratically legitimated and pro-market government, would be just the opposite of what you say. It would restore confidence in the finance system as a necessary adjunct and tool of real production and growth oriented capital and capitalists. This confidence CAN only come from the state, as voice and agent of the nation and its citizens.

    No, I’m not a socialist.

  30. SlimCarlos

    >> But consider what happens to the dollar in a massively deflating world and it continues to rise further still: the cost of all goods and commodities plunge increasing the purchasing power(what is left of it anyways) of the US consumer.

    But you are wrong here. All this credit constriction will achieve is further misallocation of capital which will, in turn, cause further inflation and dislocation.

    Case in point: Bloomberg recently reported that crop plantings ar expected to be down 4% because farmers can't get credit to plant. A 4% reduction in output against a backdrop of very low stocks-in-the-bins will cause an eruption in food prices.

    You can make the same arguments across the real sector. Folks aren't trying to offset price with volume; instead they are just cutting back and/or shutting down. This isn't hypothetical surmise on my part. It is what is happening. Constricting the flow of goods hurts incomes AND it is inflationary.

    Of course, most ecnomic slowdowns are associated with inflation. That we can't grasp this now is dangerous and bodes ill for the future.

  31. DownSouth

    john bougearel said…

    “Nothing ever seems politically feasible until an entire collapse of the economic system comes along. And then when the inevitable crash comes, they only enact measures that are politically expedient without regard for their economic viability and soundness. Thereby they leave their constituents holding the bag. We are the bagholder’s. In the greater fool theory, we are their patsy’s.”

    There’s been quite a bit of press recently about how heterodox economists aren’t very good at science. Besides Yves’ numerous postings on the subject, there’s also these two that have appeared in the last few days:

    http://www.nytimes.com/2008/11/02/business/02view.html?pagewanted=2

    http://www.nature.com/nature/journal/v455/n7217/full/4551181a.html

    But orthodox economists are not very good at history either. Once countries become as decadent as the U.S. has become (and this I believe is germane to your comment), history has shown there is little propensity for recovery. As Kevin Phillips pointed out:


    On the edge of decline the Spanish had gloried in their New World gold and silver; the Dutch, in their investment income and lending to princes and czarinas; and the British, in their banks, brokers, and global financial network. In none of these situations, however, could financial services succeed in upholding the national preeminence that had been earlier built by explorers, conquistadores, maritime skills, innovative science and engineering, the first railroads, electrical dynamos, and great iron and steel works. Invariable, power and greatness passed to new explorers, innovators and industrialists.

    One must also consider the possibility of the demise of capitalism, or at least capitalism in the form we currently know it. Robert L. Helbroner in Behind the Veil of Economics enumerates the historic economic “periods” since the advent of the Renaissance as “early and late mercantilism; preindudstrial, early and late industrial capitalism; and modern (or late, or state) capitalism.” He then goes on to chastise his fellow economists for their lack of historical knowledge, inquisitiveness and perspective:


    [C]ontemporary mainstream economists are largely uninterested in questions of historic projection, regarding capitalism as a system whose formal properties can be “modelled,” whether along general equilibrium or more dynamic lines, without any need to attribute to these models the properties that would enamble them to be perceived as historic regimes and without pronouncements as to the likely structural or polictical destinations toward which they incline. At a time when the need for institutional adaptation seems pressing, such a historic indifference to the fate of capitalism on the part of those who are professionally charged with its self-clarification does not augur well for the future.

  32. SlimCarlos

    Calling Matt Duboque out:

    >> The current fad among American commentators … is to predict that after a short bout of deflation … inflation will shortly return in a very nasty fashion … But I won't go on at length here. Telling an American that they will lose money on precious metals is generally a complete waste of time.

    Actually, I you haven't gone on at all here. All you've done, Matt Duboque, is made an unsubstantiated assertion. And then sniffed. This is hardly fair to the readers of the board, yes? If you have something to say, say it.

    I will address one of your points here and perhaps we can use this as a jumping off point:

    "From a historical perspective, it's tragic."

    Please, from a historical perspective, show us one fiat currency that has lasted as long as the dollar. Show us one fiat currency that has lasted 50 years. And show us one instance of a debtor nation on a fiat currency suffering deflation. Just one.

    Please, walk us through the "tragedy."

  33. john bougearel

    slim,

    I agree that when we come out of the backside of this deleveraging and deflation spiral that it is causing, the end result will be some sort of inflation/hyperinflation.

    The problem is how to get there from here. From where we stand now, the whole world is delevering, and when the whole world stands up to sell assets at the same time, you create a massive deflationary bubble in both housing and equities.

    We have to pass through the deflation crisis first. One symptom of deflation is credit constriction, and this is rational given that asset classes across the board are deflating. Deflation is a risk to lenders they can’t fully decompose, so they just hoard or tighten lending standards.

  34. SlimCarlos

    @ john bougearel:

    >> We have to pass through the deflation crisis first.

    Why must we pass through this phase first? And do you understand the implications?

    I quote friom an aforementioned piece at length here:

    ———————

    http://www.bloomberg.com/apps/news?pid=20601087&sid=aox4ZwDlWkvQ&refer=home


    Farm-Credit Squeeze May Cut Crops, Spur Food Crisis (Update1)

    By Carlos Caminada, Shruti Singh and Jeff Wilson
    More Photos/Details

    Oct. 27 (Bloomberg) — The credit crunch is compounding a profit squeeze for farmers that may curb global harvests and worsen a food crisis for developing countries.

    Global production of wheat, the most-consumed food crop, may drop 4.4 percent next year, said Dan Basse, … Harvests of corn and soybeans also are likely to fall, Basse said.

