The Political and Economic Aspects of the European and US Debt Crisis

Ironically the US Treasuries always gain strength in an uncertain economic environment, despite Credit downgrading of the US Treasury bonds. Why? The US Treasuries, despite some serious Debt implications, are still viewed by the Markets as much safer and risk free instruments. In my opinion, the European debt issue is far from over – there are some countries which have over-leveraged Debt to GDP ratios; Portugal, Spain, Ireland, Italy to name few.

What we need to discern is a subtle difference between the US and the European debt issues. These issues may sound similar, but they are quite different both in terms of economic scope and political underpinnings. The US debt, undoubtedly, is a long term challenge as demonstrated by a marked increase in the spread between the yields of Ten year Notes and the corresponding Inflation Protected Treasury securities. The economics is quite simple: more deficit means greater debt; more debt implies higher rates and inflationary pressures; and if they are out of balance this would result in currency crisis, massive devaluations and disturbance of global financial balance.

The European debt is a more complicated issue, at least from the standpoint of the geo-economic structure. The US debt issue, notwithstanding the massive size of debt touching $13 trillion plus, is manageable in so far the government apparatus and the Fed are well positioned to attend to any unexpected movement of debt limits. This may not be the case for the European Union – which is facing a dilemma of aligning political and economic interests. For instance, if Greece were to default and its debt restructured, it would relinquish membership of the European Union. Why? Because its currency will have to undergo massive devaluations to re-align the backlog of its horrendous debt and put the house in order again. This is not possible while its strings are attached to the European Central Bank. Ironically this guaranteed cushion by the European Central Bank might promote moral hazard for countries to take on debt and buy time. Such an eventuality might trigger a more serious crisis at a later stage; the solution lies in both short term injection of capital and long term scrutiny to ward-off risks to overleveraged economies.

The Fed has deployed unprecedented quantitative easing in history, by utilizing $2.86 trillion Balance Sheet, in order to keep the short term interest rates to near zero level. Remember the Fed has already injected a mammoth dose of $2.3 trillion into the Financial System since the collapse of Lehman Holdings in September 2008. The probability of the Fed continuing this stance of keeping rates on lower end would most likely continue; the key drivers are the slumping Mortgage Insurance and ailing housing markets. Any increase in rates would put unbearable pressure on $914.4 billion of Mortgage-backed debt of the Fed. Concomitantly, the Obama administration is struggling to close massive federal budget deficit of $2 to $4 trillion.

In this environment, Treasuries are most likely to rebound in the short term; while yields on Treasury Inflation Protected (TIPS) would escalate in the long term. In my viewpoint, an unstoppable escalation of this “spread” between the two (which would run somewhat parallel to an inverted yield curve) would signal potential threat to the Global economy. Here is the “economics story” behind this key trend witnessed recently:

1. Burgeoning Fiscal deficit would prop up the National debt of the US, unless domestic Savings are capable enough to fill the gap – which is not the case.

2. Deficits and National debts cannot go beyond certain threshold, without inflicting damage to the economic balance. This is true in case of the US as well although the Fed can print dollars literally from the “thin air” as long as it wants to do so.

3. If debt exceeds permissible limits, the first thing to be hit will be the interest rates. Higher rates will cause insurmountable burden on debt servicing as well as dampen consumer demand. Note Consumer spending, impacted directly by the strength of the housing market, is the main driver of GDP growth in the US.

4. Higher rates will prove detrimental to a very fragile housing market, which is already facing pressures from an ailing Mortgage Insurance market (a new emerging trend).

5. Remember that any quantitative easing by the Fed will keep rates low in the short run; but will come at a cost of burgeoning National debt and consequent expectations about inflations in the future.

6. Bonds (Treasuries as well as Debentures) move in an opposite direction to interest rates. Future expectations of lower yields would mean higher price (compensation) for Bonds.

7. Finally, interest rates and inflation would move hand in gloves. In this game, expectations are the key determinant of any future play out. Markets are driven by psychological factors – greed and fear – as much as by fundamental factors. In my viewpoint, presently the psychological factors, fear in particular, have masked the “fundamentals” to a great extent. The solution lies in a firm commitment of the Fed and the Government to keep the Fiscal deficits and the National Debts within a plausible limit of the GDP.

Last but not least, China is playing a very critical role in maintaining “global financial balance” – it is holding trillions of dollars and Euros of debt; and pumping its exports onto the US and the European Markets. Hefty “consumerism” of Chinese products in the US and Europe is extremely important to keep China churning its exports – any reversal can strain this delicate “financial balance” immensely.

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