This post is a follow-up to The Coming Fiscal Train Wreck — Part I, which itself was a follow-up to Revisiting The CBO's Budget Fantasies. In the Fantasies post I concluded that the Congressional Budget Office's revenue projections for the decade 2011-2021 are unrealistically high, which makes future deficits far worse than the CBO projects. The first Train Wreck post looked at outlays, focusing on the heart of the debt problem—discretionary Defense spending and health care entitlement spending (Medicare & Medicaid). It will come as no surprise that I concluded that these two line items alone will raise the Debt/GDP ratio into the stratosphere, and it will be well-nigh impossible to make major spending cuts in either program for political reasons.
I was going to discuss social security and policy problems today, but I thought it best to narrow the discussion to future interest rates on Treasury bonds. The standard assumption is that these rates will rise as the United States more and more comes to resemble Greece, which is now the canonical example of fiscal irresponsibility. Rates may rise precipitously sometime in the next decade, but the dollar is still the world's reserve currency, and the United States can print money. These conditions complicate the discussion considerably.
The Doomsday Machine
This chart from Eric Janszen's The Big Bet revisited - Part I: Turkeys Grounded puts the bond discussion into historical perspective.
The Doomsday Machine, aka. the Great 30-year Bull Market in Bonds. From Eric Janszen: "A economy-wide, 30-year refinancing boom spurred the economy but left behind trillions in unsupportable corporate, especially financial corporate, and household debt. The trend peaked in 2008. Now the Federal government is on the hook to keep the economy afloat." Note that the early 1980s marks the beginning of the decline of the Empire.
Click to enlarge.
You can see that during the FIRE Economic Era (finance, real estate, insurance), total public and private debt grew and grew, but the yield on the 10-year declined over time. Janszen explains—
John Kenneth Galbraith said "Genius is a rising stock market" to describe the mass of equity investors who feel brilliant during bull markets. A related phrase that comes to mind is "When the wind blows hard enough, even turkeys fly" that came into favor during the stock market bubble when the New Economy hype kept pet.com and other Internet stocks aloft.
The same principle applies to politicians during extended bull markets in bonds. The decline in interest rates from over 14% in 1981 to under 4% in 2011 let the economy to refinance debt — corporate, household, and government — with the same kinds of benefits that accrue to homeowners as a group when mortgage rates drop. Money that was previously spent on interest is freed up for other expenditures. New borrowing demands ever smaller interest expense.
The opposite occurs in the early stages of an inflationary period before interest rates begin to rise and the wind stops blowing. The genius politicians who took credit for the booming economy get grounded. Like now.
Janszen seems to believe we are entering an inflationary period which will ground our political turkeys and raise borrowing costs. I'm not so sure about this, but the Congressional Budget Office makes the same assumption.
From the CBO's The Budget And Economic Outlook: Fiscal Years 2011 To 2021. Future yields on the 10-year are circled.
The current yield on the 10-year coupon is 2.29%, but the rate fell from 2.77% on August 1st after the debt ceiling fiasco was resolved, and after Standard & Poors downgraded the U.S. credit rating to AA+ with a negative outlook (meaning more downgrades can be expected). This rush into Treasuries is usually called the Flight To Safety, or better yet, The Flight To Quality. Looking at Europe's sovereign debt and that of emerging economies, we can say that America appears to be the smartest kid with Downs Syndrome.
Those calling for much higher interest rates on U.S. borrowing have been disappointed over and over again. Despite the protestations of doomers like Marc Faber and Peter Schiff, rates continue to be low, following the long-term trend shown in Janszen's chart above. Can this situation continue? Where are the bond vigilantes?
Where Are The Bond Vigilantes?
To understand why the bond vigilantes are missing in action, it is enough to look at who is financing America's debt. I first broached this subject in Who Will Buy Our Treasuries? The post's title comes from Bill Gross, who was ruminating on that subject.
The U.S. outstanding debt is $14.3 trillion, and $4.6 trillion of that is intragovernmental holdings debt. See my post How F**ked Our We? Pretty Darned... to see the big debt chart. Those buying T-bills can be broadly divided into four groups.
- The Federal Reserve, which currently holds $1.6 trillion. This is casually (and correctly) referred to money printing, or monetizing the debt.
- Foreign Central Banks, which are recycling dollars. Foreign governments hold $4.5 trillion.
- Commercial banks hold about $1.7 trillion, as I described recently in Two More Years Of Backdoor Bank Bailouts. The Fed's near-zero short-term interest rates bankroll the banks, who buy Treasuries and reap the difference between the interest rates.
- Everybody else, which includes pension funds, mutual funds, and so on. These are the bondholders seeking safety, or quality. Everybody else holds $1.5 trillion.
No bond vigilantes here! Plenty of fraud, yes, but there's nobody in this list who will hold the government at gun point to get it to reduce its Debt/GDP ratio. OK, maybe the Chinese, who hold $1.2 trillion, will call us on our fraudulent funding schemes. Maybe, but maybe not.
Looking at who buys our Treasuries, we think this scheme must fall apart, it should fall apart, it is a grievous offence to all things legitimate, so we want it to fall it apart. But will it? I think it could it go on for years! That certainly appears to be the intention of current Treasury secretary Tim Geithner and Fed chairman Ben Bernanke, who recently declared that the ZIRP will remain in place through mid-2013, and hasn't ruled out Money Printing Quantitative Easing #3. We are turning Japanese. Bernanke-san.
In theory, all this should cause a massive devaluation of the dollar, and not so theoretically, punish savers until they are absolutely forced to take risks with their money. As I said in yesterday's post, the Paradox of Thrift says you've got to spend (or invest) your money, regardless of the risk to yourself, even if you've got to borrow the money to do so.
However, there is also a Flight to Safety—certainly not Quality—into dollars just as there is for Treasuries. Once again, we are the smartest kid with Downs Syndrome. And as long the dollar remains the world's reserve currency, and we have the ability—and most importantly, the will!—to print money, the phantom Bond Vigilantes might be held at bay.
As I described in the first two posts of this series, economic (GDP) growth over the next decade is likely to be sluggish (in the ~1.5-2% range). The Debt/GDP ratio will skyrocket, and I believe it will be somewhere in the 133-150% range by 2021 (about 21-23 trillion dollars). Surely these debt levels can not be sustained while economic growth remains anemic. See my post The Biggest Ponzi Scheme Ever Conceived.
There are far too many variables to consider to predict with any certainty what might happen over the next 10 years. For example, we don't know what the inflation rate will be, which also depends on a lot of unknowns like how much money will we print? However, and this is my point today, it may not be an interest rate catastrophe that reins in America's reckless spending and blows up our fraudulent debt-funding scheme.
Bonus Video — "... the Doomsday Machine is designed to explode if any attempt is ever made to untrigger it!"
You're focusing on treasury bills but I'm focused on price inflation. The numbers in the chart cannot be correct. In the last two years, price inflation has been rising steeply. Dog food up 40%. Sugar up 50%. Out of season fruits and veggies 50% or more. All my energy bills are up drastically. The government lies about inflation so it won't have to pay more to the old and disabled.
Posted by: sharonsj | 08/16/2011 at 12:47 PM