    “The credit situation is worrying even the biggest and best farmers,” said Brian Willot, … “For the financially weak, credit has dried up completely. For the strong, credit has been delayed and interest rates are higher.”

    The number of hungry around the world is at risk of increasing as the financial crisis cuts investment in agriculture and crops, said Abdolreza Abbassian.
    Brazil Squeeze

    “The net effect of the financial crisis may end up being lower planting, lower production,” Abbassian said. “More people will go hungry.”

    In Brazil, the world’s third-biggest exporter of corn after the U.S. and Argentina, production may fall more than 20 percent because farmers can’t get loans to buy fertilizer, said Enori Barbieri…

    Processors usually cover half the financing needs of farmers by accepting part of the future crop as payment. “No one is doing it,” Dahe said. “It’s stopped.”

    “Stockpiles are going to be extremely tight,” said AgResource’s Basse. “The world cannot afford any dislocation in production next year, or there will be a real shortage.”

    The value of the collateral farmers use to secure loans — crops and land — is diminishing. Lenders are demanding more equity for farm loans used to run operations or acquire land and equipment.

    “We need two to three times the amount of money we used to need with the same collateral,” said Bo Stone, 37, a seventh- generation farmer in Rowland, North Carolina. “It means we have way more risk than we’ve ever had. This is a time where one bad crop year, with the amount of money and input tied up, could potentially cost you your equipment, land and livelihood.”

    ——————-

    Is this what we want? I would think not. Yet this is what is happening, all across the world, across all different productive sectors of the economy. Vale just announced a reduction in production of ore production of 30%. Investment in future petroleum production capacity has screeched to a halt. I could go on. How is any of this helpful?

    We don’t “need” deflation nor must we stand for it. I appreciate you want to see that 28 year-old wanker who peddled toxic paper forced to sell his Porsche and take the bus to work, but snuffing out vast swaths of the productive economy only lessens our ability to resist the forces of the credit constriction.

    To persist in this thinking and to advocate for as much is to perform the same “live experiment” as letting Lehman go bankrupt. You’re playing a dangerous game.

    Devaluation: more, quicker, please.

  35. davidlewis

    This sounds like the best bubble I’ve ever heard of.

    You’d have to be quite the fool to buy a CDS that pays off if the US currency ceases to exist that would pay you in that event in US dollars.

    You’d buy one because you were convinced the market for this gibberish was going to go up. The greater fool comes along, thinking he’s the smart one buying in cheap, because he knows there’s another even greater fool out there. And so on. Everyone makes money until the crisis is over and the spread goes down. The fools clamoring to get in on this act like they believe the US will not survive in its present form just because some jackals on Wall Street cooked up some fiendish financial instruments.

    It also shows why the CDS market will be shut down. Whatever service CDS provides, i.e. real insurance against credit default to real people who need it, will soon be provided in a regulated market where you have to hold reserve capital on the CDS you issue and trades are public. If issuers of CDS on Treasuries had to hold reserve capital, it would limit the amount that could be issued. I realize this would cut down on the amount of super inferior grade ZZZ investments out there everyone wants, but you have to sacrifice some things in hard times.

    All the big bettors who want to engage in side bets at the big casino will just have to go to one. I hear there are a lot out in Vegas. You can bet on anything I hear.

  36. dh

    Re: "In other words the cost of insuring against a US government default has risen by 25 times in little over a year. Similar trends have been evident in the UK and German government bond markets."

    > It's all priced in, in the form of a future discount, so relax, we understand that there is a 50% reduction in future value.

  37. john bougearel

    slim carlos,

    Anecdotal stories I heard this past year is that farm values have appreciated quite nicely in 07. In part this may have been due to the record crop values. From the Bloomberg news story, it sounds as if the value of both the crops and the land that farmers use to secure loans have diminished.

    Diminishing values of both crops and land is part of the ongoing deflation story and will result in a loss of production for the 2009 carryout. Production losses will be incurred from both less acreage planted and lower yields/acre as less fertilizer will be used.

    Production in all sectors of the global economy is being disrupted as a result of the credit crunch. And one of the primary drivers of the credit crunch is the deflation cycle itself.

    All assets, toxic or not, are deflating and while they are deflating, business investment will come to a standstill or be reduced to a trickle and likewise production across all sectors will be cut.

    I am not advocating deflation or production cuts, merely describing the processes of deflating assets collectively and worldwide is a reason that the dollar can not be devalued. The dollar is simply not depreciating as fast as other assets. When these other asset classes are collectively depreciating, dollar devaluation is nearly impossible to do, no matter how much money the treasury and fed feed into the system. Hence, the trajectory or path of least resistance for the dollar is up in a debt deflation cycle. When the debt deflation cycle ends, then and only then will the dollar devaluation resume. But that might not be until the second half of 2009 or beyond.

    This consequent loss in production is a

  38. john bougearel

    mft,

    If only there were a real alternative to robbing of the taxpayers to save the banks from their own speculative folly.

    Confiscating (expropriating) the banks is far more preferable to me than confiscating(expropriating) or pocket books.

    Downsouth: “history has shown little propensity for recovery”: I would like to think we could be a little more optimistic here, and creative as well. If we could get the gubmints hand out of our pocketbooks, we’d stand a chance.

    This would require teaching the gubmint new strategies. Much like a drunk driver has to learn new strategies for drinking without driving. Or is that driving without drinking?

  39. heityoas

    So, when do you expect treasury yields to start rising?
    When is the bailout related debt supply going to hit the market?
    If it has already, it hasn’t really had an effect.

