The US Government Budget Smoke and Mirrors Sequestration

The world of politics is really about smoke and mirrors.

Take the supposed deadlock over the “sequestration” deal or as per CNN “series of automatic, across-the-board cuts to government agencies, totaling $1.2 trillion over 10 years. The cuts would be split 50-50 between defense and domestic discretionary spending”, which officials peddle as cataclysmic to the economy.

The debate is over this…

…a “$44 billion reduction in actual federal outlays for 2013” according to Cato’s Tad DeHaven, or a niggardly 1.2% of total spending.

Or from another perspective, spending cuts means that “that the US government budget will grow by “only” $2.4 trillion over the next 10 years” according to Cato’s Dan Mitchell

Which hardly means any cut at all, the conservative Heritage Foundation further explains, (italics original)

Federal spending is projected to grow from $3.6 trillion in 2013 to more than $6 trillion by 2023, a 69 percent increase without sequestration. Even with sequestration, federal spending would still grow by 67 percent. Sequestration barely even slows the growth in spending, let alone cuts any spending out of the overall budget.

The bottom line is that the sequestration is about the reduction of rate of growth of government spending. There will be no real spending cuts at all.

Nonetheless, all the ruckus about spending cuts, ironically, has been offset by one day of acquired debt.

From the Zero Hedge, (bold and italics original)

if one listens to Obama whose idea it was in the first place, an unprecedented $85 billion spending cuts will be sequestered, unleashing famine, pestilence, the apocalypse and grizzly bears (as all park rangers will be dead from starvation). Which is why we applaud the administration's desire to preempt this tragic for the nation outcome, by issuing, in one day alone: February 28, $80 billion in Treasurys sending debt to (obviously) what is a new all time high $16,687,289,180,215.37.

In other words, the entire apocalyptic impact of the sequester for 2013 was offset by one day's debt issuance…

From Debt To The Penny:

As the great libertarian H.L. Mencken lucidly expressed (In Defense of Women)

Civilization, in fact, grows more and more maudlin and hysterical; especially under democracy it tends to degenerate into a mere combat of crazes; the whole aim of practical politics is to keep the populace alarmed (and hence clamorous to be led to safety) by an endless series of hobgoblins, most of them imaginary. 

Politics wantonly make a fool out of the public.

US Budget Debate: The Path Towards “Running Out of People’s Money”

It is tax deadline day today, which makes a good day to deal with some du jour tax related issues.

In the US, there has been ‘fierce’ ongoing budget- budget deficit cutting debate which has apparently been used as a staging point for the 2012 Presidential elections.

The Wall Street Journal has this budget cutting table showing the Ryan-Obama square-off.

Given these, Professor Walter E. Williams, has a timely and apropos article, where he makes an assumption that considering President Obama’s “class warfare-soak the rich” rhetoric, the US government appropriates

ALL earnings of the “rich” income group $250K and above ($1.4 trillion) +

Fortune 500 corporate profits ($400 billion) +

the assets of US Forbes 400 billionaires ($1.3 trillion) =

The $3.1 trillion won’t be enough to pay for the President proposed $3.7 trillion budget for 2012.

The Business Insider has a breakdown of these proposed budget

Professor Williams writes, (bold highlights mine)

Politicians, news media people and leftists in general entertain what economists call a zero elasticity view of the world. That's just fancy economic jargon for a view that government can impose a tax and people will behave after the tax just as they behaved before the tax, and the only change is more government revenue. One example of that vision, at the state and local levels of government, is the disappointing results of confiscatory tobacco taxes. Confiscatory tobacco taxes have often led to less state and local revenue because those taxes encouraged smuggling.

Similarly, when government taxes profits, corporations report fewer profits and greater costs. When individuals face higher income taxes, they report less income, buy tax shelters and hide their money. It's not just rich people who try to avoid taxes, but all of us – liberals, conservatives and libertarians.

What's the evidence? Federal tax collections have been between 15 and 20 percent of the nation's Gross Domestic Product every year since 1960. However, between 1960 and today, the top marginal tax rate has varied between 91 percent and 35 percent. That means whether taxes are high or low, people make adjustments in their economic behavior so as to keep the government tax take at 15 to 20 percent of the GDP. Differences in tax rates have a far greater impact on economic growth than federal revenues.

So far as Congress' ability to prey on the rich, we must keep in mind that rich people didn't become rich by being stupid.

That’s why former UK Prime Minister Margaret Thatcher once said in a TV interview (which became a famous quote-bold highlights mine)

Socialist governments traditionally do make a financial mess. They always run out of other people's money. It's quite a characteristic of them. They then start to nationalise everything, and people just do not like more and more nationalisation, and they're now trying to control everything by other means. They're progressively reducing the choice available to ordinary people.

Political interests and ambitions masquerading as noble intentions eventually will get unraveled. In short, it’s all about economics—what is unsustainable economically won’t last.

So the next step will be for US politicians to go for budget plugging actions. All accrued these actions will impact financial markets and the US and global economy.

