Budget deal gets done and everything fal

The US Congress and Senate finally came to a compromise and passed a bill that increased the debt limit and allowed the US government to continue paying its bills. Why then are equity prices and the Canadian dollar all falling?

The increase in the debt came at a cost. The budget must be cut by $ 2 trillion over the next 10 years. (See a CNN article for details of the deal) That restriction will prevent the government from using discretionary fiscal policy as a tool to stimulate the US economy. With interest rates as low as they can go, the US has no room for expansionary monetary policy either. Since the US dollar is the world’s numeraire currency (the currency against which all others are measured), they have no exchange policy. None of this would be a problem except that it appears the US economy is headed for a recession. (See the Globe and Mail article). It would be a recession that the government cannot fight.

The deal also means that transfer payments from the federal government to the states will be reduced, thereby further straining their budgets. Forty-nine of the fifty states are required to have balanced budgets, so the reduction in transfers must be met by an equivalent reduction in state government spending. Those cuts reduce aggregate demand and further weaken the economy.

Any reduction in the US economy will result in a decrease in their imports. Since the US is Canada’s largest trading partner, our exports will fall. Aggregate spending in Canada is curtailed and that will slow the rate of economic growth here. The reduction in our exports also causes a reduction in the demand for the Canadian dollar which is why the loonie has fallen from its recent highs. (See the Bloomberg article)

The problems in the US have caused investors to reduce their holdings of US dollars, preferring instead the relative safety of gold and the Swiss Franc. We have recently seen record highs for both. The rise in the Swiss Franc has been dramatic enough to cause a decline in that country’s economic growth. To combat this, the central bank in Switzerland has recently reduced their interest rate to 0.25% and has initiated their own version of quantitative easing. The foreign exchange markets are now awash in Francs as the central bank forces down the exchange rate. (See Bloomberg article)

We will be watching the continued fallout from the political situation in Washington and try and keep you informed as the impacts are felt around the globe.

A new twist on our conspiracy theory

We had previously written the plot for a financial thriller based on the bizarre drama being played out in Washington. The debt deal is done and we will post a blog on the repercussions shortly.

We did find a news article in CNN that we really weren’t expecting. A rating agency in China has downgraded US debt. We had predicted a downgrade, but we were expecting it from one of the US rating services. In our previous blog we noted that such a downgrade would be detrimental to China’s holdings of US debt.

So another twist for Mr. Frey’s novel … the US Treasury Department has a mole planted deep within the Dagong Global Credit Rating Company. At the appropriate time, the mole initiates the downgrade setting in motion the selloff of US debt.

Some Insane Thoughts on the US Debt

On August 2, 2011 the United States will reach its maximum allowable debt level. When that happens, the US Treasury will no longer be able to fund the budget deficit and the United States government will technically be in default. The rating agencies will have to downgrade US Treasuries from their current AAA rating. Their bond prices will fall and the yields will rise. 

Congress, Senate and the White House are trying to put together a budget that will allow for the debt ceiling to be raised above its current $14.3 trillion limit. The Democrats don’t want any cuts to social programs. The Republicans don’t want any new taxes. The White House wants a deal that stretches to 2013 – after the next Presidential election in 2012. No one seems to be willing to compromise and the rhetoric is flying in all directions. 

A lesson in fiscal policy: to reduce a budget deficit, a government must raise taxes, reduce spending or both. The military is a non-starter as are subsidies to the energy and agricultural sector. The bailouts of Detroit and Wall Street are not to be questioned. Medicare, Medicaid, Social Security and pensions are vote killers. The astute reader will start to see the magnitude of the problem. 

Markets have been reacting by selling the US dollar, not by selling off Treasuries. As the US dollar falls, gold, the Canadian dollar, yen and Sterling all increase in comparison. (The euro has its own problems) 

Any rational person would think that this problem needs to be fixed and fixed fast. Politicians in Washington, however, don’t appear to be behaving rationally. But what if it is all a carefully orchestrated symphony of economic warfare? 

