Last month, the International Monetary Fund released its annual review of U.S. economic policy. Its summary contained these bland words about U.S. fiscal policy: “Directors welcomed the authorities’ commitment to fiscal stabilization, but noted that a larger than budgeted adjustment would be required to stabilize debt-to-GDP.”

But delve deeper, and you will find that the IMF has effectively pronounced the U.S. bankrupt. Section 6 of the July 2010 Selected Issues Paper says: “The U.S. fiscal gap associated with today’s federal fiscal policy is huge for plausible discount rates.” It adds that “closing the fiscal gap requires a permanent annual fiscal adjustment equal to about 14 percent of U.S. GDP.”

http://noir.bloomberg.com/apps/news?pid=newsarchive&sid=aiFjnanrDWVk

The overall U.S. net international debt position and the associated net international income flows derived under the base case are shown in Charts 6 and 7. Under the base case, U.S. net international debt as a share of GDP nearly doubles over the 10-year projection period, increasing from about 20 percent of GDP to 38 percent. Net international income flows turn negative and steadily decline, from roughly +1 percent of GDP in recent years to about -1.9 percent of GDP by the end of the ten-year projection. That negative net international income flow represents a wedge between GDP and national income. Note that, even with the assumption in the base case of a gradually improving U.S. net trade position over the projection, the current account deficit would gradually widen, reflecting the increasingly negative net international income flows.

Chart 6, depicting the NIIP projection, is below:

It's of interest to compare this projection to others produced using similar approaches. Bertaut, Kamin and Thomas (2008) present a projection for NIIP to GDP of -65 percent by 2020. (The Bertaut, Kamin and Thomas paper was published in an IMF Staff Papers special issue, discussed here.)

We examine a couple of other scenarios, including: (1) if foreign official holdings of Treasuries grow at the same rate as nominal GDP, and (2) one percentage point higher inflation. The former implies Treasury yields 1.5 percentage points higher, while the latter implies the NIIP to GDP ratio would be 7 percentage points less negative.

Note that the results depend crucially on the coefficient on foreign holdings; if one used the larger coefficient obtained in Chinn and Frankel (2007) (in a different specification, and for a shorter sample), then the required increase in foreign holdings would be halved.

We conclude:

... although the general interpretation presented here and by other researchers is that the world portfolio could potentially accommodate the "required" increase in foreign funding of U.S. Treasury securities, it remains an open question whether such an increase would be forthcoming. Ultimately, measures that reduce the deficit by changing the trajectory of tax revenues and spending, particularly in the latter years of the horizon we consider and beyond, would mitigate the concerns about the financing of the U.S. budget and current account deficits.

 

http://www.econbrowser.com/archives/2010/08/financing_us_de.html

This is not only the "strangest" thread ever but also the most "difficult" to understand.

What does it all mean?

Answer: It's only six minutes to midnight, don't worry we've got plenty of time

It's good to track.  Though, out of all the news I track, the raw economic stuff is the worst for me.  I mean, how do you wrap your brain around a $1.7 Trillion Deficit and a Debt of $14 Trillion?  Monolopy money :D

Everything's tied together, take your pick.  Common denominator = money

BOJ policymakers may meet to discuss measures after the yen reached a 15-year high against the dollar and stocks fell for the third straight week, the Nikkei said, without citing anyone. The bank may wait until its regularly scheduled Sept. 6-7 meeting should markets calm down, the report said. BOJ spokesman Satoshi Yamaguchi declined to comment.

“While the fiscal package has been expected, what is worth noting is that the BOJ is likely to support the government by announcing additional easing measures,” said Masaaki Kanno, chief Japan economist at JPMorgan Chase & Co. in Tokyo, who worked at the central bank for 25 years.

The most likely option for the BOJ is to expand its 20 trillion yen ($235 billion) credit program, he said.

http://noir.bloomberg.com/apps/news?pid=20601080&sid=aqXHdELwavoI

more free money! wooo...

Additionally, the US rolled another $513 billion in short-term debt: a number which continues to be persistently high, even as the total amount of short term debt as a percentage of total has declined steadily from 30%+ of total to around 20% as we have written elsewhere. Another $106 billion in Notes was rolled as well, with the intramonth cash balance dropping to a dangerous sub-$5 billion.