Much Ado Over Nothing On US Budget Cuts, Debt Ceiling Next

As we previously argued the brouhaha over US budget cuts signified nothing but symbolism.

From the Washington Post, (bold emphasis mine)

A new budget estimate released Wednesday shows that the spending bill negotiated between President Barack Obama and House Speaker John Boehner would produce less than 1 percent of the $38 billion in promised savings by the end of this budget year.

The Congressional Budget Office estimate shows that compared with current spending rates the spending bill due for a House vote Thursday would cut federal outlays from non-war accounts by just $352 million through Sept. 30. About $8 billion in immediate cuts to domestic programs and foreign aid are offset by nearly equal increases in defense spending.

When war funding is factored in the legislation would actually increase total federal outlays by $3.3 billion relative to current levels.

To a fair degree, the lack of immediate budget-cutting punch is because the budget year is more than half over and that cuts in new spending authority typically are slow to register on deficit tallies. And Republicans promise that when fully implemented and repeated year after year, the cuts in the measure would reduce the deficit by $315 billion over the coming decade.

So instead of cuts, we have budget increases. And prospective cuts only apply to projected spending which are decades away.

As Lew Rockwell writes, (bold emphasis mine)

In other words, this is all political play, which is obvious from the numbers and the norms. In the first place, no one is talking about actual cuts, not even the supposedly radical Republicans. These are cuts in projected spending, meaning that everyone is dealing with symbolic changes in a future that is just as symbolic. Even on paper, the only way to consider these cuts is to compare them with the GDP and the national debt -- both of which are slated to rise. Forgetting those two metrics, and looking at the actual numbers, there are no cuts at all and only increases.

Even the dating of the Republican’s balanced budget is ridiculous. So the budget will be fully balanced in 2040? That’s three decades from now. Few of the people in office will still be in office, and many will be dead. To see how viable this is, consider how many political plans of the year 1982 still survive today.

The Republican plan proposes domestic cuts in these gargantuan programs like Social Security and Medicare with nothing specific beyond the old prattle about establishing bi-partisan commissions and sending block grants to the states. There is nothing specific here beyond a numbers-laden pipe dream. No programs are abolished, no benefits are slashed or even trimmed, and although the propagandists claim to attack the culture of spending in Washington, there is not one word about taking on the money-printing machine that made the $14 trillion national debt possible in the first place.

This brings back my earlier observation where...

Stripping away control and spending other people’s money is so addictive that politicians can’t seem to do away with it and would fight heaven and hell to avoid it.

And so it has been.

The next step will be a vote FOR raising the debt ceiling.

Prediction Market Intrade suggests that the odds for raising the debt ceiling by June 2011 seem to be at 75% as of the moment.

The usual, government authorities will raise the spectre of fear of a prospective mayhem (bogeyman) to justify the actions of politicians.

From Marketwatch.com (bold highlights mine)

Treasury Secretary Timothy Geithner on Thursday said Congress will act to raise the debt ceiling because they realize the consequences for not doing so. "We're only two years from a cataclysmic financial crisis, and the huge damage to credibility and huge loss of confidence," he said before a Bertelsmann Foundation conference. "The idea that Washington would court that risk is inconceivable." Publicly and privately, Congressional Republicans have indicated they understand the implications of not raising the debt ceiling, Geithner said. Geithner added that markets have confidence that Congress will cut deficits. "The world basically believes that problems are manageable, and the system will solve it," he said

Could Mr. Geithner be utilizing the power of suggestion or is he conditioning the public?

This reminds me of General Douglas MacArthur who once said,

Our government has kept us in a perpetual state of fear -kept us in a continuous stampede of patriotic fervour -with the cry of grave national emergency. Always, there has been some terrible evil at home, or some monstrous foreign power that was going to gobble us up if we did not blindly rally behind it.

Of course, a further move will be by the US Federal Reserve who will bring forth QE 3.0 by the latter half of 2011.

Politicians (everywhere) and bureaucrats are nearly cut from the same cloth.

So far, everything seem to jibe.

Reason TV on Obamacare: 3 Reasons Healthcare Legislation Won't Reduce The Deficit

From Reason TV.

Federal Bailout For US States In 2010?

In spite the seemingly sanguine outlook radiated by the key markets, which appears to be reflected on many economic indicators as to signify a 'recovery', fiscal conditions of US states continue to languish.

That's because the profligate spending during the boom days haven't not been filled by falling tax revenues amidst the recent recession until the present. And this has resulted to huge budget deficits for US states.

The chart below by Casey Research shows of the dramatic fall of State revenues over the last 12 months.


According to Casey's Bud Conrad, ``The important point is that the revenues are still in decline, indicating that we are not yet out of the recession."

State fiscal conditions are lagging indicators.

Nevertheless last year's collapse in State revenues, which appears to have bottomed, still reflects on the fragile state of the US economy.

Moreover, the enormous deficits will likely entail a drastic austerity (cut in social services and bureaucratic personnel) or raise taxes or entreat for a Federal bailout in 2010 or a combination of these measures.


