Thursday, July 14, 2011

More on the Budget Battles

According to several press reports, last night's budget meeting between the President and House Republicans ended on a sour note.

Here's the report from Ezra Klein in today's Washington Post's blog Wonkbook:

House Majority Leader Eric Cantor launched into a stemwinder before the teams had even had time to look at the options papers the staffs had developed. On three separate occasions, Cantor pushed for the sort of short-term increase the administration has explicitly ruled out. Cantor's final effort to push the new plan came as the meeting was breaking up and the president was giving instruction to staff on how to prepare for the next set of talks. "Eric, don't call my bluff," the president said. "I'm going to the American people on this." Then, as the story goes, he walked out.

As I wrote yesterday, I continue to be more optimistic than many of my clients that all of this will be resolved in short order. Still, the more acrimonious the debate becomes, the more worrisome the situation becomes.

Much of the debate seems to center around political calculations, and how any resolution will play to the constituents back home.

Problem is, we tend to forget that a huge amount of our debt is held by foreign creditors, who really don't care about American politics: They just want their money to be safe.

The Chinese, for example, own at least $1 trillion of our debt obligations, and as the New York Times notes this morning, they are less than thrilled about the tempest in Washington:

"We hope that the U.S. government adopts responsible policies and measures to guarantee the interests of investors," ministry spokesman Hong Lei said at a regular news briefing in Beijing, when asked about the Moody's report.

He did not elaborate.

China, the United States' biggest creditor with more than $1 trillion in Treasury debt as of March, fears even a small default could destabilize the global economy and sour political relations.

Bill Gross, bond manager extraordinaire and head of the huge investment firm Pimco, wrote an editorial in today's Washington Post about the implications of a U.S. debt default from a bond investors perspective.

Besides the obvious tarnish that a refusal to meet our obligations would bring to our reputation, a credit default would also mean a serious increase in interest costs:

An actual default — or even the threat of one — might set off a chain reaction that would raise Treasury bond yields by 25 basis points (a quarter of a percentage point) or more, pushing up the cost of debt throughout American financial markets.... If an extra 25 basis points becomes the new benchmark, federal interest expenses might increase by $30 billion to $40 billion annually over the ensuing years as $1.5 trillion of new debt is issued each fiscal year...

Bond investors are a conservative lot. They earn only 1.6 percent on the average Treasury maturity these days, but they expect certainty on when, and whether, they will be repaid. Countries that keep them guessing or that are expected to default are punished severely, as reflected in 20 percent bond yields in Greece or even 5 to 6 percent in AA-rated Italy. Like it or not, James Carville, global investment managers have global choices these days, and a solvent Germany or Canada is just a wire transfer away for trillions of potential investment dollars looking for a safer haven.

Let's just hope that rationality reigns.