The Risk of Doing Nothing


Saturday March 19th, 2011   •   Posted by Craig Eyermann at 5:48am PDT   •  

Bloomberg BusinessWeek has identified the biggest risk in continuing today’s levels of deficit spending for the U.S. government:

Barack Obama may lose the advantage of low borrowing costs as the U.S. Treasury Department says what it pays to service the national debt is poised to triple amid record budget deficits.

Interest expense will rise to 3.1 percent of gross domestic product by 2016, from 1.3 percent in 2010 with the government forecast to run cumulative deficits of more than $4 trillion through the end of 2015, according to page 23 of a 24-page presentation made to a 13-member committee of bond dealers and investors that meet quarterly with Treasury officials.

While some of the lowest borrowing costs on record have helped the economy recover from its worst financial crisis since the Great Depression, bond yields are now rising as growth resumes. Net interest expense will triple to an all-time high of $554 billion in 2015 from $185 billion in 2010, according to the Obama administration’s adjusted 2011 budget.

“It’s a slow train wreck coming and we all know it’s going to happen,” said Bret Barker, an interest-rate analyst at Los Angeles-based TCW Group Inc., which manages about $115 billion in assets. “It’s just a question of whether we want to deal with it. There are huge structural changes that have to go on with this economy.”

The interest expense on the national debt matters because of how the U.S. national debt is structured between short-term and long-term obligations. California Congressman John Campbell describes what he learned about that factor earlier this week:

Treasury Bonds: I learned something last week. I learned that fully 40% of the over $9 trillion in Treasury debt currently outstanding to the public has a maturity of 3 years or less. Put another way, it means that we are rapidly approaching $4 trillion in U.S. debt that matures by 2014 or sooner. As I write this, the yield (interest rate paid) on a 2-year Treasury note is 0.645% or about 2/3 of one percent. The yield, at the same time, on a 10 year Treasury note is 3.4%, and on a 30 year is 4.55%. In bond parlance, this is called a “steep yield curve” where interest rates get much higher as you go farther out in time.

It’s pretty clear why the Treasury is doing this. By issuing mostly short-term notes, the Treasury is paying less interest, thereby keeping interest costs and, consequently, the deficit down. In addition, the Federal Reserve is in the middle of its “quantitative easing #2″ (QE2) under which it is buying $600 billion of our own Treasury debt over about a 6 month period. The Fed is not buying the short-term notes, but is buying 10 year maturities and longer in order to hold those rates down. And, since the Fed is earning the interest thereon (paid by the U.S. Treasury), it is improving its yield. We are currently running a deficit of about $130 billion per month, so the Fed is basically buying all of the new bond issuance from the deficit for almost 5 months.

Campbell next weighs in on the potential consequences of continuing that arrangement:

What does this all mean? I understand that the Fed and the Treasury are trying to keep interest rates low and improve the economy and the deficit. But, when coupled with the huge deficits, these moves look a bit like a Ponzi scheme that will soon unravel.

We are printing money ($600 billion) to buy our own debt so that the full effects of the deficit are not felt. We are buying long-term bonds to artificially hold down the rates on those bonds since home mortgages and many other things are based on those rates. We are selling the short-term bonds at cheaper rates to hold down costs now, but are leaving ourselves open to huge cost increases when interest rates go up. And, we are at historic lows on these short-term bond rates. If they were to rise by 3 points (which would put them where they were at as recently as 2008), our deficit would increase by another $150 billion per year, even if the long-term rates stay the same. And, once the Fed ends QE2, even if it doesn’t reverse it, the markets will then have to absorb a new influx of long-term bonds at a time when our ability to pay them is in question. The Fed can cure a bunch of this simply by printing a lot more money. That, however, will result in an inflationary period with major wealth destruction and economic malaise.

The Securities and Exchange Commission offers the following insights into what a Ponzi scheme is and what causes them to unravel:

What is a Ponzi scheme?

A Ponzi scheme is an investment fraud that involves the payment of purported returns to existing investors from funds contributed by new investors. Ponzi scheme organizers often solicit new investors by promising to invest funds in opportunities claimed to generate high returns with little or no risk. In many Ponzi schemes, the fraudsters focus on attracting new money to make promised payments to earlier-stage investors and to use for personal expenses, instead of engaging in any legitimate investment activity.

Why do Ponzi schemes collapse?

With little or no legitimate earnings, the schemes require a consistent flow of money from new investors to continue. Ponzi schemes tend to collapse when it becomes difficult to recruit new investors or when a large number of investors ask to cash out.

The difference with a government operating a similar scheme with its finances however comes down to its being able to literally print money to keep its spending party going, as Campbell notes, and also its ability to push its citizens and businesses to “invest” in the scheme. Whether they think it’s a good idea or not.




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