Pytheas

Market
Focus

August 2011

The U.S. debt crisis, the U.S. and EU

leaders and their power games

By Harris A. Samaras

www.pytheas.net
Pytheas
Market
Focus

Concerns about, the health of banks, the incapability of policymakers to perform, the U.S.s
national debt and whether the Eurozone can survive its current crisis intact; higher
unemployment, slower growth, currency tensions and the fear that blanket austerity will tip
fragile western economies back into recession, have all led to immense uncertainty to say the
least

After the collapse of the U.S. housing market, banks were recapitalized to be prevented from
going bust, interest rates were slashed, money was created, public spending was increased
As private demand fell, governments stepped up their spending more money was printed,
shares in banks were bought by governments and budget deficits were allowed to balloon,
gambling that any damage to the public finances would be temporary. Quantitative easing has
proved a double-edged sword, it has flooded financial markets with cash... but it has also
pushed up commodity prices, leading to higher inflation and a squeeze on real incomes
holding back recovery. And it took time for policymakers to comprehend the enormity of the
shock administered to the global economy...

The recovery has been both slow and costly. The recovery has been slow because the crisis
was caused by over-indebtedness among private individuals and banks. Both, in the jargon of
the markets, were over-leveraged, they had borrowed an awful lot of money, in anticipation
of asset prices going up. When the bubbles burst, households and banks realized how
exposed they were. As a result, they started to pay off their debts and even when the cost of
borrowing came down to virtually zero the demand for credit remained weak. Western
economies have become so dependent on debt-driven growth in the good years that they are
finding the sobering-up process odd and painful.

By effectively nationalizing a good chunk of the debts accumulated by the private sector,
western governments have now raised concerns about their own solvency. The U.S. has seen
its credit rating downgraded; Europe's problems are even more acute after bailouts for
Greece, Ireland and Portugal, followed in the past weeks by emergency action by the ECB to
drive down the interest rate on Italian and Spanish bonds. Europe, due to, a significantly
heavier regulatory burden, more generous social welfare programs and higher levels of
taxation as a percentage of GDP, a birthrate well below break-even, an unsuccessful
immigration policy, lower levels of productivity but above all the inability and indecisiveness of
the Franco-German leadership to take prompt action, faces unprecedented problems
Important also to note that average incomes in Europe are approximately 25% less per
person than in the U.S.

Over and above the European nations' debt crisis is much more serious due to a fundamental
flaw in the formation of EU the EU is a political and currency union while on the fiscal side
the countries remain separate. European debt is nominated in Euros, which is equivalent to a
foreign currency. Thus, to repay a sovereign debt it has to be remitted in a foreign currency
(the Euro) and cannot be absorbed by domestic central bank operations. In case a member
country needs help, ECB can act as a lender of last resort and give liquid funds for financial
assets that are distressed. This complexity makes the Euro debt problem a more complicated
one to solve than the US one.

Financial markets want to believe the "soft landing" scenario but somehow can't quite bring
themselves to do so. The fear comes from the knowledge that commercial banks in Europe
are up to their eyeballs in sovereign debt from the weaker peripheral countries, so a default
would trigger a feedback loop back into the financial system. Banks have more capital than
they had three years ago and are less heavily leveraged. Yet there are doubts about whether
they could survive a double-dip recession. And until consumers are spending more freely,
there will be a temptation for companies to pile their cash rather than invest it.

The U.S. debt ceiling deal negotiated between President Barack Obama and the U.S. House
and Senate calls for an increase in the debt ceiling of $2.5 trillion in exchange for $2.5 trillion
in expenditure reductions over the next 10 years with no tax increases somehow leaving
Social Security, Medicare and Medicaid untouched

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It has been characterized by some as a giant Ponzi scheme, like a Ponzi scheme it is
destined to eventually collapse because the earnings are less than the payments to
investors

But why did it take Americas political leadership so long to resolve something that previously
had been nothing more than a routine procedure, carried out innumerable times under both
Republican and Democratic presidents? The world is observing some of us with mixed fear
and morbid fascination as we realize once more that even at such critical times, U.S. and
European leaders (along with their corresponding organized bodies, circles and syndicates)
are basically incapable of escaping their thirst and addiction for power... risking, in the name
of their own interests, the wellbeing of their citizens and not only and most of those leaders
that dare to project patriotism as an excuse are merely pathetic and definitely unfit to lead,
blind, saturated and brainwashed by vanity!

No doubt, the pre-eminence of the US Dollar as the global reserve currency means the U.S.
government effectively has first call on excess global savings and supports low real interest
rates. The dollars status as the worlds reserve currency means the sovereign is not exposed
to any serious liquidity risk and the lack of liquidity risk gives the U.S. time to resolve its
issues. Moreover, U.S. is the world superpower and the largest economy with an
approximately $15 trillion GDP, about 25% of world GDP. As it is seen the safest country in
the world for capital investment, U.S. Treasury bonds are seen as "risk-free rate of return"
reflecting its status as the world's strongest and most robust economy for almost two
centuries. But also no doubt that the U.S. is in need of a credible plan to reduce its debt!

