A Dangerous Game

Let's start with some basic principles.

Basic principle #1: If you borrow $100 for 1 year at 2% interest per annum, you will be required to pay $102 back at the end of the term. This is basic finance.

Basic principle #2: The United States government borrows money to meet its obligations by issuing Treasury Bonds at a certain price yielding a certain interest rate for a certain term. They are considered as good as, or even better than, gold.

A quick word about the pricing of these debt instruments. As the price of a Treasury Bond goes up, the interest rate goes down. Conversely, as the Bond's price goes down, the rate it pays goes up.

This seems counterintuitive. It seems like it should be the case that if the interest rate goes up then the price should go up. Like someone would pay more for a bond with higher interest. But that is not the case. Pricing of bonds has to do with volatility and security. The stabler and more secure the company/country which issues a bond, the lower the interest rate the borrower is required to pay.

Currently, U.S. Treasury bonds pay negative interest. You read that right: negative interest! Try to buy one. That means lenders actually pay money to loan the United States money. The U.S. can borrow $100 for 1 year at approximately -1% interest. That means that after the term, the U.S. only has to pay back $99 of the $100 it borrowed. That's how stable and secure the rest of the planet views the U.S. and its debt offerings.

Basic principle #3: As a borrower, it's always better to pay it back with cheaper money. That is to say, for debtors, inflation is actually a good thing. If dollars are cheaper at the end of the term, then the borrower can actually earn even more money by going into debt.

For example, let's say on Jan. 1, I borrow $100 for a term of one year. Further, that same  $100 will buy me 50 ingots of unobtainium on Jan. 1. Now imagine that by Dec. 31, the day I have to repay that loan, inflation has hit, the dollar has devalued, and that same $100 will now buy only 49 unobtainium ingots. That is to say, if on Jan. 1 I borrow $100 and buy 50 ingots then on Dec. 31 I only have to sell 49 of those same ingots to repay the loan. I've made a profit of 1 ingot on my money. And that's not even factoring in interest—which, if it's negative, further increases my earnings AS A BORROWER.

Now, when you ramp up these principles to a national scale, borrowing trillions of dollars, you get a sense of the stakes in the current debt ceiling issue.

The U.S. is indebted to China to the tune of trillions of dollars. The Chinese have been investing in Treasuries, loaning us money, parking their money in the safest instruments in the world.

We are paying interest to the Chinese for all the money we've borrowed since 2002 when Pres. Geo. W. Bush re-started issuing U.S. bonds to pay for his Afghanistan and Iraq adventures, his tax cuts, his reorganization and expansion of Federal government (esp. Homeland Security), his increasing use of government contractors, and his Medicare prescription drug reform, among other things. Recall, after Pres. Bill Clinton balanced the budget, the U.S. government stopped borrowing money, i.e., stopped issuing Treasuries, in or around 1997. Did you know that?

If the U.S. threatens to default on its loans by Congressional failure to raise the debt ceiling, it will cause the markets to perceive more volatility and insecurity in its obligations. The U.S. will cease paying interest on its debt. As noted, this will cause the interest rate on future issues of U.S. Treasury Bonds to increase and, concomitantly, the price of their issuance to decline. In other words, the U.S. will be selling its debt for less while at the same time having to pay a higher rate of interest. Rating agencies will downgrade the U.S.'s bond rating.

Disaster, right? Not necessarily.

This happened the last time this threat presented, so we have a precedent upon which to draw. It wasn't as disastrous as it could have because the volatility and insecurity in the rest of the world (competing credit markets) was even greater due to, among other things, the vicious world-wide recession at the time. The world markets turned to U.S. credit despite its increased volatility and instability only because of its stability and security with respect to the rest of the market. That was one mitigating factor at the time and may come into play this time. That 'flight-to-safety' effect, however, cannot be assumed.

You don't have to read far or deeply into the news to discover the sorts of disastrous results a U.S. debt default from failing to raise the debt ceiling could have on both the domestic and global economies. Some economists say it could dwarf the effects of Hurricane Sandy, Lehman Brothers' collapse, and even 9/11. And then there are always the 'unknown unknowns', the unintended consequences that even the greatest economic strategists cannot foresee.

But something ailing, generous blogbuddy BDR said a few days back struck a chord. Quoting Star Trek, he wrote: "But it is true that I will miss the arguments. They were, finally, all that we had." All we have is the argument.

Is there some benefit to be gained from this constant bickering over this debt ceiling—and, in fact, the government shutdown?

"How can that be?" you might well ask. Well, factor this into your calculations: The number one customer of U.S. debt is not the Chinese, it is we, the U.S.A. Americans. An enormous proportion of U.S. debt is owed from the Treasury, which issues debt, to the Federal Reserve and the Social Security trust, among others. This is the policy called 'quantitative easing'.

"[All told] Foreign governments and investors hold 48% of the nation's public debt. The next largest part (21%) is held by other [U.S.] governmental entities, like the Federal Reserve and state and local governments. Fifteen percent is held by mutual funds, private pension funds, savings bonds or individual Treasury notes. The rest (16%) is held by businesses, like banks, and insurance companies and a mish-mash of trusts, businesses and investors."

Bet you didn't know that!

What does that mean? If interest rates go up and the price of Treasuries declines as a result of threats of a default, the U.S. Treasury will be forced to borrow money at a higher interest rate and sell its bonds at a lower price. But, as by far the largest single purchaser, other areas of our government—the Fed, Social Security, etc.—will be paying a lower price for those same instruments and receiving a higher rate of interest. 

