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.

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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.

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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.

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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.

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“Countries like Estonia and Latvia were once desperate to get in,” said Alf Vanags, director of the Baltic International Center for Economic Policy Studies in Riga. “The euro is not looking so attractive now.”

Such were to words of Alf Vanags, the director of an obscure organization that comprises of him and 18 other members. Let me point out to international readers that in the Baltics, think tanks don’t have any say in public matters, they don’t every represent anyone but themselves. And more often than not, people don’t even know they exist. In any case, the (personal) opinion voiced by Mr. Vanags is far from the truth when it comes to Estonia. Estonia is very eager to join the eurozone. Being an Estonian, I would like to think that I know better than Mr. Vanags, who resides in Latvia.

Estonia and the eurozone

The eurozone is as attractive as ever for Estonia and there are no second thoughts (with the exception of a few populist politicians and a few communists such as Mr. Savisaar*). Why? Well, it’s because the Estonian national currency, the Estonian kroon has been linked the German Mark ever since its inception in 1992. According to the law, the exchange rate is one German Mark for 8 Estonian kroons. Germany is now using the euro, so the Estonian kroon is now linked to the euro at 15,64 kroons for one euro. The key point to understand here is that in Estonia, devaluation is a political decision de jure and de facto. Devaluation is a political decision de facto in most countries, but in Estonia, only the parliament can decide to devalue the kroon, making it a de jure political decision, which means that it cannot be done without serious political repercussions to follow. Political chaos is the last thing a country needs during a recession and politicians will surely do what it takes to avoid one. There is no reason for Estonia to put off joining the eurozone since our national currency isn’t floating anyway and there is nothing in it for us to devalue.

Moreover, it is important to understand that joining the eurozone is not an if question, it’s a when question. When Estonia joined the EU in 2004, we pledged to join the eurozone. We’ve even had to change the constitution to accommodate the euro. It is not only that we’ve given a promise to join the eurozone, we really do want it. The financial crisis has proved that foreign investors don’t trust the kroon as much as they do the euro, which is only natural. Against the backdrop of the crisis the imperative to join the common currency area has become even more pressing. We don’t have any childish illusions about the eurozone being a harbinger of great riches, but we realize that joining the eurozone means that we can cross perceived devaluation panics off the list of possible risks. Estonia has fulfilled every single criteria according to the central bank of Estonia and the Ministry of Finance.

The same might be said about Latvia, but they key point here is that Latvia hasn’t even fulfilled the Maastricht criteria, which it needs to do to join the eurozone. They might talk all they want, but there is not way they are going to join the eurozone any time soon. Even with Latvia being where it is right now, aiming to join the eurozone in the future is still a prudent goal to work toward. Being left out in the cold is not something Latvia wants.

“These governments have reason to fear that, like Athens, they will be caught in a vise: unable to pay for expensive social programs demanded by citizens while staying within the euro zone’s debt limits.”

Newsflash, Mr. Kramer, Estonia and Latvia are nothing like Greece. We don’t have elaborate social programs, in fact, we have the bare minimum that we’ve been able to provide for our citizens in the almost 20 years that we’ve been independent. We also don’t have a history of street riots. It would be advisable to study history before you start writing things you don’t know about. And unlike Greece, our sovereign debt is too small to cause a meltdown in big European banks.

“To keep a faltering country’s economy in line with the euro “is a tall and very unpleasant order,” Mr. Vanags said.”

I really don’t know who is the foolish one here, the journalist for not pointing out the obvious flaw in Mr. Vanags’ reasoning or Mr. Vanags for saying something so naive. Probably both. Here is what Mr. Kramer should’ve added: eurozone requirements aren’t something pulled out of thin air. The requirements are such that if any country were to follow these in the long run, it would do well. And that is precisely why the requirements are what they are – to ensure the stability of the eurozone.

How bad can one journalist get?

Mr. Wannabe Journalist tops the article off with another fallacy, a favorite of Western bankers who would like to see countries such as Latvia fail so they could cash in on their credit default swaps:

“Despite some negative effects, devaluations have helped many countries over the years, giving a lift to their economies by making foreign goods more expensive and domestic goods more attractive.”

I would really suggest reading a bit of history before making statements like that. Devaluation per se solves nothing unless the country whose currency is being devalued has either a huge manufacturing or a huge services sector that exports most of its production (Latvia doesn’t). It is a pity that journalists trust economists’ statements without actually making sure those statements are correct. The devaluation of Argentina, which is a favorite of journalists’, didn’t save Argentina. Argentina had pegged its currency and devaluation was just one part of the big overhaul that led to the stabilization of their economy. It didn’t save Argentina, but it was done to keep the central bank from bleeding out. Net exports played a boosting role during the first year of recovery, but what saved Argentina in the end was investments and personal consumption. In fact, after the first year of positive contribution to the GDP, net exports actually had a negative effect on Argentina’s GDP. And let me remind you that Argentina’s exports were mostly comprised (still are) of agricultural products, fuels and industrial products (something not found in large quantities in Latvia). Furthermore, Argentina had it easy because the rest of the world was not going through a recession, which meant strong demand for their exports. Devaluation is not a life saver. If it was, countries would be doing it all the time. For some odd reason devaluations are not that commonplace as mainstream media would suggest useful.

Before putting this issue to rest, let me just point out that this is not the only misinformed article written about Estonia, or the Baltics for that matter. I don’t want to spend my days looking for childish articles about the Baltics and ripping them to pieces, but I had to write one of these to point out the fact that not all information is of the same value. If you want correct information about the Baltics, turn to our experts and our statistical offices. They’re not magicians that play with numbers unlike the central planners of days gone by (there was once such a thing as the USSR and we were an unwilling part of it). For those that are interested in truly objective information, take a look at Swedbank’s financial statements. They’re one of the biggest banks in the Baltics and their results give a pretty good feel of the state of the economy in the three Baltic countries. Swedbank’s numbers are good for comparison too.