The Center on Budget and Policy expects budget shortfalls for the 48 States at an estimated $193 billion for 2010 and $180 billion for 2011, or some $350 billion for the next two years.

Possibly compounded by the deficits haunting the US public pension system and the still struggling real estate industry whose next wave of resets [see 5 Reasons Why The Recent Market Slump Is Not What Mainstream Expects],may further place additional strains on the crisis affected States, the Federal government may likely to opt for a bailout route.

And in accord with Minyanville's Todd Harrison who recently wrote,

``States across the union -- particularly those that benefited from the housing bubble and the taxable income associated with it -- are now experiencing a massive reversal of those golden years. The decline is so swift that it will take several years for the real estate reset to flush its way through municipal budgets.Additionally, The US public pension system -- one of our 2009 themes -- faces a higher-than-expected shortfall of $2 trillion that will increase pressure on strained finances and further crimp economic growth, according to the chairman of New Jersey’s pension fund, as quoted in the Financial Times.

``This evolution should lead to a comprehensive Federal bailout package in 2010. TARP money returned to the government will likely be funneled back to the states, including but not limited to Arizona, California, and New York, as taxpayers shoulder the load and bear the burden of our outsized societal largesse."

Finally, while authorities appear to be engaged in a rhetorical deliberation towards a transition to an "exit" mode, where administrative (but political) therapy is supposed to pave way for organic growth dynamics, it is my view that 2010 will continue with policy accommodations (a euphemism for inflationism).

Nonetheless the string of prospective interventions will also likely put pressure on US savings, as shown in the chart below from Bloomberg's chart of the day...


...where government expenditures have more than offset accrued savings from individuals and corporations.

To quote the Bloomberg article,

``The savings shortfall widened to negative 2.3 percent in the first three quarters of last year from negative 0.2 percent in all of 2008. Before 2008, there hadn’t been a full-year drop since 1934, the last year of a four-year period when rates were below zero.

``Deficit spending by the federal government reduced net savings at an annual rate of $1.33 trillion during last year’s third quarter. State and local government deficits widened the gap by another $14.9 billion. At the same time, personal and corporate savings increased by a record $983 billion."

The grand question is who gets to finance this shortfall? The answer of which is likely to determine the fate of the markets for 2010.

The Growing Dependence On US Government’s Inflationary Mechanism

``Inflation, in brief, essentially involves a redistribution of real incomes. Those who benefit by it do so, and must do so, at the expense of others. The total losses through inflation offset the total gains. This creates class or group divisions, in which the victims resent the profiteers from inflation, and in which even the moderate gainers from inflation envy the bigger gainers. There is general recognition that the new distribution of income and wealth that goes on during an inflation is not the result of merit, effort, or productiveness, but of luck, speculation, or political favoritism. It was in the tremendous German inflation of 1923 that the seeds of Nazism were sown.”-Henry Hazlitt, What You Should Know About Inflation p.130

Despite signs of recovery in the US stockmarket which most have imputed as “green shoots” of economic recovery, the immense inflationary policies, the unwinding of huge short positions, adjustments in accounting standards to accommodate financial statements of the banking sector, huge oversold levels, the PTSD effects and ‘positive’ earnings from the financial sector have all been significant factors which may have contributed to the recent rally.

Nonetheless here’s the message we’d like to repeat: inflation is a political and not a market process. When governments chooses the winners over the rest, through subsidies, loans, guarantees, bailouts, transfers, market maker or buyer of last resort or through fiscal spending-these are actions decided not by the marketplace but by the political authority. Price inflation as manifested in the markets or in consumer prices signifies as symptoms or the consequences emanating from the accrued policies of the past.

Today’s inflationary process has been driven by the promulgated desire by the global political authorities to cushion or jumpstart markets or economies from the recent crisis based on the economic ideology that governments can substitute for markets during “market failures”. In their ideology, it is assumed that markets always needs to go forward and should never falter- a misplaced perception of capitalism which is actually a profit and loss system.

The political process to inflate the market is seen as the only antidote against the market process, which had been recoiling based on natural economic laws against systemic over indebtedness or overleverage, overvaluation and a system built on excess capacity which produced supply surpluses against an artificially constructed debt inflated demand.

The most recent global collapse in the markets and economies simply reflected the natural state of markets which overwhelmed the untenable imbalances accreted in the system.

Yet by government’s opting to duke it out with market forces works to only delay and worsen the impact on the day of reckoning. Even more so are the policies which have been aimed to perpetuate the same unsustainable paradigm which had been at the root of the crisis.

We never seem to learn that the more imbalances built into the system, the bigger the impact of the next crisis.

And while inflationary policies appear to be gaining traction, which has managed to juice up the activities in marketplace or parts of the US and global economy over the interim, the ongoing market driven deflationary forces will most likely result to outsized volatility, especially in areas plagued by the recent bubble bust.

So those aspiring for “market timing” won’t likely get the same expected conventional patterns because the operational structure of the marketplace has been unprecedented in terms of the scale of government intervention and unparalleled in the scope of massive inflationary measures applied.