    What do you think is propping up yields right now.. Flight to safety? Whose flight exactly? A lot of us seem to believe that Asians will not be interested in buying more treasuries, but apart from the agency debt aversion, do we have any evidence of them shunning treasuries yet?

  40. Yves Smith

    Some random comments;

    tompain,

    I may have missed what triggered you, but I don't recall seeing anyone advocate nationalizing the entire banking system. Even so, the Swedish did nationalize substantial portions of their banking system and privatized them after they had spun off the bad assets, and showed a nice profit on the exercise too. Investors understand that the government-sponsored franchise of deposit-taking and intermediating to longer-term lending is a nice little cash machine when not abused.

    We did pretty much the same in the S&L crisis, although the failures of banks were more evident. In the Swedish case and our S&L case the institutions failed. The Swedes merely took them over a tad earlier, but the outcome was clear.

  41. Yves Smith

    john, Matt,

    Gold does better in deflation than inflation. Deflation favors cash and cash proxies, and since currency devaluation is part of the prescription for getting out of deflation, it is a good hedge against that scenario.

    From Fred Sheehan via Marc Faber:

    • England, inflationary periods — the purchasing power of gold: 1623–1658: –34%, 1675–1695: –21%, 1702–1723: –22%, 1752– 1776: –21%, 1793–1813: –27%, 1897–1920: –67%, 1933–1975: –25%.

    • England, deflationary periods — the purchasing power of gold: 1658–1669: +42%, 1813–1851: +70%, 1873–1896: +82%, 1920– 1933: +251%

    The raw numbers are not worth much, to the investor or to the preserver of capital. Gold has been a much better hedge against inflation than is shown above. For instance, during the inflationary period of 1933–1976, gold lost 25% of its purchasing power but prices rose 1,434%. (As to what might have kept pace with inflation, “crime” comes to mind, which was the conclusion of many a corporate boardroom and trading desk.)

  42. Anonymous

    In early 2010 worldwide petroleum liquids production will be moving off the far shoulder of it’s present plateau into a year on year 4% to 8% decline. Within 2 years of this happening ALL major national resources worldwide will be fully nationalized and the liquid petroleum endgame begins in earnest.

    You people need to walk out of the trees once in a while and climb a hill and take a look around.

    In twenty years the amount of oil being consumed by the US daily will be the amount available to the entire world.

    Most of you are debating the equicalent of how many angels can dance on the head of a pin while an political/financial/economic Katrina approaches.

    The world is about descend into a PHYSICAL conflict to determine who lives and who dies.

  43. FairEconomist

    If the US is forced to default an explicit default may well be preferable to an inflationary default. Either will ruin the US government’s credit, but the inflationary default will also destroy the currency. I think explicit default is a real possibility, hence the CDS cost.

  44. SlimCarlos

    @ John:

    >> I am not advocating deflation or production cuts, merely describing the processes of deflating assets collectively and worldwide is a reason that the dollar can not be devalued.

    Yes, but if crop production is down 4% whilst stocks are at multi-decade lows, well, that's inflationary, yes?

    And of course the dollar can be devalued. What makes you think it can't? Indeed, the dollar *must* be devalued, or we are all toast.

    The western economies are insolvent (on both a balance sheet and income statement basis) and if we let "nature take its course" (which seems to be what you are advocating), then there won't be any Western economies left.

    Is this the idea?

  45. Anonymous

    There is a middle ground that should be taken:

    1. Stop bailing everyone out! Let bankruptcy happen. Auction off all other bailout and buyout assets immediately.
    2. Speed up bankruptcy process. Greatly increase size of court system to handle a huge influx of bankruptcy.
    3. Pass a one-time increase in the length of unemployment benefits.
    4. With the stroke of a pen, a couple trillion dollars can be eliminated from the U.S. debt without causing a default. The Social Security Administration could voluntarily shred the “IOUs” it has from the treasury department. Of course, this would have to be coupled with some combination of increased taxes and reduced benefits.
    5. Shut down Freddie and Fannie and any other federal agency or enterprise that is involved with extending or supporting credit. What nonsense! Auction off their assets to the highest bidder.
    6. Sell off every extraneous government asset. Be imaginative. I suspect this could bring billions if not tens or hundreds of billions.

  46. john bougearel

    slim,

    your expectations for grain prices to rise or inflate work in normalized markets and economies. Because of the globally deflationary spiral, the dollar as the worlds reserve currency is and will continue to rise against most asset classes and currencies, grains included. Against this macro-backdrop, models that work for normal markets won’t hold much water and the end results will deviate from expectations in normal market conditions.

    And no, the dollar can not be devalued in a deflationary spiral. It will continue to hold its bid until the deflation cycle ends which won’t be until home prices stop depreciating, the job losses stop mounting, businesses start hiring and a measurable uptick in demand becomes sustainable.

    Again, I am not advocating laissez-faire, I am just saying that the interventionists who are actively pursuing policies to destroy and devalue the dollar are not working, and won’t necessarily happen until the deflation spiral bottoms out. Again, these policies that are being implemented by the interventionists would have destroyed the dollar in normalized markets.

    It is a fallacy to believe the interventionists policies can stop or arrest deflation. That is one of the great lessons we must learn from this deflationary crisis. Inflated home prices have crashed, inflated equities have crashed, inflated commodities have crashed, and inflated currencies have crashed and in spite of the trillions of dollars the powers that be have thrown at the world economy since August 2007.

    And returning to the farmer, he is facing his worst nightmare. Because his crops and land values are falling, his cost of production goes up so he plants less acreage and the yield/acre declines because he doesn’t use as much fert.

