- The Odds Of Complete Collapse

So last summer we stood peering off the brink, with the markets all set to roll keel over mast before bubbling to the bottom. Then the Fed implemented QE2. I personally think QE 2 was useful in that it propped up risky assets. This pushed us back from the brink a bit, and gave the government time to smell the coffee and begin to make rational economic choices. They have since squandered that opportunity. So here we are again. Same people, same brink, same choices.

A few months ago I got in a big argument with one of my more knowledgeable friends about the likelihood of QE3.

“It would be a disaster.” he said “And may mean the end of the fiat money system.”
“You’re right, I replied, ‘but we’ll get it anyway.”
“No, you don’t understand.” He said, “It would be ineffective and would set the stage for hyperinflation, which might inevitably mean the end of everything.”
“You’re right.” I said, “But we’re going to get it anyway.”

We went back and forth like that for a while. Him saying what the right thing to do would be and me agreeing, but not believing the people in Washington would do it.

In short, it was my contention that QE3 would always happen. I believed that after QE2 (which ends this month) risky assets would sell off, and make another round of QE more politically viable. What looks crazy with the S&P at 1400 looks absolutely essential with it at 1050, so I always thought the political wind would change. And with falling S&P would come the rising demand for government to ‘do something’ to save the system. It would be all but universal…not the least of all from those seeking reelection.

So the fed would implement QE3 – not just because they could, but also because we haven’t actually done anything to improve our fundamental growth issues. Higher oil prices still kill more jobs than the subsidized windmill and solar panel companies create. The housing market is a wreckage, unemployment remains lofty and the only thing the Keynesian stimulus package actually stimulated was union jobs, union dues, and Democratic campaign contributions.

The only thing that’s really different now is that we have a lot more debt. The federal government continues to borrow 40c of every dollar it spends, and the number of dollars spent continues to be astounding, so we’ve reached our debt limit yet again.

As I’ve said, I’d be in favor of leaving the debt limit where it is so long as we could be sure the Obama administration would continue to pay all the debt. But to be honest I’m unsure that they’ll do so. In fact, I don’t think Obama is aware of any of the real costs of a default. He sees the political costs to himself of course, but I think he underestimates even those. I think he believes that with some careful spin, even a debt default could be portrayed as his administration standing up to the rich wall street fat cats and making them ‘share the burden’.

Remember, Obama’s economic worldview is based almost entirely on fantasy. In his world, supply and demand are mutable, and the only real constant in economics is the “exploitation” of the lower classes by “the rich”. In his world, he’s the only thing that can prevent this exploitation, and if the rich bond holders are hurt by being forced to give up a coupon payment, then that can only mean that the poor will benefit from it in some small way. I’m sure he believes he can portray it that way if he has to, and to him a US debt default can become one more populist political piece to move around the chess board.

So if we were to try to estimate the probability of a US debt default we need to consider 2 issues. The first is that we need to guess at the odds that the congress will not get the debt limit raised before the federal government runs out of cash. I personally would put the odds of that event at somewhere between 20% and 40%, but feel free to use your own estimate.

Then we need to multiply that by the odds that lacking the funds to pay for everything they want, the Obama administration will elect to pay for windmill subsidies and AFL-CIO giveaways instead of debt coupon payments. I personally would put the odds of something like that at about 80%. So some rudimentary math shows us that at present, my estimate of a US debt default is a cumulative risk of about 16% to 32%. As much as 1 chance in 3. Those are pretty short odds for an event with such utterly cataclysmic consequences. But the American voter wanted hope and change… I would certainly call that a change.

What about the odds of QE3? I’d still put them at 100%...the only issue is when. Given today’s numbers, I’d say the autumn is looking more likely.