We, as both borrower and lender, stand to gain on either side of the equation. It will balance out domestically. Our foreign creditors, the Chinese and Japanese, do not stand to be so 'lucky'.

Also inflation. As interest rates go up, it will have an inflationary effect on the U.S. dollar. That is to say, we will be paying back our foreign creditors, in particular, the Chinese, in cheaper dollars—giving them the equivalent of fewer unobtainium ingots. Thereby further reducing Chinese leverage over our economy.

So, is all this wrangling and posturing merely a grand kabuki (or its Chinese equivalent) on the part of both parties intended to talk down our foreign debt?

I'm not suggesting a conspiracy, mind you. But the interests of the U.S. government are paramount for both the executive and legislative branches. Their actions may, in fact, be furthering those interests. Meaning, of course, even in its dysfunction, the government is actually somehow managing to further its own interests.

Of course, U.S. debt is the gold standard for world finance. And this chaos in the Treasury markets could roil the world economy. That could have other and possibly unintended consequences which I am in no position to evaluate. I am, after all, no economist.

But the question remains—assuming the panjandrums have gamed the whole thing out—do the dire consequences to the world economy outweigh the potential domestic advantage to be gained by all these money-juggling monkeyshines in reducing Chinese leverage over our economy?

It's a dangerous game. Gambling on the stability of the world economy. Threatening a global collapse of potentially catastrophic proportions. Worrying that the partisan adversaries will know when and how to stop the game of chicken once the finances and economics have been sufficiently economically jiggered. But it might just explain this whole "seeming" fiasco.

10-Q: The Form of a Problem

Okay, here's how we got in trouble—

Every three months, all publicly-held companies are required to file with the Securities and Exchange Commission and make available to the public certain information about their financial performance. On the whole, this is a good thing. The price of shares on the stock markets is, theoretically and ideally, based on everyone having access to the same information when they make the decision either to purchase or sell. Trading on inside information, or 'insider trading', is what Martha Stewart was charged with (though she went to jail for lying to government investigators looking into those charges). Every year, companies must file what's known as a Form 10-K which details the companies' performance for the year. The idea is to provide transparency into the financial well-being of a company to prevent fraud in the trading of its securities.

As I said, that's all well and good, but with this admirable regulation has arisen a perverse set of incentives: the managers of the companies subject to regulation must provide positive short-run performance or the price of their shares will take a hit—as will their bonuses and, eventually, their job-security. Thus, they do things like selling off company assets or diluting equity or borrowing heavily or skimping on planning and Research & Development to fund current operating costs or, in other cases, relying on PR and misleading marketing to exaggerate their poor performance, or, in still others, using accounting tricks like taking certain charges off-budget so they don't appear in the main text of the financial forms.#

Do you see where this is going?

There are the same sort of incentives in U.S. politics. The Congressional cycle is two years, the Presidential cycle is four. There are annual budgets—though the oversight is, one suspects, hardly so comprehensive. After all, the Iraq invasion and occupation have been off-budget items since the inception, in effect concealing their true costs.

[T]he real scandal is Mr. Bush's own preference for financing much of the cost of the Iraq war outside the normal budget process. That is convenient for the administration, which does not have to count the money when it is pretending to balance the budget. But Iraq is not some kind of unexpected emergency, like Hurricane Katrina. It is a highly predictable cost... .

Moving the war's financing off budget is no mere technical distinction. For one thing, it subjects the military's spending requests to less careful Congressional committee scrutiny than they would receive during the usual budget process. More important, this fiscal sleight of hand makes it that much easier for the Pentagon to duck the hard choices it desperately needs to be making between optional and costly futuristic weapons and pressing real-world needs. NY Times, May 8, 2006

This is an old trick, but it still works. The President* managed to make his fiscal performance, dismal enough to begin with, look better than it truly was by an accounting sleight-of-hand. Taxes were cut: this was a political trick to fool us into believing the illusion. The fact is, though some were paying less in taxes (which go to fund measures for the public good such as infrastructure, security, government oversight and regulation), we are paying more for commodities (gold, oil, etc.) which are, for the most part, privately held. Profits in these sectors have been obscene. Crude oil prices are five times as expensive as they were when GWB took office. Do you think it's a coincidence that GWB was an oilman and that his VP was in the oil-services business? But that's off-topic. The larger point is the incentives in the system to make the government managers look good in the short term, with no thought for the long-term good of the country or its people. The CEO mindset.

Think back to the first invasion of Iraq. Pres. GHW Bush refused to pursue Saddam Hussein into Baghdad and ended the action early and before a prolonged occupation. Thus, when the presidential cycle rolled around again, he could no longer claim to be a 'war president' and rally the support of the American people. And, guess what, domestic issues took over and he lost. His second son, as dumb as many think he is, clearly learned his lesson. He extended his own invasion all the way to Baghdad and claimed to be a 'war president' at election time which, you can be sure, was just enough to eke out a highly-contested election against a fairly inept opponent (we won't go into the splitting of the opposition caused by Ralph Nader). He needed our troops to remain in Iraq just long enough to get him (re-)elected. It worked, but created the current quagmire. The short-term incentives outweighed the long-term consequences in the political calculus. And now we have to pay for it.

Fraud, expedience, short-term manipulation of information (e.g., labor and unemployment statistics, war costs and casualties, M3), asset foreclosures, privatizing the public weal, lack of long-term planning, heavy borrowing, currency devaluation: these all appear to be structural problems, perverse incentives in our system of governance which this particular administration has managed to exploit for the cynical purpose of gaining and remaining in power maugre the consequences.


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# Rather, they are buried in footnotes at the end of the document.