    Then, because the dollar is still the worlds reserve currency and rising in a deflating global economy, the cost of US grain for foreign countries rises and thereby curbs foreign demand. Declining demand begets even lower grain prices and the downward price spiral continues.

    The only floor for the farmer and the only rescue for starving countries is for the US gov to buy the grains at some established price and then ship it for free to these foreign nations. This action of course bankrupts further the US gov.

    As the US gov steps up to put a floor under all sectors of the crumbling economy,from the farmer, to autos, banks, insurers, etc, you name it. eventually the US incurs a credit rating downgrade and or default.

  47. alexblack

    John;

    Naive question – even in a deflationary spiral caused by deleveraging, in which prices of many or most assets are declining, wouldn’t grain prices escape this spiral? The law of supply and demand remains immutable. If the supply of grains decreases due to credit squeezes of the farmers, and the demand remains constant – 6 billion mouths, 6 billion bellies. Same demand plus lower supply equals higher price, no?

    In a deflationary environment, the price of everything else may fall – cars, TV’s, clothing, steel, copper, lap dances at one’s favorite strip club, etc etc, but people will spend their last penny, or barter their child, in order to eat.

  48. SlimCarlos

    @ John,

    I must say, I have heard it said that it would be unwise to arrest deflationary forces and I have heard it said that it would be immoral to arrest the deflationary forces. I have never heard it said, however, that it would be impossible to arrest the deflationary forces.

    Like Matt Dubuque, however, you simply assert that deflation is inevitable, which is quite different than making a case for your position, convincing or otherwise.

    I don’t know how you can make this case. All the Fed has to do to arrest deflationary forces is start issuing bank notes willy nilly. It can start by issuing notes to buy treasuries. It can then issue notes buy to corperates. It can then get into equity index futures. It can then issue notes to shipping companies. And yes, it can then start buying grain at $10/bushel.

    What FDR did was a little bit simpler: He arranged that gold be bought from $20/oz up to $35/oz and then he stood firm, bid $35 and offered at $35 and a bit. Gold flooded in from all over and cash flooded right back out, irrigating the economy with liquidity.

    Boom. A one-time devaluation. Problem not quite solved. But certainly, problem much fixed.

    I should also say that this system, modified a bit at Bretton Woods, served the US quite well for about 30 years.

    You can say that devaluation is a bad idea; you can say it is an immoral idea. But you can’t say that it is an impossible idea.

    And neither can Matt Dubuque.

  49. SlimCarlos

    Only Matt Dubuque can save the dollar now….

    ————————
    America’s “Economic Egotism”
    World Tires of Rule by Dollar

    By PAUL CRAIG ROBERTS

    What explains the paradox of the dollar’s sharp rise in value against other currencies (except the Japanese yen) …?

    [T]he burden on foreigners and on world savings of having to finance American consumption, the US government’s wars and military budget, and the US financial bailout is increasingly resented.

    Russian president Dmitry Medvedev said that the “economic egoism” of America’s “unipolar vision of the world” is a ”dead-end policy.”

    The deputy prime minister of Thailand recently designated the Chinese yuan as “the rightful and anointed convertible currency of the world.”

    Zhou Jiangong, editor of the online publication, Chinastates.com, recently asked: “Why should China help the US to issue debt without end in the belief that the national credit of the US can expand without limit?”

    http://counterpunch.org/roberts10302008.html
    Paul Craig Roberts was Assistant Secretary of the Treasury in the Reagan administration. …

  50. thomas j

    john,

    You make some excellent points.

    In fact, you are apparently the only commentator on the board today who clearly understands the inevitable deflationary outcome that accompanies the unwinding of a fractional reserve banking system.

    Particularly, in a situation such as that which exists today, where the shadow banking system responsible for much of the last few years of credit expansion is now dramatically contracting outside any possible control of the central banking authorities, there is no alternative but deflationary collapse with a concomitant moon shot in the value of the world’s reserve currency v. all other asset classes.

    People have become so conditioned to the last seventy years of ongoing inflation in the world’s reserve currency they are now simply blind to the reality that the terminal point has to be deflationary collapse. Their eyes will be opened soon enough.

    The only question remains is whether the “authorities” will be able to maintain sufficient control to orchestrate a reset to initiate another seventy year franchise lease.

    Great posts. Please keep up the good work.

  51. thomas j

    slimcarlos,

    Exactly who is it that you believe the central banking authorities work for?

    The only way deflationary collapse is avoided is if the Federal Reserve is abolished. And the US government no longer has to borrow money to fund deficit spending, i.e. FRNs are abolished. Such an outcome would necessarily entail the prior overthrow of the existing government.

    Otherwise, as john so astutely points out, the US government in its efforts to continue obtaining funding for deficit spending, will be forced to do everything it can to keep T rates as low as possible, thereby, pushing out the timetable for its eventual default.

    Any hint that the Federal Reserve will monetize to the degree necessary to overcome the ongoing credit contraction would immediately result in the withdrawal of creditor funds with long term T rates skyrocketing instantly crowding out the private equity and debt markets, thereby, only serving to accelerate the process of deflationary collapse.

    It is akin to being stuck in quicksand. The victim quickly realizes that any movement on his part only serves to hasten his demise.

    And the gold in his pocket will likely be of little use at his final destination.

  52. SlimCarlos

    @thomas j:

    >> Exactly who is it that you believe the central banking authorities work for?

    I am sorry — why does this matter? The question at hand is whether or not deflationary forces are impossible to arrest. John says says. You say yes. And Matt Dubuque says yes.

    Yet I give you a counterexample — how FDR dug America out of the last deflationary spiral — and you just ignore it. Not very sporting of you.

