Warren Buffet in the New York Times has a few words to say about the national debt and how it’s going to be funded.

He applauds the way in which the current and former administrations managed to avoid financial meltdown. I think we can all applaud them. In spite of the mistakes, we still have an economy.

However, there’s a however in this story. However part one is that the debt will be 13% of GDP, more than double any peacetime debt. However part two is that as the debt mounts rapidly, our nation loses its “reputation for financial integrity.” Translation: we may rack up too much debt for lenders to feel comfortable letting us borrow more.

The next however, however, is a big, bad one. The US Government needs to borrow $1.8 trillion. Buffet’s optimistic guesses can supply $900 billion from domestic and foreign lenders. That leaves another $900 billion left to borrow from someone. If lenders can’t be found, then the only other way to get the money is to print it.

Congress and the President have approved spending equal to 185% of tax revenues. That is a lot of money. Seriously. If the spending is canceled or taxes almost doubled, the recovery such as it is would have no chance of working and, worse from a Congressman’s view, his chances of re-election would be shot. Nobody has the political courage to pull a stunt like that. That means the printing presses have to run… with almost a trillion more dollars out in the world, what does that do to the value of the dollar? Mr. Buffet looks sternly at the possibility of inflation.

But is that what’s really staring us down? There are other voices that are tapping Mr. Buffet on the shoulder, hoping to get him to direct his glower at the more ferocious threat of deflation. Japan’s had deflation for quite a while now and all the money they’ve printed and debt they’ve run up have still done nothing to budge their economy out of the doldrums. Japan’s economic bad turn came about as a result of a collapse in a real estate bubble.

That’s something worth looking up – market bubbles and Minsky moments. Check the wikipedia and get back to me when you’ve done that. CTRL+T and go to town…

… back? OK. The US already had a massive drop in residential real estate, with many hua hin beach villas hitting an all-time low. Now we’re looking at the coming drop in commercial real estate. Where the residential fall crippled banks that had gambled on subprime, the commercial fall will hit local banks that only gambled on enough tenants to make the projects they underwrote viable enterprises. When those enterprises falter, the economy will see massive asset devaluation.

Now the trillion-dollar question: if the banks catch cold, where will be the domestic lending needed to finance the national debt? If it’s not there, then the government printing presses have to run that much harder, pushing the threat of hyperinflation all the harder. Foreign investors have already shied away from dollar-only debt purchases. That adds to the threat of really bad inflation. Maybe not Zimbabwe bad, but worse than the inflation of the 1970’s and early 1980’s.

While we’re on the subject of debt, what happens if interest rates go up just a smidgen? How much more expensive will it be to just service the existing debt, let alone borrow more?

This is a lot up front for my new students and, quite frankly, it’s a lot for me to sort out. That’s OK, though. The best financial minds in the world are kinda stumped about which way things are going to work out, be it inflation or deflation. There are likely other factors to consider before making a final call.

Go to page five. There? Good. Read with me, then…

1. The market for home purchases can be divided into segments of 26% for damaged REO, 23% for move-in ready REO, 14% for short sales, and 36% for non-distressed properties. That means about 2 out of 3 homes up for sale are distressed properties. There are even more homes owned by banks that aren’t on the market right now because the market’s already glutted enough.

2. Forty-three percent of homebuyers are first-time homebuyers, 29% are current homeowners, and another 29% are investors. OK, so yay for the first time homebuyers, but look at what they’re buying:

3. First-time homebuyers account for the majority of move-in ready REO sales while investors account for the majority of damaged REO sales. In other words, those damaged REOs aren’t getting snapped up as fixer-upper bargains. Will their prices fall further?

4. Current homeowners concentrate their home purchases on non-distressed properties and buy comparatively less damaged REO. Underscores the concern from #3.

5. Real estate agents expect appraisal issues to be the No. 1 reason for cancellations of signed Purchase and Sales agreements over the coming summer months. This is a big one. People are not going to agree with prices as they’re being set. Sellers want a higher price, and the buyers are hoping for lower.

6. Only 31% of non-REO home sale listings are unforced or optional; other major reasons for listings include financial stress (including short sales), long distance relocation, and divorce or estate sales. OUCH. This is a big one. This means about 10% of the market is “unforced or optional.” The economy is still in a very tough spot, and this shows it.

7. Homeowners are choosing to not list homes primarily because of “Falling prices”, followed by “Competition with distressed properties”. That means they want to sell, but they can’t get a price to equal what they put into it. Nobody wants to lose money on a huge deal, like a home sale.