For the 11 months ending August 30, the US has paid $180 billion in interest expense in a time of record low interest rates.

At the current rate, we expect that the statutory, and completely irrelevant, debt limit of $14.3 trillion will be breached in the first two months of 2011. At that point total federal debt as a % of US GDP will be roughly 100% in its purest definition, and the inevitable greenlighting by Congress to raise the ceiling then will means that America is fully sliding into a debt-to-GDP ratio of >1.

http://www.zerohedge.com/article/america-adds-210-billion-gross-debt-august-rolls-620-billion-bills-and-notes

What does this mean for US financial markets? (take a wild guess)

In these circumstances, the financial markets likely will be highly unstable and volatile.  Looking at the longer term, strategies aimed at preserving wealth and assets continue to make sense.  For those who have their assets denominated in U.S. dollars, physical gold and silver remain primary hedges, as do stronger currencies such as the Canadian and Australian dollars and the Swiss franc.  Holding assets outside the U.S. also may have some benefits.

http://www.zerohedge.com/article/john-williams-sees-onset-hyperinflation-little-6-9-months-fed-tap-dances-land-mine

 Moreover, there is no agreement on what should be the post-Bretton Woods 2 rules of the game for international finance.  Is there even a meaningful policy discussion?  Perhaps a little hope via Bloomberg:

Suggestions for how to resolve currency differences were vague in Washington, with French Finance Minister Christine Lagarde proposing better coordination and more diversification, while Canada’s Jim Flaherty suggested that new “rules of the road” be outlined.

Of course, in the next sentence hope is dashed:

 European Central Bank Executive Board member Lorenzo-Bini Smaghi suggested the G- 20 may be too big to find a compromise.

 Unless checked in South Korea, the discord may snap the G- 20’s united front formed to fight the financial crisis and recession.

And don’t expect that the International Monetary Fund is prepared to deal with this crisis:

Unable to find common ground themselves, governments agreed the IMF should serve as currency cop by preparing reports which show how the policies of one economy affect others. The studies will focus on the U.S., China, the U.K. and the euro area.

 “The need to have this kind of spillover report has been discussed for months and now it’s part of our toolbox,” IMF Managing Director Dominique Strauss-Kahn said.

Well, thank the Heavens above, the IMF stands ready to produce a report.  Now I can sleep easy.

Bottom Line:  The time may finally be at hand when the imbalances created by Bretton Woods 2 now tear the system asunder.  The collapse is coming via an unexpected channel; rather than originating from abroad, the shock that sets it in motion comes from the inside, a blast of stimulus from the US Federal Reserve.  And at the moment, the collapse looks likely to turn disorderly quickly.  If the Federal Reserve is committed to quantitative easing, there is no way for the rest of the world to stop to flow of dollars that is already emanating from the US.  Yet much of the world does not want to accept the inevitable, and there appears to be no agreement on what comes next.  Call me pessimistic, but right now I don't see how this situation gets anything but more ugly.

http://economistsview.typepad.com/timduy/2010/10/the-final-end-of-bretton-woods-2.html

So what happens in a financial crisis? First, the probability distribution shifts to the left as the financial environment deteriorates and the financial firm takes losses that deplete its capital. Second, and even more importantly, the dispersion of the probability distribution widens—lenders become more uncertain about the value of the firm. These two phenomena are shown together in Figure 2. A lack of transparency in the underlying assets will exacerbate this increase in dispersion. As the degree of dispersion widens, a portion of the probability distribution falls into negative territory. This means that there is a real risk of loss for unsecured creditors if the firm were forced to liquidate its assets.

Finally, in a crisis, unsecured lenders become more uncertain about others’ assessment of the probability distribution. For example, if creditor A believes the probability distribution looks like Figure 1, but at the same time is concerned that creditor B views the probability distribution as looking like Figure 2, creditor A may pull back. If there is a risk creditor B and others will not lend, the firm may not receive sufficient funding. In other words, even if creditor A believes the firm is solvent, it may not lend because it does not want to risk a delay in repayment.

So what can creditors do to mitigate these risks? First, they can respond by charging a higher interest rate in compensation for the increase in the risk of default. However, there are a number of difficulties that limit how well this works in practice. Most significantly, by undermining the firm’s profitability, the higher interest rates may increase the risk of insolvency. If higher rates push insolvency risk up sharply, then higher rates may not be sufficient to make lending—even at higher rates—an attractive proposition.