The same global inflationary process has apparently been manifesting its presence in the equity and commodity markets.

And that’s why most of the mainstream analysts have apparently been perplexed by the present developments, as economic figures and market signals have been in a deep disconnect. For the bulls, present market actions seem reflexive, they read today’s signals as signs of recovery, for the bears, market actions signify as overreaction and rightly the effects of manipulation. For us, today’s market action has been anticipated and represents as principally a function of inflationary dynamics.

Diminishing Federalism And The Emergence Of Centralized Government

Nonetheless, we expect that global governments to continue to use their “limitless” power to churn money from their printing presses to counter the adverse reactions from market forces.

The financing of US states could be an example why inflationary policies will persist. Presently, revenues in 45 out 47 states in the US have been sharply falling as shown in Figure 2.

Figure 2: Rockefeller Institute: Across The Board Slump in Taxes

And falling revenues against present level of expenditures implies of huge state budget deficits, this also translates to rising risks of state bankruptcies, if not the loss of the autonomous “federalist powers” from a deepening trend of dependency on Washington.

According to the USA Today, ``In a historic first, Uncle Sam has supplanted sales, property and income taxes as the biggest source of revenue for state and local governments.

``The shift shows how deeply the recession is cutting. Federal stimulus money aimed at reviving the economy and a sharp drop in tax collections have altered, at least temporarily, the traditional balance of how states, cities, counties and schools pay for their operations…

``Federal grants — early stimulus money plus conventional federal aid — soared 15% in the first quarter to a seasonally adjusted annual rate of $437 billion, eclipsing sales taxes, which fell 2%.”

Incidentally, California will hold a “special election” or plebiscite aimed at addressing the largest ever state budget gap next week (May 19^th). The electorate will vote on several proposed measures as raising taxes, paring down several social service programs, selling state landmarks and laying off some state workers. However, polls suggest that Californians will likely to vote down on the proposed measures which could translate to a credit rating downgrade or higher costs of financing.

Given the high chances of voter’s disapproval, the state of California will possibly have a harder time borrowing, which means that the odds for a bailout from the Federal Government loom larger, otherwise a state bankruptcy .

California could be a precedent for other states. And state bailouts by the US Federal government should translate to expanded deficits which will likely be met with more money printing, especially if the borrowing window shrinks (Financial Times). Yet if we look for signs from the recent actions in the auction market of US Treasury bonds, then government borrowing does not seem like a promising option.

So aside from inflationary costs, the other costs from state dependency on Washington, according to Conn Connell of the Heritage Foundation (bold emphasis mine) are, ``The costs of the loss of federalism to the American people are real. As Reagan outlined above federal aid to states blurs the lines of government accountability, making it easy for politicians to sneak in government-growing legislation and hard for voters to hold those politicians accountable. Moreover, as states become more dependent on federal funding, they begin to lose their ability to set priorities and make policy decisions that are best-suited to their specific needs. Finally, sending money to Washington, only so that it can later come back to the states, creates a fiscal detour of inefficiency and inequity.”

The point is: The Federalist structure of the US government appears to be evolving into a centralized platform gravitating around Washington, which has been using deficit financing as the primary instrument to shore up or consolidate power.

Entitlement Imbalances + Deficits From Present Crisis = Risk Of New Crisis

We may further add that recent developments have point to the imminence of the possible entitlement crisis encompassing the welfare programs of the US Social Security and Medicare as discussed in US Presidential Elections: The Realisms of Proposed “Changes”, see figure 3.

Figure 3: Heritage Foundation: Entitlement Crisis Dwarfs Current Spending

According to a report from Bloomberg (emphasis added), ``Spending on Medicare, the health insurance plan for the elderly, will reach a legal limit by 2014, the same year predicted in 2008, the trustees’ report said. It’s the third year in a row that Medicare’s trustees have pulled the so-called trigger, a law mandating that the president introduce legislation the following year to protect the program’s financing.

``The trustees’ annual report also estimated that Medicare’s hospital fund will be exhausted by 2017, two years earlier than predicted a year ago. The trust fund will need an additional $13.4 trillion to meet all its obligations over the next 75 years…

``Spending on Social Security is expected to exceed revenues in 2016, one year earlier than last year’s forecast, the report said. The trust fund will need an additional $5.3 trillion over the next 75 years to meet all scheduled benefits, the trustees said. The retirement-assistance program can continue to pay full benefits for about 30 years, the report said.”

In short, growing payments to beneficiaries are likely to be unmatched by revenue collections which should lead to expanded deficits. Again according to the same Bloomberg article,`` The government retirement system faces a cash shortfall because the number of retirees eligible for benefits will almost double to 79.5 million in 2045 from 40.5 million this year. By 2045, there will be 2.1 workers paying into the system for every retiree, compared with 3.2 workers this year.”

This implies another major source of pressure to raise financing.

Author and former Treasury Department economist Bruce Barlett in Forbes recently posited that the US may require taxes to rise by some 81% just to meet these coming budgetary shortfalls.

