davidbau.com

Capital Elephant

Isn't it clear that the current financial crisis is a consequence of our national debt?

The huge, one trillion dollar pile of questionable mortgage debt that is punishing markets today is puny compared to our national debt - about nine trillion dollars borrowed by the federal government alone. Nine trillion dollars of public debt backed by an administration that has been incapable of raising taxes or cutting spending to meet its debt obligations for the last eight years.

Our national debt means that every citizen starts off $30,000 in the hole. How many people have 30k in their bank account to make up for this investment shortfall? It is a price of citizenship: Americans are all borrowers.

How is this connected to the collapse of our debt markets?

The World Is Awash In Capital

There is plenty of excess capital in the world - many people are capable of saving and loaning money. Just not Americans.

Instead, money is pouring into America from thrifty Asia and oil-producing parts of the world.

There's nothing obviously wrong with borrowing money from Shanghai or Dubai: it's just a trade. We take their goods or their oil, and they get a fraction of ownership of our economy. Unless you're xenophobic, there's nothing wrong with this exchange. And we have a massive economy - there's plenty of ownership to go around.

But there is a problem when foreign investment rises so quickly that it completely dominates US debt markets. What ends up happening is the vast bulk of lenders are too separated from the borrowers, and our markets cease to function.

The Great American Debt Pyramid

Any investor has two ways to manage their risk. The old-fashioned way is to know your investments intimately and build a level of trust. The new-fangled way is to build a portfolio that diversifies across many investments.

For faraway investors, only one of these strategies is a realistic option. It is pretty hard to sit in Dubai and have any specific trust in the mortgage borrower (or even a whole bank) in Kansas City. So our increasing American debt has meant that more and more of our obligations are bundled up together with lots of loans and traded blindly. The idea with big bundles is that they are just like market indexes: if you don't know the borrower, you can't beat the market.

This works normally when somebody thinks they know enough to beat the market: those smart investors differentially buy up good-risk loans and sell the bad-risk loans, and prices converge to the right value. Normally the market is driven by attentive investors who actually know their investments. But what happens when all of the investors are far away? Nobody can know their investments, and the market prices are just set by other blind investors.

Indexing theory tells Dubai investors that they are hitching a ride in an investment bus driven by the invisible hand of a mob of smart investors, but really they've just been investing in a pyramid scheme, with prices pumped up (and mortgage rates driven down) by other Dubai investors who are being duped by the same scheme.

What Comes Next

The real carnage comes next, when the world starts to believe that the US is not a great place to park money after all.

In a world where the world doesn't trust the U.S. with loans, the Federal Reserve loses its ability to drive global interest rates. Instead of following suit when the Fed lowers rates, foreigners will pull money out of our country and keep it closer to home, in investments that they can touch and feel. The gap between the fed rate and other loan rates means this is already happening now.

The eventual result when nobody wants to keep their cash in dollars? A devalued dollar, and spiraling inflation.

Spend your money now: it won't be worth much tomorrow.

The Only Way Out

There is really only one way out. As a nation, we need to learn to pay our debts.

I'm not suggesting all borrowing is bad, or that borrowing from overseas is bad, but that we need to have enough domestic investment to maintain functioning markets. We need to be driving market prices locally, saving money in America and loaning money to our own people where investors can understand the investments.

But getting out of debt is hard. It means we need to do two very politically unpopular things.

1. We need to pay back our national debt.

That means higher taxes for the rich.

I think this is an easy sell for rich people. I am definitely in the "Obama will raise my taxes" bracket, but I have been horrified to watch the dollar devalue and watch the value of my savings drop in the borrow-and-spend Bush administration. I will gladly pay 20 or 30% more taxes if that's the way to stop inflation and dollar devaluation.

Right now, the dollar devalues itself much faster than I can save. It's like pouring cash into a black hole. We need to put an end to that.

2. We need consumers to borrow less.

As a nation, we have a crazy borrowing culture. It is madness to borrow ten times our income to buy a house. It is insanity to buy a car with any sort of debt. And credit cards are simply loony. We need to regulate loans to put an end to the jumbo loan, the zero-money-down car, and the balance-transfer credit card carousel.

That means we might not be able to afford that hot little car just right now.

But here's the thing. If we let our debt run and let inflation loose, we won't be able to afford anything at all.

Posted by David at September 19, 2008 06:06 AM