What will happen if politicians don’t reach an agreement? The rating agencies downgrade the debt and bond prices fall. The balance sheets of financial institutions take a hit due to the loss on Treasuries. To prevent the credit markets from drying up due to insufficient bank capital, the Fed institutes QE3, providing financial institutions with liquidity. The liquidity is used to purchase more government debt at reduced prices. The sellers of US debt receive US dollars which are then sold into the foreign exchange market depressing the value of the US dollar and causing an increase in the price of gold. Who is selling the gold in exchange for US dollars? Perhaps the US government and the profit on gold sales pays off some of the bonds.

After a period of adjustment, bond prices recover, gold falls and the US dollar rebounds. The US government buys gold off the market to replenish their reserves. (Buy low, sell high – not necessarily in that order) The financial institutions repay the Fed with the treasuries they have accumulated ending up with stronger balance sheets than they started with. 

So who loses in this scenario? Ask who is the largest external holder of US Treasuries and you will have your answer. The major flaw in all this is that the politicians have to be involved and agree to the plan and the secrecy, which we find highly unlikely. If we throw in a murder and a love interest for the economist that uncovers the plot, we have a pretty good Stephen Frey novel though.

The US Debt Debaucle

I would love to interupt my vacation in Florida to do an entire series of articles on the US Debt situation, but the sun is shining and I am feeling "disinclined" as Capt. Barbossa would say. There are enough news articles floating around.

To summarize the issue, the US Congress has imposed an upper limit on the amount of debt that can be issued by the US treasury. The ceiling will be reached early in August. To reduce the amount of borrowing, the government must reduce the size of the deficit. This requires an increase in taxes, a decrease in spending, or both. The Tea Party wing of the Republicans has vowed not to raise any taxes. The Democrats don't want to cut spending on social programs. Hence the stalemate.

The 14th Ammendment to the US Constitution tends to imply that the US Government cannot default on its debts which brings into question whether or not the debt ceiling limit is constitutional or not. President Obama sounds like he believes the 14th supercedes the ceiling. The US Supreme Court will have to decide at some point.

Moody's has threatened to downgrade US debt if they default in August. That would cause an increase in US interest rates and a drop in treasury prices. Banks holding treasuries would have to write down their holdings which, once again, would cause them to fall below the capital adequacy requirements. Enter QE3.

One issue that I have not seen, and am not entirely sure about (since palm trees are more interesting) is what happens to corporate debt ratings in the event of a downgrade of US government debt. In the mid 1990's when Canada's debt rating was downgraded due to the debt-to-GDP ratio, the bond ratings of all major banks was also downgraded. I recall the reason being that no private corporation in a country can have a higher credit rating than the sovereign debt rating. I reiterate that I don't know if that is still true, but if it is, the backers of certain Republican lawmakers may see an increase in their borrowing costs and a coincidental drop in their bond and stock prices if the Congress can't overcome this impasse.

An update on the European poker game

Last month we wrote a blog entry about the ‘game’ that is playing out in Europe with respect to the Greek debt situation, the proposed EU/IMF bailout, and Germany’s reluctance to go along with the plan. A thorough discussion of the issue surrounding a potential default can be found in a Financial Post article. 

The Flop

A Reuters article confirms that Fitch has cut Greece’s credit rating, as expected. The rating is now B+ which puts it well into the “junk” category. Most investment policy statements of mutual funds and pension funds prohibit the holding of bonds rated less than BBB (or equivalent). The rapid selloff has lifted the yields on Greek bonds to 16.18% (Bloomberg June 25/11). With debt of 150% of GDP, this means that the interest payments alone take up 24% of GDP. An article in the online version of TIME magazine indicates that Germany has capitulated on their demand that Greece roll over maturity dates, and will join France is supporting the bailout. The bailout is contingent on Greece significantly reducing their deficit.