    And you may have Matt Dubuque on your side, but I have Ben Bernanke on my side, da man with da hand on da lever. Recall his helicopter speech:

    The conclusion that deflation is always reversible under a fiat money system follows from basic economic reasoning. A little parable may prove useful: Today an ounce of gold sells for $300, more or less. Now suppose that a modern alchemist solves his subject’s oldest problem by finding a way to produce unlimited amounts of new gold at essentially no cost. Moreover, his invention is widely publicized and scientifically verified, and he announces his intention to begin massive production of gold within days. What would happen to the price of gold? Presumably, the potentially unlimited supply of cheap gold would cause the market price of gold to plummet. Indeed, if the market for gold is to any degree efficient, the price of gold would collapse immediately after the announcement of the invention, before the alchemist had produced and marketed a single ounce of yellow metal.

    What has this got to do with monetary policy? Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.

    http://www.federalreserve.gov/BOARDDOCS/SPEECHES/2002/20021121/default.htm

    And yes, I am happy to put a five-spot on Bernanke over Matt Dubuque any day of the week.

    Now — it is your turn: why is deflation impossible to stop?

  53. Murph

    Could someone please post an intelligent answer to the question:

    Who is writing the CDS on UST debt, and, in what denomination – and how are these secured for payment (assuming that a UST default would be globally catastrophic) ?

  54. CreditTrader

    Just for fun – try regressing the US Treasury 2s10s curve against the 10Y CDS spread on US Treasuries!!! R^2>80%!!! I am guessing this implied default risk is somewhat responsible for the steepening (causation)! Independent researcher I subscribe to suggested a 2s10s steepener vs selling some protection on US: Convexity in the curve in our favor, noone pays out on the US protection anyway, as default risk rises so curve will steepen even further as everyone sells long-dated Treasuries!!! Might be a fun (cheap) way to bet on major catastrophe showing up in the US YC

  55. joe

    Amazing.
    The other shoe dropping.
    Not the death of capitalism, just capitalism as we know it.
    We must have government spending.
    We can’t have government debt.
    We must !
    We can’t!
    Can we have government spending without government debt?
    Oh, wait a minute.
    Abraham Lincoln.
    The Chicago Plan.
    A new monetary system.
    The old one’s gone.
    And THIS is how it went.
    Better get busy doing something that matters.
    best.
    joebhed

  56. joe

    And this is to slim.
    The ONLY way to do it is to print debt-free money.
    Otherwise, the faster you spend your way out, the more debt you create.
    And you have to pay back twice as much.
    And you need to create the interest payment to add on.
    With new debt.
    It’s as simple as that.
    With debt-money, we’re phuqued.
    And the financial economy of the fractional reserve banking system of Mr. Bernanke and Mr. Paulson is built exclusively on debt-money.
    The interest-bearing heel of Achilles.
    And I don’t care what lever he has his hand on in that helicopter speech.
    If the high priest who made all that new gold did so on the basis of having to pay back twice as much gold, then guess what?
    We’re phuqued.
    Can’t V it up fast enough.
    Best.

  57. john bougearel

    Slim,

    Bernanke’s helicopter model is undergoing a stress-test, and it has failed miserably in a deflationary spiral. And this fact ought to scare the shit out of you and everyone else, because he is supposed to be the omnipotent depression/deflation scholar.

    What Bernanke is learning in real time deflation are many things.

    First, Ben is learning that the Fed is certainly no alchemist. Secondly, markets are not efficient to any satisfactory degree in abnormal markets. Three, Paulson’s Bazooka, is a flipping joke. Four, the printing press, like Paulson’s pea-shooting Bazooka can not reduce the value of the dollar in terms of goods and services either by credibly threatening to do so or by cranking out trillions of dollars. It’s value is established by the virtue of it’s being the world’s reserve currency, and not because it is backed by the so-called full faith and credit of a government. And fifth and finally, a determined gubmint can not generate/induce higher spending during a deflationary spiral. Hell, it can’t even induce banks to lend after cramming $250 billion dollars down their throats in the past two weeks. Market inefficiencies and gubmint impotence are the hallmarks of this deflation spiral.

    Ben’s helicopter model is failing him in a deflationary environment, and if I were his teacher, I’d give this model an “F”

    The Japanese have been trying to induce a bit of inflation for nearly twenty years now and to no avail. Do you think Ben noticed that the Japanese helicopter model hasn’t been working so well? Or does he believe that our printing press is magically better than the BOJ, or does he believe that the Fed is a better alchemist?

    Another great lesson learned from this deflationary crisis is that we give way too much credit and put far too much faith in our leadership, and therefore we have been and continue to rely too heavily on them to see us through the storm they helped steer us into. The gods in their temple are not infallible, they can and do f-up like the best of us.

    Watch what happens when you substitute dollars for gold in Bernanke’s helicopter model:

    “The conclusion that deflation is always reversible under a fiat money system follows from basic economic reasoning. Suppose that a modern alchemist finds a way to produce unlimited amounts of new dollars at essentially no cost. Moreover, his invention is widely publicized and scientifically verified (just like Paulson’s Bazooka if you recall), and he announces his intention to begin massive production of dollars within days. What would happen to the price of the dollar? Presumably, the potentially unlimited supply of cheap dollars would cause the market price of gold to plummet. Indeed, if the market for dollars is to any degree efficient, the price of dollars would collapse immediately after the announcement of the invention, before the alchemist had produced and marketed a single dollar.

    U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent),that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.

    Is it impossible to arrest deflationary forces you ask? Indubitably in the short run. And in the long run, we are all dead.

