A worst case for the possible US government default

(This is crossposted from Google+. If you use Google+, you scan find the original here.)

Lots of people are scared about the possibility of a US government default. But I have an unusual reason that few share. And many might think me crazy for worrying about one of the things that I worry about. So I'd like to share why I think what I do before I confess to my worry.

Close to a decade ago I read a fascinating book, Wealth and Democracy by Kevin Phillips. SIt is a large book. It is a detailed book. Most of it is a detailed history of when and where great wealth was created in US history, and its effects on the political process. (In a nutshell the conclusion is that periods of great wealth are periods where the wealthy wield great political influence, and conversely periods where the wealthy have less political control saw great declines of wealth disparities.) Don't try reading it unless you can get into the idea of reading close to 500 pages from a policy wonk going on about things that happened a hundred years ago.

Of course if you are able to read it, there is a lot of interesting material there. Kevin Phillips put a lot of effort in, and knows his stuff. He also has a history of making absurd predictions that work out. For instance in 1970 he wrote The Emerging Republican Majority which made the (then) absurd prediction that white Southerners who reflexively voted against the Republicans because of their role in the Civil War, were about to switch to the Republican party. Nixon followed the strategy that Phillips outlined, and they eventually did. In 1990, when Bush Sr had the highest approval rating of any president ever, Phillips wrote The Politics of Rich and Poor: Wealth and Electorate in the Reagan Aftermath which argued that Bush was vulnerable. Clinton later said that he used it as his election plan.

So what absurd prediction did he make in Wealth and Democracy? Well here is it as best as I remember it. In the last 400 years there have been three other examples of a country that was the sole global superpower. (Spain, the Netherlands, and England.) All three followed a remarkably similar trajectory. All had a major boom that was more based on financial speculation than real production. During this bubble, actual production was outsourced to other countries. This bubble crashed. A couple of years later all three got into a foreign adventure that was supposed to be quick and easy. Said foreign adventure turned out to be much longer and more costly than predicted. Parallel to this there was a "recovery" in which average people didn't really get much ahead. During this period there was even more outsourcing of real production. That ended in a credit crisis some 7-8 years later. Following the credit crisis there was a paper recovery whose effects weren't widely felt. That was not many years later followed by a second financial crisis. After the second financial crisis there was growing outrage in the population. Followed, almost exactly 15 years after the peak, by civil war in 2 of the cases. In the case of England there was civil unrest, but it was overwhelmed by WW I. The outcome was the establishment of a third major political party, Labour.

Incidentally in all three cases one of the countries that production and industrial knowledge was transferred to eventually wound up as the next superpower. Currently the best two candidates for that next superpower role are India and China.

Remember. This was written after the dot com bust, and before the Iraq invasion. Now compare with events of the last decade.

At first I thought, "He did a lot of work, and has a good track record, so I'll not discount it out of hand but I'll keep a lot of skepticism." Ever since then things have played out as predicted, almost like clockwork. I currently see lots of potential triggers for the second financial crisis. So I think that part is likely to play out, and my main hope is that we're more like England with civil unrest than Spain and the Netherlands with an actual civil war. However I have to say that the increasing polarization of the country over the last decade has made civil war much less unthinkable to me as a possibility than it was when I first read the book.

If the next financial crisis is triggered by a political stalemate, that makes me fear that civil war is more likely. Because the event will be one which arrives with already polarized constituencies that each has has a well-articulated story for the crisis that blames the other for not being willing to (cut government|consider any kind of tax). As financial disaster is felt by all, how can tensions fail to escalate along already clearly drawn boundaries? As they escalate, where will it end?

Please, Congress, find a way to compromise. If you fail, trillions of dollars in excess interest payments is the best possible outcome we can hope for. None of us wants to see the worst. Really.

Is the financial crisis really over?