* Yes, dear fellow Estonians, I called him a communist. I call a spade a spade when I see it. Deal with it.

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Which brings us to today. As is evident, the dollar swaps did everything they were supposed to do. But now that they’re gone, there is a possibility that the dollar shortage will return. The dollar has been gathering momentum for quite some time. Those that look at charts had to have seen the massive divergence between the price action and most of the indicators (MACD is a good example) that first appeared in the spring. Now that the dollar is back in an uptrend with negative news from the Eurozone supporting it, we are looking at what could possibly be the second phase of the dollar shortage. It’s on the brink already and it only needs one little push.

Where could the push come from? A number of sources, really:

1. Higher interest rates
2. Negative news that would dismiss the validity of the recently published GDP gain of 5.7%
3. Second wave of home mortgage resets
4. Commercial real estate

Any one of these would have the effect of plunging asset prices. Given the huge amount of dollar claims amassed by the European and other non-US banks, it does not seem reasonable to assume that they have managed to sell those assets or hedge away their risk completely. The situation is quite a bit different from what it was in 2008, but there are a number of disturbing similarities. The Libor-OIS and TED spreads are both looking calm right now (this was not the case in 2008), but volatility is starting to pick up. Derivatives also pose a problem as there were $604 trillion worth of derivatives as of June 2009, according to the Bank for International Settlements. This is $79 trillion less compared to June 2008, but $57 more compared to December 2008.

If the dollar shortage were to return, equities as well as futures would get hammered just like they did in 2008. Some claim that gold is a safe haven during a liquidity crisis, but there is no proof to back up that claim*. During a liquidity crisis, all assets get sold. Even if gold and gold equities were to hold up for a while, they would be sold soon enough just because they could. Don’t be fooled into thinking that fully funded clients are different from those on margin – a plunging asset loses value regardless of leverage, some just get wiped out earlier than others.

*Gold is definitely a safe haven in the long term, but there is nothing to protect short term holders in case of a fire-sale.

Disclosure: Long physical gold and silver (long term)

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Moving On

The first thing you should do is start investigating what really happened. Pick up a few books and start reading. You might also want to add a couple of blogs to your reading list – there is plenty of free and reliable information on the internet, you just have to be a bit skeptical about what you read (if it doesn’t make sense of smells like a conspiracy, it probably is). If you already have a good overview of what happened the next step is to evaluate your own behavior and see if there is anything you could improve on the next time. Before the crisis I didn’t have the habit of saving money but a 15% fall in my home state’s GDP (I live in Estonia) and the bankruptcy of two media companies that paid me for content did plenty to change that . I now have a clear goal in mind – I want to grow my savings account to a minimum of three months’ expenses (the ideal would be a one year cash cushion). I don’t care that my savings account doesn’t yield much because I don’t want to risk my emergency funds. The bigger the potential reward, the bigger the risk.

Historical Averages

I remember buying stocks in October 2008, one of the worst times to be entering the stock market. I wasn’t too worried about my investment because I used money I could afford to lose, which is what one should be doing. Scared money will only bring you losses and misery over the long term. I bought the stock when it was trading around $25. When it fell to $5 in March 2009, I felt stupid. Really stupid. I knew it would rebound so I had no problem holding it. But I knew I had made a grave mistake. When buying stock in that company, I was so enthusiastic about it that I didn’t care about the broad market or the economy. I thought their products were positioned so good that there was no way they could suffer. Besides, the stock had already come off from its highs in the $70 range.

I should’ve kept the money and waited for a better opportunity. In hindsight I can see clearly that the dollar was in an uptrend (bad for US dollar denominated stocks) and the broad market was in terminal decline due to a credit crunch (due to the failure of Lehman). I eventually sold my stocks when it reached the $20 range.

When making an investment in any asset class, be it stocks, commodities or real estate, always check the historical averages and look at the trendlines. Estonia, much like the rest of the world experienced a spectacular real estate boom (without the option ARMs and RMBSs, luckily) and I always knew it was going to pop. I’m not saying I’m an expert, because that knowledge was largely based on the magazine cover indicator and the number of real estate shows on TV. But now I know how experts do it. The experts look at historical averages. There are many such as standard deviation plotted on a price chart, all the numerous housing affordability measures, population growth to asset price ratios, inflation adjusted prices etc. To top it off, it doesn’t hurt to buy a couple hundred bucks worth of books before buying a house. I’ve heard many people call in on the Financial Sense Newshour Q-lines saying that they avoided buying a house during the boom times and are now starting to look around for a bargain. Most people buy one house during their lifetime and it doesn’t really matter if you push the purchase forward a few years. They probably got at least 50% compared to the height of the boom.

Recession come and go but if we learn from our mistakes, we will most certainly benefit from them or, at the very least, we’ll be able to weather the storm the next time it hits. I’ve read about some great deals over the last year. People that are older than me and have more experience, who know the ins and outs of business cycles, picked up some great deals at bargain prices and are now selling at 100% or even 300% gains. They didn’t go along with the euphoria, held on to their money and bought assets when they were truly cheap, not just attractive.

In the end, we can’t do much to change the business cycle. They exist in every economic system so doing away with capitalism, as some have suggested, isn’t going to solve it. Swinging from one extreme to the other is a recurring theme in nature and since prices are a reflection of the collective action of all the market participants: private individuals, companies and organizations comprised of people; economies are bound to have booms and busts. The best we can do is adapt and prepare. Do a service to future you and start learning today. Future you will thank you for that.

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