  58. tompain

    Mft, there is no such thing as confiscation by a pro-market government. Confiscation is anti-market. It's also unconstitutional. I am not advocating giving the banks gifts of taxpayer money. If the banks are going to fail on their own, let them fail on their own. But it is unwise and counterproductive to confiscate them based before failure is imminent, which is what I understood you to be advocating.

    Someone mentioned the S&L nationalization. In that instance, the S&Ls failed and then their assets and liabilities were assumed by the RTC. RTC did not go around stealing equity from institutions that were still able to operate.

  59. tompain

    Can any of you who are certain that an extended period of deflation is coming please explain why you believe that no matter how many dollars are printed, they will still grow and grow in real value? If that can happen, how come I can’t just print my own money and get everyone to accept it?

    You seem to be confusing an extended decline in GDP and standard of living with currency deflation. The currency can be plummeting in real value at the same time the economy is going to hell. Happens all the time, all over the world.

  60. Yves Smith

    tompain,

    Regulators have very broad authority to declare institutions insolvent and the bank has NO recourse. Freddie and Fannie were told that if they didn’t go along with the conservatorship, they would be forcibly taken over.

    Given the state of the industry, the marking of real estate related assets at prices that do not reflect current housing market declines and default rates (Meredith Whitney writes on this regularly, only BAC is reasonably current on its marks) plus the large Level 3 books may players have, I guarantee you most banks could be declared insolvent without the regulators even having to get creative about it.

  61. thomas j

    slimcarlos,

    Apparently you feel that Bernanke’s thinking, as expressed in his speeches, is the most reliable source for understanding likely monetary and financial outcomes.

    Then you must have also believed Bumbling Ben’s sworn testimony that the problem with subprime mortgages was contained. Or that the banking system was fundamentally sound. And you must have also believed Ben when he promised Friedman that the Fed had learned its lesson and wouldn’t let another Great Depression happen on its watch.

    I would suggest, if you insist on relying on the speeches and writings of central bankers, then at least do yourself the favor of relying on the works of more cogent central bank thinkers such as Malcolm Knight at BIS who actually predicted the arising of the current deflationary situation. In case you are not familiar with Mr. Knight’s work, he explains how deflationary collapse inevitably results from central bankers who labor under the false delusion they can micromanage interest rates as Bernanke, et. al., have done.

    By the way, if you read Bernanke’s speech closely, he makes it pretty clear that the Fed Chairman is NOT “da man with da hand on da lever” when it comes to inflating out of a deflationary collapse. But don’t feel too bad, you are not the only one who has bought into the omniscient Fed meme.

    By the way, do you really think Volcker is going to let the federal government print away its debt obligations into hyperinflationary oblivion, thereby, killing the remaining banking cartel franchise? If I were a debtor, I certainly wouldn’t hold my breath waiting for a direct deposit from Treasury to settle my delinquent accounts particularly with Volcker and his minions at the economic helm.

    As far as FDR and the Great Depression is concerned, I won’t deny that initiating a world war on a scale equivalent to World War II would be one way of possibly resetting the monetary board game. However, I’m not sure that World War III is a likely policy prescription that will be advocated by the Federal Reserve — at least not publicly.

  62. SlimCarlos

    @ John:

    >> Bernanke's helicopter model is undergoing a stress-test, and it has failed miserably in a deflationary spiral.

    Appreciate the post, but all you have really established is that the Fed hasn't yet inflated/devalued. This does not speak to my contention that it can't/won't devalue. Insofar as you do not address this point, I will take it as a given that, yes, they could/might proceed in this fashion at some point in the future.

    (This said, as an aside, we are early days now. Ben has not gassed up the helicopters, but we are seeing no real signs of deflation either. In the 30's, prices were down 10% YOY. We're in early days right now.)

    Now, a more productive line of discussion would have us talking about whether they should/must devalue. My point is that they must and they will.

    Your POV seems to be let western economies go the way of WorldCom. You think it somehow healthy to wipe out the economy, productive sectors and otherwise.

    I just don't see that happening.

    But can we agree to get away from the "can't devalue" line of reasoning? It's a crutch for the happy deflationsist set. Not helpful, either.

  63. SlimCarlos

    @ thomas J:

    Alright, as per my last post, can we agree that the Fed has the ability to inflate/devalue? And can we agree that the operative question is will/should they devalue? This much should be clear by now.

    >> By the way, do you really think Volcker is going to let the federal government print away its debt obligations into hyperinflationary oblivion, thereby, killing the remaining banking cartel franchise?

    Reaching back to Volker, are ya? How can that be comforting? The guy is 81 years old. Compare life expectency here with the tenor of US debt obligations.

    >> As far as FDR and the Great Depression is concerned, I won't deny that initiating a world war on a scale equivalent to World War II would be one way of possibly resetting the monetary board game.

    Disingenuous, not sporting, etc. You continue to dodge the front & center plank of FDR's efforts to bootstrap the US out of the great deflationary spiral. It was not the war that kick-started the economy. It was is policy of devaluation/reflation.

    Amazing — not a word about this on this site. Avoided like the plague. Which, sentiment-wise, only leads one to think that cash is sure looking like a bubble more than ever.

    Black swans can paddle their way into your world too, you know….

  64. thomas j

    @slimcarlos

    “Alright, as per my last post, can we agree that the Fed has the ability to inflate/devalue? And can we agree that the operative question is will/should they devalue? This much should be clear by now.”

    Do you not yet understand that Ben already admitted in his famous helicopter speech that the Fed itself does not have sufficient power in the event of a liquidity trap to inflate?

    That is the definition of a liquidity trap — the total failure of monetary policy. Even a committed monetarist like Ben knows when the game is up. But apparently you know different.