8. For first-time homebuyers, “Government incentives to buy (tax credits, mortgage deduction)” is the No.1 motivation to buy. Take that motivation away, and the market takes a huge hit. Sad but true.

9. For current homeowners buying homes, “Retirement relocation” and “job relocation” are the No.1 and No. 2 motivations to buy, respectively. They’re not trading up, anymore. They’re either downsizing the empty nest or following that all-important job.

10. “Sale of residence” is the No. 1 impediment to current homeowners seeking to buy another home. OUCH #2. I know people that are selling their home, then renting it for about 3 months after the sale while they buy a home after having confirmed the sale on their current home.

11. “Down payment for mortgage” is the No. 1 impediment to first-time homebuyers seeking to buy a home, followed by “Slow answers on short sale offers.” If you can’t get the down payment together, you ain’t buying a home. In this economy, that’s going to be a big problem.

12. Seventy-six percent of first-time homebuyers accept a mortgage recommendation of the real estate agent, 68% of current homeowners accept a recommendation, and 53% of investors accept a recommendation. Not much to say there.

13. On average, mortgage servicers take 9.5 weeks to provide a “yes” or “no” response to an offer to buy a short sale property. Wow. That’s two and a half months of the home sitting on the market, doing nothing. That can’t be good.

14. According to real estate agent respondents, “Mandated one-week response time on short sales offers” is the No. 1 rated action that the government could take to increase home sales and stabilize prices. Sure, the real estate agents want this. But I can’t help but wonder if this wouldn’t somehow mess up the mortgage servicers.

15. According to real estate agent respondents, “Provide consistent one-week ‘yes’ or ‘no’ response to offers” is the No. 1 rated action that the mortgage servicers could take to increase short sales. Again, what’s going on in the mortgage servicing biz that’s keeping them from doing this?

16. According to real estate agent respondents, “Provide consistent one-week ‘yes’ or ‘no’ response to offers” is the No. 2 rated action that the asset managers could take to sell REO properties with lower overall losses; the No. 1 rated action is “Turn on utilities for inspections.” So people don’t want to buy distressed properties in the dark? I guess when banks feel like it’s worthwhile to switch on the lights, the economy’s good enough to move that house. Until then, we’ll all be in the dark…

If you go on past page 5, there’s some interesting anecdotal information about the condition of the market starting on page 19. One set of observations that caught my eye was that banks are wanting cash or conventional loans for their properties and are not taking FHA loans. Another lament was how the properties sitting off the market are getting more and more damaged and distressed, making them more difficult to sell.

The distribution of distressed properties is not even, not by a long shot. Some areas have no surplus of homes: others are awash in distressed properties, driving the market down hard. Banks are encouraging bid wars for their properties, but the homes don’t appraise for the bid value, causing a cancellation of the sale agreement.

One thing I see mentioned over and over is how prices are being driven lower and people are holding back from making purchases as they wait for the prices to go lower. That’s asset value deflation. That’s not a good thing at all. With ARM homes set for a reset this year and next, there will be even more downward pressure on home prices.

Government bailouts are supposed to be last-ditch resorts. Instead, they’re built into financial risk assessment as guaranteeing no negative returns for major players. Corporations bank on them – pun only slightly intended – to be there to prevent a sticky end for them at the expense of the taxpayers and all those businesses that weren’t too big to fail.

Worse, when the government tried to act like it wasn’t going to bail out the guys that gambled with everyone’s retirement money and let Lehman Brothers fail, the consequences were so horrendous that the government couldn’t show that tough love ever again. It had to keep the oligarchy of major financial institutions going, even if it meant abandoning the small businesses of America that were struggling just as much.

Moral of the story? First off, if you want to succeed, your corporation needs to be so huge that it can’t be ignored. Second, you have to gamble with other people’s money with guarantees from those people – or their government – to make good on your losses. Third, you need better political connections than Lehman had, so the government won’t let you fail… and so you can also get a preferred bid on the contract to buy up the remains of your competitor. Moral hazard all the way.

The market doesn’t always know best, particularly when it’s able to buy or otherwise demand government influence. Had there been no guarantees, those financial institutions would have had to been more careful, right?

Nope. There were no such guarantees in 1907, and the same thing that happened in 2008 happened then. That’s when we learned there was such a thing as “too big to fail.” The government then worked to keep financial institutions from getting that big again.