And considering the degree of deficit financing arising from today’s crisis, which if present programs don’t succeed to rekindle an immediate return to growth “normalcy” for the US economy, and combined with the growing risks of the entitlement crisis, all these could translate to a jarring future for Americans-the risks may not be one of deflation but one of bankruptcy or at worst hyperinflation.

On the same plane, the former comptroller general of the US David Walker recently warned at the Financial Times of a prospective downgrade of America’s AAA credit rating should current trends persist.

Hence it seems to be much ignored by the mainstream or by policymakers how the structure of the US political economy has been evolving to apparently increase dependence on the US government’s inflationary mechanism to support the status quo, as currently depicted by evidences of the diminishing Federalism and from the huge intractable welfare programs which looks increasingly like a Ponzi financing model.

As famed economist Herb Stein once said ``If something cannot go on forever, it will stop.”

A Policy Of Bailouts Will Increase Their Number

Former President of Federal Reserve Bank of St. Louis, William Poole once accurately observed that ``Everyone knows that a policy of bailouts will increase their number.”

And the addiction to bailouts seem to be snowballing at a very rapid clip.

Following yesterday's passage of the $838 billion stimulus package in the US Senate, the US government through its Treasury Secretary Timothy Geithner announced a far bigger rescue package and "envisions a far greater government role in markets and banks than at any time since the 1930s", reports the New York Times.

And the rescue plan translates to commitment of as much as $2.5 trillion!

Again from the New York Times, ``Administration officials committed to flood the financial system with as much as $2.5 trillion — $350 billion of that coming from the bailout fund and the rest from private investors and the Federal Reserve, making use of its ability to print money."

The $2.5 trillion Geithner plan...

Bloomberg quotes Treasury Secretary Geithner, “Instead of catalyzing recovery, the financial system is working against recovery, at the same time, the recession is putting greater pressure on banks. This is a dangerous dynamic, and we need to arrest it....I want to be candid: this strategy will cost money, involve risk, and take time."

Obviously, the US government's approach in resolving the unsustainable debt problem is to do the same, pile on more debts.

So far, the US government commitments have reached nearly $8.8 trillion and spent $2 trillion according to the New York Times and the Geithner plan and the latest stimulus package should add to this.

Nonetheless all of these government spending will translate to exploding fiscal/budget deficits which the Casey Research team estimates to reach nearly $3 trillion (Investor's Business Daily)

But with bank related losses nearly at $ 6 trillion, according to Robert Reich (RGE Global), ``Goldman Sachs -- not one to exaggerate the overall problem -- recently estimated the total value of troubled U.S. bank assets to be $5.7 trillion", we can expect even MORE taxpayer exposure in the future.

And Prudent Bear's Doug Noland has nailed it in his article (bold highlights mine) , ``The Government Finance Bubble is being called upon to reflate with little assistance from private Credit, while at the same time it is faced with a Deeply Maladjusted Economic Structure still overly dependent upon inflationary Credit expansion. Throwing mega-Trillions at our distorted economy is just asking for trouble.

``It is in this context that I fear that the Trillions of Government Finance spent to save the world from “deflation” will, in the end, require perpetual needs for Trillions more. There will be no kick-starting asset Bubbles or a return of private-sector Credit excess. Instead, it will be a case of throwing repeated doses of government-directed finance/purchasing power at the system. Temporary but fleeting economic boosts will then require only stronger doses of artificial stimulus.

``We’ve commenced a new cycle dominated by government electronic printing presses in all their various forms. The inflationary consequences will be a different variety than we’ve grown accustomed to from previous reflations. But the bottom line is – and there’s ample history to support this view – that once the “printing presses” get humming along it’s going to be darn difficult to slow them down."

Overall, a policy of inflation begets more inflation.

And that's where we are likely headed for. But don't count on a benign outcome.

Sovereign Debt The New Ponzi Finance?

``I have no sympathy for Madoff. But the fact is his alleged Ponzi scheme was only slightly more outrageous than the 'legal' scheme that Wall Street was running, fueled by cheap credit, low standards and high greed. What do you call giving a worker who makes only $14,000 a year a nothing-down and nothing-to-pay-for-two-years mortgage to buy a $750,000 home, and then bundling that mortgage with 100 others into bonds, which Moody's or Standard & Poor's rate AAA, and then selling them to banks and pension funds the world over? That is what our financial industry was doing. If that isn't a pyramid scheme, what is?" Thomas Friedman, The Great Unraveling

As we have earlier exhorted, navigating the rough waters of 2009 markets will be challenging. It is because conventional analysis would have to be sidelined in exchange for the reading of political actions into the pricing system of the marketplace. The traditional scrutiny of earnings and GDP growth will have to pave way for the fundamentally altering risk reward environment motions of political preferences and the unforeseen reactions that such directives may engender.

As PIMCO’s Mohamed El-Erian recently wrote, ``Where does this leave investors? As my colleague Paul McCulley likes to say, only a thin line separates courage from stupidity. Investors should position their portfolios predominantly under the umbrella of government support rather than outside it; they should follow government actions rather than pre-empt them; and they should focus primarily on the senior parts of the capital structure.”