    And if you think Volcker’s age has any relevancy or will determine whatsoever the monetary or fiscal policies that will be adopted going forward then you are grasping at flimsy reeds indeed.

    But, of course, you contend that WWII was not a factor in getting the US out of the Great Depression. I guess, according to you then, the fact that unemployment in the US went from 14.2% in 1940 to 1.2% in 1944 was not at all attributable to WWII and the Lend Lease Law.

  65. thomas j

    @slimcarlos

    By the way I take no comfort whatsoever in Volcker at the helm.

    It is you who apparently labors under the alchemist’s delusion that somehow through the magic of the right set of monetary and fiscal policies the ship’s course will be righted.

    I fully expect black swan events will arise. But in this environment I suspect such events won’t be of the pleasant variety you are counting on.

  66. Richard Kline

    To tompain, the scenario you envision is the probable trajectory in my perception also: a descent to the event horizon of genuine deflation at which point credit issuance and unsanitary money pushes make for big time though likely not hyper inflation. The RotW pulling back from our debt will only accelerate that vector. And consider this, too: given how many kinds of debt and market functioning the Treasury and the Fed combined are guaranteeing, we are seeing in essence the rapid expansion of our ‘quasi-sovereign’ liabilities. A run on commercial paper, or on the MMs or just away from ‘too big to fail’ financials will be transfered _directly_ into a run on the Treasury. Far from buffering the financial system against further shocks by closing and cauterizing unstable nodes, Hank and Ben are busily wiring all such shocks to the Central Dynamo. Not A Good Thing . . . .

    Slim Carlos, I have been advocating a controlled devaluation of the $ since before the present crisis started. It is the single most constructive macroeconomic maneuver which could be undertaken, but it will be very nearly the last initiated. I broadly agree with your use of historical examples through your comments in this thread; that said, I think you significantly underestimate the function and influence of war production in the US from 1940 on in reflating the US economy. This last was the _real_ stimulus which put US industry back in the black as domestic demand had not revived sufficiently to that point to get any substantial growth going. Devaluation substantially put a floor under the currency and the economy, but it floated no boats of note. The military-industrial complex is what put the country back to work. When Truman tried to build down some of those commitments, he nearly turned the unavoidable post-War recession into another bout of depression—and learned his lesson which is why we have had the military-industrial macroeconomic policy we have maintained ever since. I agree with you that a) we have had _no real deflation as yet in the US despite being fifteen months into this thing, and b) that true massive credit-and-currency flotation by the US government is only beginning. Though it has begun: that huge buy of commercial paper last week was backed by _NOTHING_ and functionally unsterilized. In principal, private debt is ‘supposes’ to reassume these liabilities for the government at term (80 days or so) but that’s a laugher, not gonna happen, so the Fed will be left rolling over this paper indefinitely, hence totally unsterilized injection of half a trillion. But that supports your contention that we are more likely to go from credit contraction _directly_ to massive inflation without passing through any substantial deflation in the real economy along the way, yes.

    So FairEconomist, I’m with you that a deliberate cramdown on US debt is less damaging and hence more probable than an inflationary run off. The devil is in the details there, though. Only when burgeoning inflation in the US makes debt default an impending certainty will negotiations be undertaken, and these are likely to prove exceptionally sticky. We are more likely to see the private markets treat older, priceyer debt as ‘distressed to default levels’ while officials wrangle, to me. If we had smart leadership, we would do a devaluation tied to a debt contraction agreement, but I’m not holding my breath.

  67. Richard Kline

    To tompain, the scenario you envision is the probable trajectory in my perception also: a descent to the event horizon of genuine deflation at which point credit issuance and unsanitary money pushes make for big time though likely not hyper inflation. The RotW pulling back from our debt will only accelerate that vector. And consider this, too: given how many kinds of debt and market functioning the Treasury and the Fed combined are guaranteeing, we are seeing in essence the rapid expansion of our ‘quasi-sovereign’ liabilities. A run on commercial paper, or on the MMs or just away from ‘too big to fail’ financials will be transfered _directly_ into a run on the Treasury. Far from buffering the financial system against further shocks by closing and cauterizing unstable nodes, Hank and Ben are busily wiring all such shocks to the Central Dynamo. Not A Good Thing . . . .

    Slim Carlos, I have been advocating a controlled devaluation of the $ since before the present crisis started. It is the single most constructive macroeconomic maneuver which could be undertaken, but it will be very nearly the last initiated. I broadly agree with your use of historical examples through your comments in this thread; that said, I think you significantly underestimate the function and influence of war production in the US from 1940 on in reflating the US economy. This last was the _real_ stimulus which put US industry back in the black as domestic demand had not revived sufficiently to that point to get any substantial growth going. Devaluation substantially put a floor under the currency and the economy, but it floated no boats of note. The military-industrial complex is what put the country back to work. When Truman tried to build down some of those commitments, he nearly turned the unavoidable post-War recession into another bout of depression—and learned his lesson which is why we have had the military-industrial macroeconomic policy we have maintained ever since. I agree with you that a) we have had _no real deflation as yet in the US despite being fifteen months into this thing, and b) that true massive credit-and-currency flotation by the US government is only beginning. Though it has begun: that huge buy of commercial paper last week was backed by _NOTHING_ and functionally unsterilized. In principal, private debt is ‘supposes’ to reassume these liabilities for the government at term (80 days or so) but that’s a laugher, not gonna happen, so the Fed will be left rolling over this paper indefinitely, hence totally unsterilized injection of half a trillion. But that supports your contention that we are more likely to go from credit contraction _directly_ to massive inflation without passing through any substantial deflation in the real economy along the way, yes.