The Turn

The Greek coalition government has fallen apart over the austerity budget that is required to meet German/French conditions for the EU/IMF bailout. A reshuffling of the cabinet has been met with protests from other parties according to a CNN article. The general populace does not want to bear the brunt of an inefficient and corrupt government and has taken to the streets in protest. A Reuters article explains the alleged corruption and shows photos of the scale of the Greek protests. The bailout is contingent on the austerity measures that must be passed and implemented by a coalition government that can’t agree and imposed upon a population that refuses to accept those measures.

The River

So, as time runs out in Europe, we wait for the last card to be turned and find out who is bluffing. The betting is taking place in the market for credit default swaps where the rate on the 5 year CDS is 2025 basis points (20.25%) according to fxstreet.com, and on the foreign exchange market where the euro has fallen to a 3-week low, according to a Reuters article. We’re still betting on a bailout, followed by an orderly restructuring of Greek debt supported by the private institutions that hold the debt. 

Bombardier Bombs This One

The British government has recently announced that a consortium led by Siemens, a German firm, was its preferred bidder for the Thameslink route. This route is a £6bn North-South cross-London venture demanding Siemens to provide 1,200 new carriages. This is bad news for Derby firm Bombardier, who lost out to the competition. In the BBC report here, we economists can’t help but comment on this quote by Mark Young, regional co-ordinating officer for Unite:

"The government's decision to award this contract to a consortium which does not have British manufacturing and British job creation as its prime focus is absolutely disgraceful".

Most important transport proposals in the UK are promoted by local authorities and the Highways Agency, and are usually financed by central government. These are then decided on a case by case basis by the Secretary of State for Transport as to whether or not to approve funding. Part of the decision-making process involves a detailed appraisal of the proposed scheme using an approach specified by the Department for Transport (DfT). The commonly applied appraisal method in transport is cost-benefit analysis (CBA). CBA effectively compares the projected future stream of benefits from a project with its initial and future costs. This allows numerous competing projects to be ranked. The project is deemed worthwhile if and only if it is predicted that the monetary values of the revenues will exceed the monetary values of the cost. In order to determine VfM, policy makers turn to cost benefit analysis. For those who are not familiar with Value for Money, the HM Treasury defines value for money in the following manner:

"VfM is defined as the optimum combination of whole-of-life costs and quality (or fitness for purpose) of the good or service to meet the user’s requirement."

What we should explain, is that VfM is not the choice of goods and services based on the lowest cost bid. At the core of any procurement policy is a guarantee that an infrastructure project will allow taxpayers to get value for money. Bombardier was not able to demonstrate that the NPV cost to society of the carriages they would provide, were less than what it would cost for the same service provided by Siemens

Siemens represented the best Value for Money (VfM) for tax payers. This measure used in transport and investment appraisals allows policy makers to analyse and sift through efficient firms and not so efficient ones. Clearly Siemens falls in the latter category.

References
HM Treasury (2006) Value for Money Guidance

Environmental Policy by Demand

There are several methods of implementing environmental policy. Governments can use taxation, tradable permits or command and control mechanisms. Another method, and the subject of a recent Washington Post article, is to change consumer tastes.

Policies designed to effect the supply side of the market typically result in lower quantities but higher prices, often leading to the formation of black markets. Higher prices tend to induce more production, not less. Supply side policies also require government resources to enforce them; for the collection of taxes or the monitoring of market participants.

A concerted effort thirty years ago brought to the world’s attention the plight of dolphins that were drowning in tuna nets. We now see tuna labels adorned with the dolphin free logo.

The same exercise is now being focused on the effects of shark fin soup. It is estimated that 73 million sharks are killed each year for the production of this soup. As the Post article reports, a group at the University of Hong Kong has initiated a program of public awareness in an attempt to reduce the demand for this Chinese delicacy.

The benefit of demand side initiatives is that a reduction in demand causes the market price to fall, reducing the incentive to catch sharks. Demand side solutions also require less government involvement and a more efficient allocation of resources.

Reducing demand reduces the economic incentive to produce. Reducing production lessens the harmful effect on the environment. Saving sharks may not be as easy as saving dolphins however. After all, who is cuter; Flipper, or Jaws?