Some time ago, Obama suggested opting for pay-go, the implementation of which would require the Congress to find financing for new projects before writing a check – this way federal deficit would be capped at current levels. Needless to say, nobody really cared about that and new checks were written, which further added to the decifit. This chart really tells you everything, doesn’t it?

Unfortunately, there is no indication that this is about to change any time soon. Indeed, the President and the Congress are talking about deficits all the way into 2020. But what does this mean for the US economy and the US dollar?

1. Rising debt means bigger interest payments (currently around $250 billion), with higher interest rates, this could double in a matter of years. Interest payment goes into spending, but if they want to keep spending the way they have, the deficit will rise even further.

2. More debt means the US dollar will have to weaken – after all, they are ‘paying off’ old debt with new debt. This doesn’t have to happen overnight, but if deficits aren’t brought down to a manageable level, the US dollar will very likely fall like it did during 2000-2007 – slowly, but in a determined fashion.

3. More debt, more money printing and a falling dollar will lead to higher inflation numbers. Again, this is a process much like the weakening of the dollar. Don’t expect hyperinflation until you see the signs (you will know when you see it). But there will have to be at inflation, even amidst all the deleveraging and defaults.

4. US companies will find it increasingly harder to make money. Why? Because more spending and falling revenues always lead the politicians to raise taxes. Indeed, this has already been happening – states, cities and counties all over the US have raised taxes and fees for almost everything. The expiration of the Bush tax cuts further raises the tax burden and there are talks about carbon taxes and even VAT in the US. This should be a time of lowering tax rates, not increasing them. Go figure.

5. Living costs are going to go up, up and away. A falling dollar and higher tax rates can only mean one thing – the US will have to pay way more for its imports, especially staples that are in tight supply over the long term. I’m talking about oil and food. There doesn’t seem to be a shortage or a bottleneck right now, but it has been acknowledged that food supply is at a critical point (record low warehouse supplies and a growing population that eats more every day). Developing agricultural land is a tough one these days as there is less and less arable land every year. Combine that with water shortages and you have a problem. Oil supplies aren’t anything to cheer about either – you can argue all you want over peak oil, but the fact is that oil is getting harder and more expensive to get out of the ground. So, all in all, with the supplies of staples running almost below demand, you can be sure that food and energy will get a lot more expensive.

Chairman of the CFTC, Gary Gensler has really grabbed the bull by its horns – he is proposing wide-ranging reform of the over the counter derivatives market, with a special focus on credit default swaps. I understand that for some of you this might look like gibberish, but it is important to understand that derivatives played an important role in the credit crisis (see this link for explanation). Without credit default swaps, AIG wouldn’t have needed a bailout. Lehman would not have failed, were it not for their huge (off-balance sheet) position in mortgage derivatives such as CDOs and synthetic CDSs.

Here are some excerpts from Mr. Gensler’s speech, the full version of which can be downloaded here: Keynote Address of Chairman Gary Gensler, OTC Derivatives Reform, Markit’s Outlook for OTC Derivatives Markets Conference. All highlights are my own.

The 2008 financial crisis had many chapters, but credit default swaps played a lead role throughout the story. They were at the core of the $180 billion bailout of AIG. The reliance on CDS, enabled by the Basel II capital accords, allowed many banks to lower regulatory capital requirements to what proved to be dangerously low levels. They also contributed to weak underwriting standards, particularly for asset securitizations, when investors and Wall Street allowed CDS to stand in for prudent credit analysis.

Mr. Gensler goes on to talk about reform:

Effective reform of the marketplace requires three critical components:

First, we must explicitly regulate derivatives dealers. They should be required to have sufficient capital and to post collateral on transactions to protect the public from bearing the costs if dealers fail. Dealers should be required to meet robust standards to protect market integrity and lower risk and should be subject to stringent record-keeping requirements.

Second, to promote public transparency, standard over-the-counter derivatives should be traded on exchanges or other trading platforms. The more transparent a marketplace, the more liquid it is, the more competitive it is and the lower the costs for companies that use derivatives to hedge risk. Transparency brings better pricing and lowers risk for all parties to a derivatives transaction. During the financial crisis, Wall Street and the Federal Government had no price reference for particular assets – assets that we began to call “toxic.” Financial reform will be incomplete if we do not achieve public market transparency.

Third, to lower risk further, standard OTC derivatives should be brought to clearinghouses. Clearinghouses act as middlemen between two parties to a transaction and guarantee the obligations of both parties. With their use, transactions with counterparties can be moved off the books of financial institutions that may have become both “too big to fail” and “too interconnected to fail.” Centralized clearing has helped to lower risk in futures markets for more than a century.