    So FairEconomist, I’m with you that a deliberate cramdown on US debt is less damaging and hence more probable than an inflationary run off. The devil is in the details there, though. Only when burgeoning inflation in the US makes debt default an impending certainty will negotiations be undertaken, and these are likely to prove exceptionally sticky. We are more likely to see the private markets treat older, priceyer debt as ‘distressed to default levels’ while officials wrangle, to me. If we had smart leadership, we would do a devaluation tied to a debt contraction agreement, but I’m not holding my breath.

  68. john bougearel

    just as an aside,

    Has anyone scientifically verified if Paulson has a bazooka in his pocket?

    slim,

    the RFC, not FDR, did most of the bootstrapping to put floors under all segments of the economy. Still, the RFC as a lending agency did not reach the average man. The everyday, joe-the-plumber, still could not get a job during the 1930′s depression.

    And FDR’s WPA (1935-1943: deridingly aka – We Poke Along) which provided roughly 3.3 million jobs at peak in 1938 did little to alleviate unemployment offered little more a security check.

    It wasn’t until the war machine was cranked up as Thomas J rightly points out that the unemployment rate shrunk meaningfully.

    Meanwhile, the Fed pursued a ZIRP policy between 1934-1948 with the discount rate oscillating between 0.5% to 1.5% indicating the markets were far from normalized during the 30′s and 40′s.

  69. SlimCarlos

    John B: >> It wasn't until the war machine was cranked up as Thomas J rightly points out that the unemployment rate shrunk meaningfully.

    Thomas J: >>But, of course, you contend that WWII was not a factor in getting the US out of the Great Depression.

    No, I dint ever say that. I only contended that devaluation was key to the arresting of the deflationary spiral.

    Stepping back, the point being debated was is it **possible** to arrest a deflationary spiral and the sense on this board was no, it is not. Which I found incredible as a most glaring case in point contradicted your contention.

    Here is some more background on the devalution. Pls consider this snippet and if you had any comments on the entire paper I'd be interested to hear your views. It may be worth reading through:

    "The war was not the chief foundation of the American recuperation, at least not in the same manner that is characteristically contemplated. The U.S. economy began recovering in 1933 predominantly because of tremendous increases in the money supply. Soon after taking office, Roosevelt, instituted emergency provisions designated to him by Congress, allowing the U.S. currency to depreciate. A new lower price for the dollar was fixed by law in January, 1934. This devaluation greatly increased the total value of the United States gold reserves. The Treasury opted not to ignore the increase in the value of gold reserves and issued gold certificates equal to the amount of the increase and deposited them in the Federal Reserve. As the government spent money, these gold certificates were converted into Federal Reserve notes, which are a component of the monetary base. Devaluation also brought in a large inflow of monetary gold from abroad as foreigners traded gold for the new less expensive dollars. After 1934, gold continued to flow into the United States because of the new price and political unrest in Europe. Hitler’s quest for Europe caused Europeans to want to invest in American assets, which required they buy U.S. currency with gold. Instead of stabilizing this gold inflow by borrowing the dollars to trade for the gold, the Treasury paid for the gold with deposits at the Federal Reserve, and then replenished the accounts by ssuing gold certificates.

    "As a result, money supplies in the United States grew by 12 percent between April, 1933, and April, 1934. Also, the monetary base increased another 40 percent
    between April, 1934 and April, 1937. The monetary base increase is direct evidence that the money supply was growing during the 1930’s as a result of policy decisions rather than political events in Europe or changes in the economy because of the recovery itself. Prior to the expansion of the money supply, devaluation assisted the recovery by serving as a warning sign of a change to a more expansionary monetary system. It advocates that the decline in value instantaneously encouraged acquisitions of agricultural apparatuses and additional principal supplies by producing opportunities of prospects in currency inflation, and economic progress. After 1934 the tremendous increase in the American money supply instituted precisely the effect on the U.S. economy that economists would forecast. Statistics demonstrated that interest rates declined and fell stridently in connection to the flow of gold into the U.S. Treasury. The action capitalized because the nominal rates subtly fell and actual and predicted inflation rose substantially. The producer price index rose at eight percent every year between January, 1933, and January, 1937. The fall in interest rates was pursued somewhat rapidly by a revitalization in expenditures initiated by falling interest rates, such as construction spending and citizen consumption of resilient products. This result may be seen in the fact that the
    American recovery, more than any other country, was led by a rush in the manufacture of investment goods. An additional piece of evidence suggesting a causal link between the fall in interest rates and the tremendous increase in specific categorizations of spending in the United States is the fact that American consumer purchases on durable products went up prior to consumer spending on services did. This serves as a good indicator that some factor affected only durable good purchases, such as the fall in interest rates instituting the healing from the Great Depression."

    http://www.marshall.edu/etd/masters/napier-steven-2005-ma.pdf

  70. tompain

    Yves, I don’t doubt that the regulators CAN seize any bank they want. The question is whether they should, and to what degree. I think they should not do so except in instances where failure is imminent. Pre-emptive arbitrary seizures (such as the effective seizure of NCC, and also FNM and FRE) only serve to cause flight of equity capital at a time when it is sorely needed.

    I also think that such seizures – including that of FNM and FRE – probably qualify as “takings” of private property under the Constitution. The Constitution does not prohibit such regulatory activity, but it does require just compensation when private propery is taken for public use, as is clearly the case here. I think there is a good chance we will eventually see a lawsuit on these grounds. It could reach the Supreme Court.

  71. autostrada

    The pack of wolves are going to run wild, the day comes when the US government would default on the debt….

    with $7.76 trillion pledged at last, this unprinted money would not be paid back unless severe devaluation of USD. Or altast they might take the easy way out and default.

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