Tuesday, July 26, 2011

Bove: Ripple Effects of the Debt Stalemate

On Monday, Larry Kudlow of CNBC interviewed Dick Bove. During the interview, Bove warned that the ripple effects would be severe if the debt ceiling stalemate results in higher borrowing costs.

Ripple Effects of Debt Stalemate

I realize that there are many strong views on this debt ceiling and budget battle. That's, of course, as it should be.

The U.S. now has low borrowing costs as a country. This is no small advantage (though not to be taken for granted). It provides, even if not infinite, a runway potentially long enough to solve the structural problems.

Now, those low borrowing costs may not disappear as a result of the high stakes political/economic roulette game being played here but why mess around. A little humble respect for the complexity of these interconnected systems would be nice.

The U.S. needs budget reforms in a big way. Yet, a sudden increase to U.S. borrowing costs and these very real and troublesome problems we have now theoretically become more of a true crisis*.
(Especially if in combination with eurozone sovereign debt problems and their relatively weak banking system.)

A financial system relies on the trust and confidence of humans as basic building blocks. A complex system built this way has the potential for a whole range of not knowable outcomes if that trust and confidence begins to disappear. We are talking here about sometimes-manic-other-times-depressive human market participants that often move in dangerous herds, not the coldly calculated types we'd all like to imagine.

I am not saying it won't work out okay but we are taking some silly risks here. Who knows when trust and confidence becomes scarce. Trust and confidence is a bit like oxygen. You don't think about it much until there's little of it.

So how will this debt/budget battle end up ultimately impacting the financial system or global economy as a whole? From this article:

"The fact is, no one knows when or what deal will be cut. Those who are predicting this outcome are guessing. The ultimate effect on stocks and bonds in the short or long term is also unknown. But we keep tuning in, hoping for an answer, listening to confident and educated individuals making predictions."

I think it is wise to be a little skeptical of those in the business of forecasting who think they do know how it will impact the system and economy. With enough folks making bold guesses someone ends up right with fame and books to follow. There's little accountability for those who made the incorrect predictions. It pays to make extreme predictions.

"We will continue to ignore political and economic forecasts, which are an expensive distraction for many investors and businessmen. Thirty years ago, no one could have foreseen the huge expansion of the Vietnam War, wage and price controls, two oil shocks, the resignation of a president, the dissolution of the Soviet Union, a one-day drop in the Dow of 508 points, or treasury bill yields fluctuating between 2.8% and 17.4%." - Warren Buffett in the 1994 Berkshire Hathaway (BRKa) Shareholder Letter

It's important to know the limits of what one can foresee.

"A different set of major shocks is sure to occur in the next 30 years. We will neither try to predict these nor to profit from them. If we can identify businesses similar to those we have purchased in the past, external surprises will have little effect on our long-term results." - Warren Buffett in the 1994 Berkshire Hathaway Shareholder Letter

A bit of humility, sound pragmatism, and compromise is much needed to resolve our debt and budget troubles.

Yet, in the context of investing, the macro stuff has less impact on long-term returns than most think. It comes down to buying good businesses at an appropriate discount to a conservative estimate of value.

Otherwise, expect external shocks, some severe, from time to time.

Adam

* If only our debt ceiling/fiscal issues were happening in a vacuum. Consider the potentially unpredictable interaction that could occur if U.S. financial troubles hit the eurozone while it attempts to resolve its own sovereign debt issues while dealing with that regions much weaker banking system. That region has a remarkably fragile financial and monetary system at this time. It's not like their troubles can't unravel in ways that feedback and damage our own financial infrastructure. In other words, making what would be a manageable problem in a vacuum extremely difficult to say the least.
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