In the last 25 years, those century-old regulations were stripped away, and the financial sector became more and more reckless as it became bigger and less failworthy. The government promises to keep disaster from happening actually made the banks act as if disaster could never happen, and that’s the very definition of moral hazard.

Right now, Obama’s solution to the financial sector problems does not deal with the moral hazard that currently exists. Nothing’s on the table to get the industry back where it needs to be to keep another major collapse from happening.

Paul Krugman wrote in August 2002 that in order to deal with the aftermath of 9/11 and the collapse of the stock market bubble, Greenspan and the Bush administration needed to do stuff to create a housing bubble in order to stimulate demand based on home equity loans. He wasn’t optimistic that such a bubble could be created only a few months after writing, but felt it should be done.

Well, here we are at the end of the housing bubble.

Dagnabbit, Krugman! Don’t you remember what happens at the end of an economic bubble? BAD THINGS. Lots of people in 2002/2003 were predicting a double-dip recession. In those double-dippers, the second dip is typically worse than the first.

It looked like the USA dodged that bullet for a while, but I’d always been waiting for the other shoe to drop. It started to fall in 2007 and kept falling all through 2008. I think it’s rolling around on the floor right now… anyway, welcome to the second dip of that 2001 recession. It’s worse than the first one, and that worseness is sharpened by the unwinding of the artificial constructs designed to fend it off in the first place. In avoiding a deeper recession, we risked collapse of our banking and financial sector – and it’s still not out of the woods just yet.

Now he’s calling for more stimulus spending. There’s something wrong with this picture. No, I’m not arguing that we’re headed for massive inflation. I learned the lessons of the 30’s, which Krugman cites. What I see going horribly wrong is a lesson from the 80’s… the 1780’s…

The French economy was a ruin in the wake of its involvement in the War of the American Revolution. In order to work through its troubles, the government had to borrow more money. No problem, right? Wrong. Over 100 years of overspending on luxuries and wars meant France was maxed-out. No creditor wanted to lend anything to a nation that could not afford its commitments and make interest payments. The only solution was for the French to raise taxes in order to be able to make payment on more loans along with meeting its obligations.

The idea was pretty straightforward: raise taxes, take out more loans, sort out the public finance mess, then start paying down the debts. It ran into a bit of a snag when, in order to raise taxes, the king had to convoke the Estates-General, which promptly made itself the supreme authority in the land. But that’s for another story… economically, I want to go back to that creditor part: France could not borrow more money without raising taxes.

The US’ debts are increasing to the point where we may be faced with such a situation. Moreover, EVERY nation in the world is trying to borrow money to finance massive amounts of public tick. What do we do when there’s not enough money being lent? Our interest rates are next to zero right now. If we raise them, the government could borrow more money at the cost of strangling growth in business investment and personal consumption spending.

If the government instead chooses to just print money, most folks holler about the specter of hyperinflation. Set that aside for moment. Right now, most folks are saving money – and the first step of saving is paying off debts. Paying off debts destroys money, and that’s a deflationary pressure. If we should have deflation, that’s even more incentive to pay off debts today rather than tomorrow: today’s money is less dear than tomorrow’s in deflation.

The Emperors all have fancy degrees and Nobel prizes to spare: so far, basic Economics has been the child pointing out how very little they have on. The market paradigm did not shift in the 1990’s with the “Internet Economy” and neither did it shift in the 2000’s with the seemingly-eternal increase in housing prices. Those were bubbles, and they popped. Now there’s a call for massive spending: where’s the money going to come from and how will we be able to afford to borrow it? I’m sorry, Mr. Krugman. Your solution to the earlier recession was bad enough: I don’t think your solution to this one is going to be any better.

A basic tenet of Keynesian Economics is that, in times of recession, governments should cut taxes and/or increase deficit spending. The US government is doing just that right now.

However, and you knew there had to be a however for this to be a story, most state governments have to balance their budgets. In these hard times, that means they have to raise taxes and/or decrease overall spending. That means the requirements of their state budgets are working to cancel out federal fiscal stimuli.

While we’re on the subject, Keynes held that imports are a drain on GDP. When imports decrease, that shows up as a GDP increase, even though it may be indicative of a deeper economic problem, such as a collapse of demand in a nation. GDP in the USA can go higher in the recession due to this and fiscal policies and the economy can still be in the toilet. So if a talking head on the news should start bubbling about an increase in GDP for a quarter, look carefully at how much of that was due to a collapse in demand for foreign goods and unsustainable government overspending.