October 15, 2003

Too Big to Feel

Someone at the New York Times has Paul Krugman writing about economics again...and truth be told...he's doing a pretty good job. Krugman makes a point in his piece yesterday that I've made in SI over the last six months: if you don't' reduce spending and keep running larger deficits, sooner or later the market will see you for what you are: a very bad credit risk. You can read the whole thing here (registration required), or check out the excerpt below. American are investors are complacent that when it comes to credit, size matters...that Treasuries would never be downgraded because...well, the U.S. bond market is just too important. I'd size (of the deficit) is exactly the weakness...not the strength. Picture the Treasury market as a giant dinosaur whose brain is so small it can't feel the ground giving way underneath its massively bloated body (there is probably a better metaphor, but you get the picture.) From Krugman: "...a third world country with America's recent numbers — its huge budget and trade deficits, its growing reliance on short-term borrowing from the rest of the world — would definitely be on the watch list. "I'm not the only one thinking that. Lehman Brothers has a mathematical model known as Damocles that it calls "an early warning system to identify the likelihood of countries entering into financial crises." Developing nations are looking pretty safe these days. But applying the same model to some advanced countries "would set Damocles' alarm bells ringing." Lehman's press release adds, "Most conspicuous of these threats is the United States. "The crisis won't come immediately. For a few years, America will still be able to borrow freely, simply because lenders assume that things will somehow work out. "But at a certain point we'll have a Wile E. Coyote moment. For those not familiar with the Road Runner cartoons, Mr. Coyote had a habit of running off cliffs and taking several steps on thin air before noticing that there was nothing underneath his feet. Only then would he plunge. "What will that plunge look like? It will certainly involve a sharp fall in the dollar and a sharp rise in interest rates. In the worst-case scenario, the government's access to borrowing will be cut off, creating a cash crisis that throws the nation into chaos." I'll show you what a plunge will look like. It will look like what happened when Brazil devalued its currency in 1999, rather than defaulting on its bonds (as both Russia and Argentina did more recently.) A disorderly devaluation or a default...take your pick...neither is good for stock prices. Free-Falling on Devaluation


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