For starters, we understand that governments around the world will jointly be conducting monetary and fiscal programs to arrest the destructive impact of debt deflation and its aftermath. For instance in terms of fiscal measures, some of the reported expenditures earmarked for stimulus programs are (IIF.com): Japan $105 billion or 2% of GDP, European Union $254 billion (1.5% of GDP), Australia $7.4 billion (1% of GDP), China $586 billion (8.9% of GDP), India $4 billion (1.5% of GDP), South Korea $11.3 billion (1.1% of GDP), Chile $2 billion or (1.5% of GDP) and Mexico $5.8 bullion (.8% of GDP). Overall an estimated $3 trillion could be sourced from the markets this year three times that of 2008 (Financial Times).

Yet despite these immense allocations from the fiscal side, yield spreads in benchmark sovereigns of most OECD economies have been dramatically falling to reflect a “flight to safety” (see figure 1).

Figure 1: IIF.com: 10 Year Bonds

And this is not just reflected in nominal yields but likewise in real yields (or inflation adjusted). This means that based on market price signals from today’s bond market, interest rates of major economies are expected to remain low despite the proposed surge of issuance of government bank debt instruments.

To consider, bond yields play a very significant role in the economy as they signify ``an important transmission mechanism through which an easing in monetary policy affects the broader economy” to quote the Institute of International Finance (IIF), the world’s only global association of international financial institutions with some 375 members in 70 countries. Big segments of consumer credit are being benchmarked to these instruments. As the IIF further points out, `As low rates permeate down the yield curve, so they help support activity affected by longer-term rates”. For example, the US mortgage market used to be highly correlated or had been benchmarked from the 10 year bond yields until the emergence of this crisis.

While it is true that today’s bond market “flight to safety” boom favors government’s activities of providing cheaply funded fiscal programs, it is unlikely that the prevailing conditions could be sustained over the long term. As a caveat since we are not in the business of market timing, booms can last until it can’t.

Why? As we have previously stated, the fundamental problem is one of debt overload. Most of the major economies have absorbed far too much debt more than it can afford to sustain. And the subsequent debt deflation preceding the inflationary boom comes with the feedback loop dynamics of regressing and shriveling collateral values, funding or liquidity constraints and a paucity of capital.

With over $30 trillion of stock market capitalization vaporized in 2008, additional enormous losses in other markets (see 2008 Trivia: Lobby, Bailouts and Losses) and most importantly, losses in the financial institutions have now tallied over $1 trillion see figure 2.

Figure 2: IIF: Losses and Capital Raised

According to IIF (bold highlight mine), ``Reported and potential losses have put pressure on bank capital, despite the fact that banks and other financial institutions have raised $930 billion of capital, more than a third of which represents government’s stakes. As a defensive response, banks have conserved their capital and liquidity to be in a position to absorb potential losses, thus reinforcing counterparty risk aversion in drying up interbank transactions. Investors have also pushed banks to raise their capital, not only as measured by their Tier 1 ratio but also the equity/asset ratio. Essentially, until asset markets settle down so that investors can form a clear assessment of potential losses, more capital injection including by governments will not be sufficient to stabilize the banking system.”

As noted by IIF, the mounting losses in asset values as reflected in the financial system losses will likely impel the industry to remain on the defensive by trying to remediate balance sheet impairments than to provide “normalized” business activities or rekindling risk activities. This essentially relegates the burden of providing support of collateral asset values, liquidity constraints and capital provision to the government which ironically depends on taxpayers, or borrowing capacity or the printing press. As clearly manifested in figure 2, the US government have substantially been replacing the private sector as purveyors of such capital.

Yet, in a recessionary environment, which technically means decreasing economic output but factually translates to the market clearing of malinvestments caused by previous inflationary policies, surviving private businesses will likely be safeguarding assets and also be conservative or scrimp on expansion plans while households will likely exercise austerity. Thus, the ability to save should essentially reflect the ability to refinance or reinvest.

But governments aren’t interested about savings. In fact governments are afraid of savings or the so-called misguided popular Keynesian concept of the “paradox of savings” or “paradox of thrift”. What is good for the individual is extrapolated to be bad for the economy, as we discussed in Consumer Deflation: The New Fashion. A weakening economy is always projected on the prism of the slackening of demand which necessitates government’s role to assimilate on such shortcomings. Thus, governments everywhere expect to takeover the role of “inflating” their national economy billed to the taxpayers of the next generation. It is a concept which relies on the principle of SOMETHING for NOTHING based on the virtue of consumption over production. (Why do you think central banks are adopting Zero Interest Rate-ZIRP regimes?)

Proof? From the incoming President Obama [CNNMoney], ``What's required for the economy right now [is] to put more money into the pockets of ordinary Americans who are more insecure about their jobs, who are continuing to see rising costs in an area like health care, who are struggling to make ends meet." Where does one source funding “to put money into the pockets of the masses”?

But if history should serve as guide, the performance of a command driven economy almost always underperforms and produces more dependence on inflationary actions which exacerbates the entire vicious process of inflation-deflation (boom-bust), market-socialism cycles.