As the government borrowed to bail out the nations banking system and lift the economy out
of recession marketable U.S. government debt outstanding has risen to $9.4 trillion from
$4.34 trillion that it was in mid-2007. The U.S. went from budget surpluses averaging $139.7
billion from 1998 through 2001 to a deficit of $1.29 trillion last year.

Medicare, Medicaid and Social Security today account for almost half of Federal spending
the federal government spends $26,000 per year for every American over 65. If nothing
changes, these three programs will consume more than 100% of the U.S. budget in 25 years.
Note that the unfunded liabilities of Social Security are $8 trillion; Medicare, $22.8 trillion and
Medicaid, $35.8 trillion

According to Brown University's Watson Institute for International Studies (June 2011), U.S.
citizens have paid for the wars in Iraq and Afghanistan between $3.2 trillion and $4.0 trillion.
Additionally, Pentagon spending is estimated at around $700 billion per year while the
Defence Department expenses per annum at about $1.4 trillion. The costs of Washington's
different intelligence services, Homeland Security, nuclear weapons, military retiree pay and
healthcare for vets in relation to the Iraq and Afghanistan wars, FBI (for its war-related
military work), etc. comes to about another $1.3 trillion per year.

If it was a company, the United States of America would presently have a negative net worth
of about $40 trillion This is clearly unsustainable and is why there must and will be major
cuts to social programs in the U.S. in conjunction with significant tax increases. In turn, this
will increase intergenerational conflict in the future between the boomers and younger
generations; destroying healthy government programs while imposing large and growing
burdens on young people the world over

The aging of the population, characterized by the unprecedented growth of the elderly and
the unprecedented decline in the number of youth is another major issue that the western
world has to deal with. It is estimated that today there are three workers for every pensioner
and this will decline to 1.5 to 1 or even 1 to 1 in the next few decades. If nothing changes
government social and health insurance related programs around the western world will
consume more than 100% of their budget

The world economy is incredibly interconnected today, it is truly global, and the United States
would not be immune. Contagion to the core euro area and then onward to emerging Europe
remains a tangible risk. But also vice versa, each and every economic tremor in the U.S.

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affects Europe and the rest of the world almost simultaneously... The global economy is
interconnected to such extend, that movements in exchange rates, interest rates, stock prices
and prices of goods are influenced in most of the globe. See also by the same author
Laissez-faire, the Freer Market Global Economy, the investment banks and the
policymakers

On the other hand we have to realize that financial markets are inherently unstable, and
international financial markets are more so, and international capital movements are
notorious for their boom-bust pattern. Also, the natural tendency for monopolies and
oligopolies to arise needs to be constrained by regulations. But these regulations should not
suffocate those individuals or entities that do excel and perform! If policymakers were only
able to monitor what they were suppose to monitor neither companies, nor stocks, bonds nor
would properties be overvalued

Closing, the increase of the debt-ceiling must be short termed. Over hasty deficit reduction
will definitely harm the U.S.s short-term growth prospects and thus the rest of the world. A
politically-backed medium-term framework that raises revenues and addresses long-term
expenditure pressures should be the cornerstone of fiscal stabilization. Sovereign debt should
not be the only concern, but growth and social instability. And social instability can be only
addressed by employment! Additionally, asset values in indebted nations have to be written
down to reflect reality; there is too much debt outstanding in the world and the only remedy
is strong economic growth. If asset values are not adjusted realistically social upheaval will
not ease

Humility is required to resolve the crisis but above all political courage!

Sources (Alphabetically)

Bloomberg Fitch affirms U.S. AAA rating

Foreign Affairs Gray dawn: The global aging crisis
G20 Workshop on the Global Economy Causes of the crisis: Key lessons
Reuters Debt issuers brace for impact from U.S. downgrade
Reuters Global policymakers discuss debt crisis, market turmoil
Reuters Moodys cautious about U.S. deficit cuts plan
Reuters United States loses prized AAA credit rating from S&P
The Guardian Three years after Lehman, a new debt crisis looms
The Vancouver Sun The real U.S. debt crisis is yet to come
Watson Institute of International Studies Costs of war
Watson Institute for International Studies This time it really is different: Europe, the financial crisis, and
staying on top in the 21st century

See also other related publications by Pytheas:

Could the Greek Financial Crisis lead to the end of the EU as we know it? (June 2011)
Twenty years after the collapse of communism, the global financial crisis pushes emerging European
markets to the brink of collapse! (November 2009)
Laissez-faire, the Freer Market Global Economy, the investment banks and the policymakers... (August
2009)
The US economy is in trouble! (February 2008)

Disclaimer
The above notes have been compiled to assist you; however, actions taken as a result of this document are at the discretion of the reader and not
PYTHEAS or Harris A. Samaras.

Copyright 2011 Pytheas Limited 28 August 2011 4