I recently asked a friend who works on Wall St about whether these warnings about the municipal bond market were accurate. He gave me a detailed response, and gave me permission to repeat the comments but without his name or company attached. This is very reasonable given his current position, so I won't say anything more detailed than that he is in a good position to know what is happening in the credit markets, and I trust his opinion far more than any of the talking heads you see on TV.

Here is what he said:

Well, more than remotely accurate....

We have 3+1/2 more disasters to go in this crisis:
- Resi: this is the 1/2 disaster, as we're a little more than half way through the resi correction; unfortunately, we still have a long ways to go!

- Commercial real estate lending / CMBS: 4th Q retail will likely be a disaster, and commercial real estate has had as much or more price explosion as resi; already we are seeing soaring bankruptcies, etc. Many shopping center tenants have 'go dark' provisions (no rent due if >x% of the mall is dark), which are coming close to exercise. Banks and insurance companies are hugely exposed here; could make subprime look like a walk in the park.

- Credit card debt: even though the pace of job destruction has slowed, we are still in job destruction mode; consumers are increasingly falling behind on all debt payments. People are (wisely) looking to save rather than pay down debt (treating the debt as a lost cause)....

- Muni. As an example, tax revenue in your golden state is down 40%, and this story is repeated all over the country at all levels of government. So far, the Fed government has kicked a huge amount of money down the muni chain, which has kept the problems largely at bay; however, this process is nearing an end. The fact is that the entire country is massively leveraged: consumers, local government, state government, and the federal government. In the boom years, governments piled on debt and hugely increased their services, and most also hugely grew employment as well as entitlements (health care and pensions for muni employees). Now, they are facing revenue shortfalls but have great difficulties cutting services (often mandated by law), cutting staff (administration is opposed), cutting capital expenses (again, mandated by law). Default is in the cards for a lot of them, as federal money runs out.

Given the way the administration handled the automakers, I expect the muni bond holders to get hurt while the pension plans are made whole. I don't know what government does to avoid massive service cuts, though! It has seemed to me that one of the motivations for doing federal health care now is actually to ease up on state medicare spending (that's why your Governator has been making pro-health care reform statements).

So far, managing the crisis has relied on using the remaining credit of the borrower of last resort (the US). And while lots of reports have shown that govie debt is low relative to GDP on a historic max basis, these reports have completely overlooked the net debt position of both government and consumers. It is of course difficult to tease it all out (lots of munis fund housing projects), but personally I feel that we really can't have much debt ceiling left. Particularly if you consider that current/recent levels of GDP require a level of corp credit, but we now have vastly less corp credit available: without more corp credit availability, GDP must continue to slide, which implies debt-to-GDP continues to rise even without more borrowing.

An economist friend of mine (who lived through Argentina) and I both believe that the only real outcome of the whole crisis is that the Fed will manage a graceful and slow dollar dilution, so that we see a huge inflation but over a long enough stretch of time so as to not be unduly destabilizing. This process would basically inflate away our debt as it revives the domestic economy. Unfortunately, so far as I know, no country has ever achieved economic success via a weakening currency!

Anyway, yes, this is all really bad, and still has a ways to go!

Reading this I am strongly reminded of what I saw predicted in Wealth and Democracy several years ago. The book is a long read, but buried in it were a list of parallels between the USA circa 2000 and the last 3 great world empires shortly before their collapse. In all 3 cases shortly after a boom caused by financial speculation there was a financial crisis, which they recovered from fairly fast at the same time that they launched a military adventure that was expected to be a quick, successful war. The war dragged on and cost far more than expected. Then public mood turned against the war around the time that a more serious financial collapse hit. After a series of subsequent financial collapses there was political unrest leading to civil war 15 years after the peak in 2 out of 3 cases. (The exception was England, which got involved in WW I before the civil unrest could become worse.)

When I first read this I thought, "Interesting, and Kevin Phillips does have a track record of making apparently absurd predictions that came true, but I'm not overly concerned." I still believe that the prospect of expressing ourselves through democracy can head off the possibility of civil war, but it has been scary watching the timeline unfold like clockwork.