Back in 2001 the US Fed was considering the very real risk that the US government would be able to pay off their entire national debt. The government had been running a fiscal surplus for five years and was projected to continue with this to 2010. It was this which underpinned George W Bush’s (then recently elected) $1.3 trillion tax cut.
Why worry about paying off all the debt? Well, the Fed controls money supply by using dollars to buy the bonds which the US government issues to cover its debt. No debt, no bonds … and the Fed had to consider new ways of controlling money supply.
At the time then Fed Governor, Alan Greenspan, would rather that additional capital went to prepare the US economy for the pressure to be placed on it through obligations in Social Security and – especially – Medicare.
Squandering the Surplus
As events played out, shortly after the tax cuts were made permanent (for any given value of permanent) events changed dramatically. It turned out that the massive tax bonanza was as a result of short-term capital gains which were being unwound. The surplus turned into a hair-raising deficit overnight.
Bush’s tax cut did have another unintended consequence. The Fed lowered interest rates to counteract the sudden liquidity crunch that came from the tax shortfall (and stock exchange shrink). This made Americans feel richer. They bought property.
Banks had long packaged their debt into what are known as Collateralised Debt Obligations (CDOs). It works like this. If you know the chance of default is 1.5% then you can package a whole bunch of loans together (say $10 million in a single tranche) and sell it as a single package. Banks do this for a simple reason. By international banking law (updated to Basel II in 2008) banks may only carry a certain amount of debt relative to their total deposit base (this keeps them solvent in case of a bank run on their deposits, since they can’t call in their debts immediately). By packaging the debts and selling them, they then remove this debt from their books.
Companies would buy CDOs for some discount rate relative to the expected default (so, perhaps that $10 million tranche would be sold for $9.5 million). However, in case of default the buyer would lose both the capital and the interest in one go. If the risk had been calculated correctly, no problems. If the risk hadn’t been …
This resulted in a moral hazard situation. Since the banks weren’t carrying the actual risk, and the people buying the debt weren’t that familiar with risk profiles, the banks started lending to people who shouldn’t have a hope in hell of getting a loan. Those people (with no jobs, no assets, and no income) are known as the “sub-prime” borrowers.
These loans got packaged in amongst the rest. Because the loans are sold as solid packages, though, the standard risk of default continues but is astonishingly high on sub-prime loans over and above the predicted rate of failure. Companies took out very elaborate insurance on these risks in the form of derivatives and hedges.
Losing the Plot
All of this clever financial packaging had the effect of immeasurably complicating debts until no-one was really sure who had what, or what the impact would be. Hence the slow and erratic declaration of write-downs all across the world that significantly exceed the real value of sub-prime losses (some 1.5% of all home loans issued).
The more amusing thing (for those who find humour in this) is that the hedge funds and insurance companies who bought these CDOs often took out loans from the other banks who were also selling CDOs in order to cover the debts. In other words, the debts never left the bank’s books.
So, this has resulted in a liquidity crunch (exactly what Basel II was supposed to prevent) and the rapid devaluation of US housing stock. All those unfulfilled loans are now not backing all the US dollars in circulation. Rapid devaluation of the US dollar has followed to soak up the excess money supply.
At the same time the US has not reformed either of Social Security or Medicare and fully 76 million people out of the total 150 million of the US employment base are due to retire over the next 10 years as the Baby Boomers hit 65. This will increase consumption while reducing production. Leading to inflation and tax collection shortages which would make Medicare even more unsustainable than it is now.
Dealing with the Morning After
Hence, hoping that the US economy is simply suffering from a bout of investor negativity is a somewhat optimistic given the overhead still to be dealt with.
Both inflation and the obligations facing Medicare are within the ambit of US government control. Neither the current democratic contenders for the presidency (Hillary Clinton or Barack Obama), nor John McCain, have given any indication that they take this seriously. In other words, worries are likely to continue over the medium term.
And, for the rest of the world, a shrinking dollar and recessionary America is continued cause for concern.
In the final analysis, what Americans may consider the lasting legacy of GWB’s administration won’t be the war in Iraq, but the lingering headache of the opportunity to reform Medicare lost for good.