AEI on Sovereign, Mortgage, Banking Issues

This AEI seminar from last week is highly worth watching on the next wave of the financial crises as it ripples through currencies, mortgage markets, and the banking system.

Chancellor of the Exchequer George Osborne, in formally presenting the government's budget plan to the House of Commons, said it would eliminate the country's structural deficit by 2015.

"Today is the day when Britain steps back from the brink, when we confront the bills from a decade of debt," he said.

The government plans the equivalent of $11 billion in additional welfare budget cuts, but no reduction for the National Health Service. Police funding will be cut by 4%.

Defense spending is to be reduced by 8% over four years, meaning the loss of 5,000 jobs each for the air force and navy, 7,000 for the army and 25,000 among the Ministry of Defense civilian staff.

http://content.usatoday.com/communities/ondeadline/post/2010/10/britain-plans-deepest-spending-cuts-since-wwii-rise-in-retirement-age/1

“Our national security is a priority, so defense and security budgets will contribute to deficit reduction on a lower scale than most other departments,” Cameron told the House of Commons.

Cameron said civilian staff at the defense ministry would be cut by 25,000, while the Army will lose 7,000 troops and the Royal Air Force and the Navy will face reductions of 5,000 each.

Tanks and heavy artillery numbers will be cut by 40%, and the Navy will reduce the number of destroyers and frigates, he said. All British military personnel in Germany will be removed by 2020.

The government plans to press ahead, however, with building two aircraft carriers, Cameron said, noting that the cost of canceling the contracts at this stage would exceed the cost to build them.

http://www.marketwatch.com/story/britain-to-slash-defense-budget-8-2010-10-19?reflink=MW_news_stmp

What next? Over the coming week, we have a full schedule of Fed speakers from both ends of the hawk-dove spectrum. The Fed's decision is pretty clear in terms of operational details, but what the markets will want to hear is how the Fed expects the new policy to impact the economy. How will the Fed gauge and assess whether the policy is working? We are among those sceptical about the effectiveness of QE2 beyond its ability to anchor inflation expectations from below.



The country has spoken... and it is sick of government spending. With QE2 out of the way, policy watching will now shift to the fiscal front. Following a republican victory in the mid-term elections, fiscal policy is bound to undergo significant changes. The Bush tax cuts are increasingly likely to be extended for all income levels, but after that we see thin prospects for additional fiscal stimulus. The country has spoken, and policy will respond. Republicans are already promising budget cuts to the tune of $100 bn and the Democrats will likely become more sensitive to the issue of fiscal responsibility. Where Republicans and Democrats could potentially agree is on tax breaks for businesses.

http://www.businessinsider.com/matt-taibbi-explains-why-tea-partiers-dont-get-the-economy-2010-11

Damien: So, do you think the U.S. is entering a new phase?

Matt: That’s a difficult question. We are transitioning to something new and it has less to do with the evolution of an individual country like the United States and more to do with the withering away of states in general. This is causing a corporate anarchy where there are really no rules or regulations for the game, and there are no physical borders.

I think across states and borders, these banks and financial companies are going to become more concentrated and more unaccountable. I think that process is irreversible. Unless something remarkable happens here in America, we’re just going to see more of that and a weaker state to deal with it.

Damien: Do you think we’re now just on the cusp of another situation where Wall Street is moving into the next big scam and the fallout is only years away?

Matt: Yes. I don’t think it’s any secret on Wall Street that there is another shoe that has to drop. I was just in a foreclosure court down in Florida and I watched a foreclosure lawyer come in with a stack of foreclosures that literally went above his head. Each one of those folders had faulty paperwork in it. That implies all those mortgage bank securities are still infecting the entire economic universe and there’s a place for those to fall too.

They are all probably going to blow up and there’s going to be a tremendous reckoning when that finally happens because we’re propping up that part of the economy. But there’s also evidence that suggests there’s bubble-like activity going on right now. We have a recovery without jobs, we have quantitative easing where they’re going to dump another ton of money through Wall Street — that’s just printing money out of thin air.

Clearly, there are going to be consequences for all of this. And when we balance the books and figure out how much everything is actually worth on our balance sheets, I think there’s going to be another problem.