Posts Tagged ‘Credit Default Swaps’

Black Swans lurking because Uncle Sam has less margin for error

Tuesday, March 16th, 2010

Yesterday, we can’t help but notice newspapers headlines reporting that China’s Premier Wen Jiabao warned of a double-dip recession in the global economy. The reason is simple- governments all over the world are expected to scale back their ‘stimulus’ spendings for fear of price inflation and/or blowing a bigger hole in their budget. This goes to show that the word ‘stimulus’ is a weasel word that only has value as a propaganda tool. As we wrote in Will governments be forced to exit from ?stimulus??,

In fact, the word ?stimulus? is the most misleading word in economics lexicon because it conveys the idea of a surgeon ?stimulating? a heart into self-sustained beating. In reality, what government interventions did was to put the economy on a crutch.

If the right word is used (e.g. “crutch,” “prop up”) to describe the counter-productive government policies of spend, spend and spend, then it will do wonders to increase the economic IQ of the masses (see Are governments mad with ?stimulating??). Consider this very simple chain a logic:

  1. Someone is falling.
  2. You place a crutch to prevent him from falling.

Isn’t it plain common sense to see that once you remove the crutch, that person will crumble? From this, it follows that government crutch (‘stimulus’) lifts government expenditure to a higher plateau. Once we have bigger government, it is very difficult to shrink it as the difficulty currently faced by Greek government shows. Consequently, with a government budget already in deficit, there’s very every chance for it to go deeper into debt. Sooner or later, the bond vigilantes will doubt the credit worthiness of the government, which means the interest rates on government debts will rise, which in turn makes debt servicing even harder. Eventually, this will result in a currency crisis.

This time, governments are cornered with very little margin for error. As Moody’s warns about diminished margin for error on U.S. debt reported,

Cutting back on public spending too soon risks a double-dip recession, Moody’s said, while leaving stimulus measures in place too long could lead to a sharp rise in interest rates “with more abrupt rating consequences a possibility.”

Wherever there’s very little margin for error, Black Swans (see Failure to understand Black Swan leads to fallacious thinking) will be lurking. You see, it is open knowledge that the United States government is heading towards where Greece is in right now (see Currency crisis: UK, Japan and US). What if, there’s another macroeconomic shock? It could be a meltdown in the Credit Default Swap (CDS) market, trade war with China, another wave of mortgage default (see Next wave of defaults to come?), or something else. With the United States government already stretched thin on faith and credit, any additional macroeconomic shock that requires further faith and credit of Uncle Sam will simply be unavailable.

GoldMoney. The best way to buy gold & silverTo understand what we mean, consider what a typical bond vigilante will be thinking. The only reason why he is still lending money to Uncle Sam is because Europe is a worse debtor. Since it is open knowledge that the US is heading towards a Greek tragedy, he knows that it is only a matter of time he will stop lending to Uncle Sam (assuming that Uncle Sam remains unrepentant of his spendthrift ways). But what if Uncle Sam is hit with an unexpected huge bill (macroeconomic shock) today? Will he continue to lend to Uncle Sam? Perhaps he may even demand his money back straight away? After all, if he worries whether Uncle Sam can repay his debt in 10 years time, wouldn’t that unexpected bill bring forward the day of reckoning? Or perhaps that will be trigger for giving up on Uncle Sam?

That’s where another macroeconomic shock can potentially descend into a USD currency crisis. We are not saying it will happen. But given that we are in a situation whereby the margin for error is getting smaller and smaller, it pays to watch out for Black Swans.

All quiet on the Greek front?

Sunday, March 14th, 2010

It’s less than a couple of months ago, financial markets around the world were panicking over Greek government debt default. Speculators like George Soros were probably short-selling Greek government bonds, which in itself will result in rising interest rates for the Greek government. That in turn would increase its debt servicing burden, which would make it even more likely for the Greek government to default. This is like the positive feedback loop that we talked about in Thinking tool: going beyond causes & effects with systems thinking. Those speculators holding Credit Default Swaps (CDS) will have a perverse hope of seeing a Greek Government default.

Today, it seems that this story is a non-issue for the market. Has the story ended?

We afraid this is just the beginning. The Greeks had merely just announced on an austerity plan and some of its people are taking to the streets in protest. As you can read from European politicians hammered from both sides, there will be many parts to this story. Much of the ugly political and legal sausage making process will be happening behind closed doors, which means you wouldn’t get to read them in the media. That will lull many into a false sense of calm.

But make no mistake, this story is like a trench warfare that will play out over a period of years (see Currency crisis: first countries in the line of fire- PIIGS). It will engulf more than Greece- vulnerable? countries include Portugal, Italy, Ireland and Spain. While the Euro may stage a counter-rally here and then, it is most likely to be in a secular down-trend.

As Marc Faber said, the Greek austerity measures will cripple the Greek economy:

Austerity measures may end up making the Greek economy weaker, which means tax receipts will be reduced. That in turn may even make it harder for the Greek government to service its debt. When that happens, you will see speculators moving in again, resulting in another panic quite some time later. This is what we will call the Part 1, Act 2 of the story.

In the meantime, even if the speculators’ hands are tied from touching Greece (by government regulations), they may be setting their sights at countries like Spain or Portugal. That’ll be Part 2, Act 1 of the story.