Here, Mr. Gensler makes an excellent point regarding the right to buy insurance. It is not known to many that credit default swaps can be bough ‘naked’, that is, you can buy insurance on an institution that you don’t even have stake in. That would be like buying fire insurance on your neighbor’s house -  it doesn’t take a college degree to figure out what happens next to the house in question. Mr. Gensler:

Though credit default swaps have existed for only a relatively short period of time, the debate they evoke has parallels to debates as far back as 18th Century England over insurance and the role of speculators. English insurance underwriters in the 1700s often sold insurance on ships to individuals who did not own the vessels or their cargo. The practice was said to create an incentive to buy protection and then seek to destroy the insured property. It should come as no surprise that seaworthy ships began sinking. In 1746, the English Parliament enacted the Statute of George II, which recognized that “a mischievous kind of gaming or wagering” had caused “great numbers of ships, with their cargoes, [to] have . . . been fraudulently lost and destroyed.” The statute established that protection for shipping risks not supported by an interest in the underlying vessel would be “null and void to all intents and purposes.”

Hat tip: Barry Ritholtz
Image courtesy Businessweek.

It seems to me that Greeks really don’t get it. A few days ago “Greek singer Nana Mouskouri offered her pension to help end debt crisis”. The singer had previously worked for the European parliament and is now receiving a monthly £14,700 pension from Brussels. She offered her pension to held end the debt crisis. But this is not all:

There have been widespread calls for wealthy Greeks, including those from the country’s huge diaspora, to contribute money to a national fund to help the country climb out of its economic black hole.

There are two reason this doesn’t make any sense. First of all, Greece’s public debt is over 250 billion euros. It would take years to pay it off, even if Greece stopped borrowing money today, which it won’t. Second of all, it was the government that spent the money, not the rich people. Politicians’ populism is what got Greece into the mess it’s in right now, not rich people. The money was spent on welfare and government employees, essentially this spending was done to guarantee the votes of the electorate. There is no reason rich people should carry the burden the government willingly put on itself. In any case, paying off Greece’s debt won’t solve Greece’s problems. They need to reign in on spending and put labor union contracts up for review. If Greece’s government were able to borrow more money, they would! And that’s the problem. You can’t solve Greece’s problems by paying off their debt, because they would revert back to their old habits in no time. They will have to pay off the debts themselves so that they remember the pain. Nobody is advocating pain for pain’s sake, but economic pain is what guarantees you won’t step in the same bucket twice. In addition, Greece needs to learn to be a lot more polite. Calling names and blaming Germans for what happened is ludicrous and shows absolute lack of commitment to reform.

Quite a few members of European Union are eager to join the eurozone to boost confidence in the eyes of foreign creditors and investors. Any talk about ‘confidence’ and ‘the euro’ in the same sentence might raise a few eyebrows in the light of Greece’s problems and the recent fall of the euro exchange rate, but compared to sovereign currencies of the former Soviet-occupied bloc the euro is a big step forward. Sovereign currencies carry the risk of devaluation and rapid depreciation due to an aftershock flight of capital. Of course, the same can happen to the euro, but with smaller currencies with no reserve currency status (the euro is a reserve currency) the risks are much higher. Perceived risks, anyway. So in essence, the countries of Eastern Europe are eager to join the eurozone because they figure it makes more sense to stand among the strong, even if they themselves are weak, currency-wise at least.

One of the criteria that a country looking to join the eurozone has to fulfill is a debt to GDP ratio of less than 60%*. According to IMF data, Latvia’s debt to GDP ratio will reach a maximum of 89% in 2013, after which it will start a slow decline. This projection is made on the basis of a weak economic recovery (13.9% cumulative growth in 2010-2014), but even with a strong recovery, the outlook is gloomy indeed. The 2009 GDP data for Latvia is not out yet, but it’s very likely that Latvia will have breached the 60% threshold due a combination of rising government debt and contracting GDP. There is not telling whether IMF’s debt to GDP projection for Latvia is accurate in terms of the ratio reaching 90%, because the IMF has already made a number of missing projections due to nature of Latvia’s economic decline. However, there is a high probability that Latvia’s debt to GDP ratio will remain above or close to the threshold for an extended period. In any case, it looks likely that Latvia will have to work harder than ever before to join the eurozone. It might have to shift the date five or even ten years into the future.

The data and charts were taken from CEPR’s report on Latvia from February 2010: Latvia’s Recession: The Cost of Adjustment With An “Internal Devaluation”.

*Just to be clear on this, here is a link to the Maastricht criteria, also known as euro area convergence criteria.

Coming soon to a cinema near you. It’ll be difficult to beat the previous one for obvious reasons (Charlie Sheen vs. LeBeouf), but Michael Douglas is still there so my hopes are high. Greed really is good.