As Ludwig von Mises presciently wrote (bold emphasis mine), ``“The boom produces impoverishment. But still more disastrous are its moral ravages. It makes people despondent and dispirited. The more optimistic they were under the illusory prosperity of the boom, the greater is their despair and their feeling of frustration. The individual is always ready to ascribe his good luck to his own efficiency and to take it as a well-deserved reward for his talent, application, and probity. But reverses of fortune he always charges to other people, and most of all to the absurdity of social and political institutions. He does not blame the authorities for having fostered the boom. He reviles them for the inevitable collapse. In the opinion of the public, more inflation and more credit expansion are the only remedy against the evils which inflation and credit expansion have brought about.”

This is unfortunately true today. As for our politicians and their lackeys, this addiction to spend using taxpayer’s resources, which is construed as an inexhaustible pool, is unsustainable. But like the recent real estate boom bust conditions, unsustainable [boom] trends can’t last, as the popular Herb Stein quote goes, ``If something cannot go on forever it will stop.”

Predicated on the surge of government rescue programs, the IIF views the onrush of government issuance and today’s market pricing as brewing pressure of destabilizing imbalances (bold highlight mine), `` It is hard to reconcile this bond market pricing with economic policies (both monetary and fiscal) designed to stimulate recovery. The inference, of course, is that G10 bond markets have become distorted by extreme conditions under which end investors and financial institutions are desperate for the apparent security offered by government bonds. As a result something of a bubble has developed in these debt markets. The problem with this flight to “quality”, however, is that G10 government bond yields are thus liable to upward correction at some point, either because of credit or inflation concerns (or a bit of both). This implies considerable downside price risk, which could be a new source of financial sector volatility at some point in the future.”

Nonetheless, the basic problem lies squarely with the patent building up of the mismatches between the supply side-availability and accessibility of capital-with the government’s demand for it.

Hence, if global economies recover and risk appetite regains ample groundswell then the safehaven pricing for treasuries will severely be reversed, as money flows will be redirected towards risk assets.

On the other hand, if the leverage absorbed and produced by the governments can’t be sustained or paid for by the revenues generated by the economy or its lack of ability to pay gets reinforced, then the sovereign risks of a credit default could become a reality.

This reminds us of Mr. William Gross’ outlook who recently discoursed about some of the intrinsic Ponzi structures in the US economy, `` Municipalities with begging bowls now extended for over a trillion of Federal taxpayer dollars, based their budgets and their own handouts on the perpetual rise in home prices, the inevitable upward slope of sales taxes, and the never-ending increase in employment and personal income taxes. To add injury to insult, they conveniently “balanced” their books with a host of accounting tricks that Bernie Madoff could never have come up with in his wildest imagination. Now, with cash flow insufficient to meet current outflows, they are proving my point that we have met Mr. Ponzi and he is us – all of us: auto companies that siphoned sales dollars to make labor peace instead of research and design expenditures; hedge funds that preposterously billed investors for 2% and 20% of nothing; a President and politicians who thought they could fight a phony war for free and distract the nation’s attention from $40 trillion of future social security and health care liabilities. Ponzi, Ponzi, Ponzi.”

Yes, sovereign debt has now assumed the new role of Hyman Minsky’s Ponzi financing.

Fundamentals of Credit Default Risks

So the credit default risks from sovereign debt emanates primarily from the debt issuance far outnumbering the pool of available capital, especially in a world where external trade has been shrinking and collateral has been losing value.

Another, any signs of the reemergence of inflation or of a global economic recovery may result to a stampede out of a one sided trade.

Furthermore, government debt will be competing with the private sector debt on a global scale for funding or capital raising, which is likely to lead to a “crowding out” effect. The crowding out effect as defined by wikipedia.org is ``when the government expands its borrowing to finance increased expenditure, or cuts taxes (i.e. is engaged in deficit spending), crowding out private sector investment by way of higher interest rates.”

Of course, the “crowding out” phenomenon will only happen once the mechanism of the present global flow of funds diminishes. (We don’t believe that it will reverse because under a US dollar standard system, deficits are the inherent characteristic of the currency reserve economy.) Yet such phenomenon will likely occur as a result of governments working to strengthen their domestic economies, by utilizing their savings and or forex surpluses at home than by undertaking the previous global “vendor financing scheme”.

The crowding out effect, which gives priority to domestic government consumption than to private investment, therefore stifles economic growth. Therefore a world which engages in “nationalist” oriented policies would likely see repressed economic growth.

In addition, if the US Federal Reserve makes good of its threats to close the arbitrage gaps along the yield curve of US treasuries, by manipulating (buying) the long end, which is meant to reduce the incentives for the US banks to hold reserves and compel them to normalize operations (as we discussed in 2009: The Year of Surprises?), then such actions could possibly function as a window for the forex surplus rich major trading partners to “gracefully” exit US treasuries, while at the same time massively expand the balance sheet of the US Federal Reserve (possibly beyond the capacity for its citizenry to finance) and or serve as the bubble “blow-off” which could reintroduce substantial volatility back into the financial markets.

Remember, any drastic upsurge in the interest rates, as indicated by the activities in the US treasuries, will only serve to undo any incremental gains accrued from the recent activities.

Moreover, given the ginormous leverage built into the financial system, a sudden increase in US interest rates will mean higher cost of financing for the US government or for those institutions and virtually the economy on a lifeline which could further undermine its economic recovery path.

As we have earlier said, 2009 could likely be an exciting year, simply because government policy actions risks creating an environment where financial and economic conditions could swing from one extreme end to the other.

Philippines Secures Funding Requirements; Return Of The Bond Vigilantes?

At the onset of 2009, so far there have been a few signs of troubles evident in the global bond markets.

If there is anything paramount, I should salute or commend the Philippine Central Bank, the Bangko Sentral ng Pilipinas (BSP), for their intrepid and swift actions as the “first mover” in tapping of the debt markets in the region, amidst a jittery backdrop.

You probably have read how the Philippines secured $1.5 billion in what was to be a remarkable FOUR times oversubscribed issuance (Businessworld) under a highly apprehensive atmosphere.

This comes even as the government’s budget deficit has reportedly increased to Php 102 billion from Php 75 billion which incorporates the Php 300 billion stimulus package (AFP). While a foreign institution have made a call to sell the Peso based on perils of “exploding” fiscal position, our view is that currency valuations are always relative, if paired with the conventional US dollar, fiscal cost of the latter will likely balloon more than the Philippines.

Anyway, the Philippines haven’t reportedly overpaid, in terms of high interest rates, in enticing investors though.

Besides, analyzing the buying composition of the deal gives us some clues of the potential flow of funds or source of future investments for Philippine assets.

According to the Finance Asia (bold emphasis mine),

``The 10-year bonds were priced at 99.158, which gives investors a yield of 8.5% – equivalent to a spread of 599.9bp over US Treasuries and 20bp over the implied 10-year curve. Investors paid a very tight new-issue concession of just 23-24bp, which compares very favourably with similarly sized 10-year offers by Brazil and Colombia on Tuesday, and a $2 billion 10-year offer by Mexico in December, all of which paid premiums of between 40bp and 50bp.

``This is partly explained by the strong Asian sponsorship of Philippine deals – 41% of the issue was picked up by regional investors, with 38% going to the US and 21% to Europe – because many of the region's investors are not heavily influenced by the premiums paid in international markets…

``In total, the lead banks – Credit Suisse, Deutsche Bank and HSBC – took $5.8 billion of orders from 281 investors. Funds dominated demand for the bonds, accounting for 58% of the orders, followed by: banks (20%); pension funds, insurers and government institutions (16%); and retail and corporates (6%).”

As you can see aside from the remarkable huge bid-to-cover spreads albeit slower than last year (Finance Asia), Asian buyers which may have comprised of regional financial institutions had been the primary buyers, although a significant chunk of the regional demand could have also been rooted from local institutions.

The point is Philippine bond deal may have reflected some improvement in investor’s sentiment, as we have seen positive uptake of emerging market issuance in Turkey for $1 billion, Brazil for $1 billion and Colombia for $1 billion (Financial Times) or even in France and Spain for a combined € 11.4 billion (guardian) or Austria € 3 billion and Ireland € 6 billion (Financial Times), this despite the seeming outlier or the poorly supported German bond auction which initially targeted € 6 billion but received only 87% bid for an issuance of € 5.24 billion (Financial Times). Incidentally, the dismal result of the German bond offering came almost a day ahead of the Philippine tender, which has shown little influence to the deal’s outcome.

Besides, despite the highly anxious global financial market conditions, the success of the Philippine bond deal could have indicated of the improving liquidity conditions in the region or locally, aside from the surprisingly strong appetite for its securities from the financially and economically besieged Anglo Saxon economies.

As for the demand from Western markets, perhaps the closing of year end related tax portfolio rebalancing (see Phisix: The Fantasy Of The 2008 "Window Dressing" Year End Rally) could have likewise enhanced the reception of Philippine bonds.

Additional interesting insights from the recent offerings:

One, the yields were significantly higher than the previous, for the Philippines 6.5% in January 2008 while 8.5% for last week. Austria and Ireland were likewise “forced to pay higher yields than existing bonds to issue debt”. This gives credence to our belief that funding cost will climb over time, especially as governments actualize their purported programs.

Finally, while the drab results of the German bond auction could be construed as a market anomaly, on the obverse side, it could likewise signal an incipient crack in the bond auction markets as ‘bond vigilantes’ stage a reawakening.

Bond vigilantes, by the way, are fixed income investors who, according to the illustrious Forbes analyst James Grant, “took a pledge: Never again would they be the dupes of a central bank. They would henceforth sell at the first sign of inflation.”

Thus, the latest offering secures the Philippines and the other early birds, who availed of the seemingly improved market sentiment and conditions, the trouble of a probable “buyers strike” or the return of the bond vigilantes possibly anytime within the year.