In an effort to combat deflation and loosen credit, policymakers could cause the bursting of the Treasury bond bubble and create immediate consequences that will further complicate recovery plans. Read the following article from Money Morning.
Frighteningly, like the rush into tech stocks, then the rush into real estate, and then the rush into commodities, the rush into U.S. government bonds has created a Treasury bubble. In a cruel twist of economic fate, passage of an aggressive Obama administration stimulus plan could further inflate that bubble—before popping it.
The United States of America is an expensive household to run. In order to pay the nation’s bills, the U.S. government levies taxes. When expenditures exceed tax revenue, the government has to borrow money. The United States borrows money by ordering the Treasury Department to sell government IOUs to investors in the form of Treasury bills, notes and bonds, collectively known as Treasuries.
How much does the government owe? As of Friday, according to TreasuryDirect.gov, total U.S. public debt stood at $10,620,397,126,433.54 ($10.62 trillion)—and counting.
The case for Treasuries
Investors throughout the world—including those here in the United States—buy Treasuries because they pay interest and, moreover, because they are backed by the full faith and credit of the United States. What underlies the faith that investors have in repayment is the knowledge that the U.S. government has the power to levy taxes to raise money to pay back creditors. In addition to its taxing authority, the government can literally print money and pay back investors with dollars fresh off the U.S. Federal Reserve’s printing presses.
Because investors in the United States and around the world have been fearful of the collapsing residential and commercial real estate markets, declining equity markets, and potentially insolvent banks, they have had a tremendous appetite for safe U.S. Treasuries. The extraordinary flow of money into Treasuries caused their prices to rise. When prices rise on fixed-income investments like Treasuries, their yields fall.
In some cases, the demand for safe Treasuries drove yields on short-term bills down to zero; in fact, for a brief few days last November, yields were actually negative, meaning investors were paying the government for the right to own those Treasury securities.
At the end of the first week of January, the three-month T-bill yielded 0.08 percent; the two-year note yielded 0.87 percent; the 10-year note yielded 2.4 percent; and the 30-year bond returned a miniscule 2.82 percent, Barron’s reported.
It’s a good thing that there’s been a huge demand for U.S. Treasuries, because the United States has been spending billions—if not trillions—bailing out banks and acting as the investor of last resort during the ongoing credit crisis.
Troubled assets, Troubled times
Last October, as part of the so-called Troubled Assets Relief Program (TARP), Congress allocated $700 billion to buy "troubled assets" from banks that were losing money. Those institutions were truly troubled: They were unable to sell non-performing assets, were taking huge write-offs and, as a result, were not making new loans.
The initial TARP outlays—about $350 billion—went to suffering banks, in a few cases so they could buy lipstick and pretty themselves up before courting other wallowing institutions. Merged companies still declared massive losses and—as a result—bank-lending declined. In fact, 10 of the 13 largest beneficiaries of bailout money received $148 billion and saw outstanding loan balances drop by $46 billion, The Wall Street Journal reported on Monday.
None of the TARP bailout money actually went to buying troubled assets from floundering banks, earning the Treasury Department a stern rebuke from a congressional watchdog. Instead, most of the capital given to banks went onto their balance sheets as a capital asset and most of those institutions bought the highest-yielding government and agency paper they could find.
For instance, of the $45 billion Citigroup Inc. received from the Treasury Department, $10 billion was invested in short-term commercial paper issued by Fannie Mae, said a person familiar with the situation.
The other $350 billion that Congress authorized from the original bailout package was released last week, without any clear plan as to where it should go.
A snapshot of where taxpayer money has already gone reveals that what’s been spent and lent is a little more than the headline news services report. According to a Bloomberg analysis incorporating data from the Treasury Department and Federal Deposit Insurance Corp. (FDIC) and interviews with regulatory officials and others:
- $300 billion has been spent on Fannie Mae, Freddie Mac, American International Group Inc. and Bear Stearns Cos. (now part of JP Morgan Chase & Co.)
- $300 billion on Citigroup.
- $700 billion on TARP—though not on what TARP was intended for.
- $800 billion on Fed-directed asset-backed debt-purchase programs.
- $1.4 trillion on FDIC bank guarantees.
- $2.3 trillion on Fed commercial paper programs.
- And $2.2 trillion on other Fed lending and government commitments.
That totals a little bit more than $8.5 trillion.
Stop the presses?
As if it isn’t frightening enough that the Treasury is selling huge amounts of cheap debt to investors to bail out bloated, insolvent banks and inefficient industries, the Federal Reserve is printing money to buy commercial paper and illiquid assets from just about everybody to facilitate lending in almost every corner of the economy—and is then carrying these "assets" on its balance sheet.
Isn’t that how the credit crisis got started, with banks holding illiquid "troubled assets" on their balance sheets?
Since nothing the Treasury or Fed has done has alleviated the credit crisis in any meaningful way, and the economy is threatening to reprise the Great Depression, the newly installed Barack Obama administration is being forced to formulate another "new" stimulus plan.
With an "introductory" price of a mere $825 billion, there should be little doubt that the ultimate plan—once all the bells, whistles and pork have been added—will actually cost taxpayers several trillion dollars.
And government borrowing is already off to a flying start this year. Last year, the Treasury Department sold $892 billion of notes. According to Goldman Sachs Group Inc., one of the 17 primary dealers that buys Treasury debt directly from the government, the United States is expected to borrow a record $2.5 trillion in the current fiscal year.
This week’s Treasury calendar is set to top all previous records of debt issuance. After selling $8 billion of Treasury Inflated Protected Securities (TIPS), last Monday, the Treasury Department last Tuesday sold $40 billion of two-year notes, the largest two-year auction in history. Then on Wednesday, in another record-setting auction, the Treasury sold $30 billion of five-year notes. So far, the supply has been absorbed, but like the song says, "If it keeps on raining, the levee’s gonna break."
A blueprint for a burst Treasury bubble
In something like a cruel joke, because all the banks are still holding the bad assets that the original $700 billion Troubled Assets Relief Program was supposed to buy, the new "Plan B" may include going back to "Plan A," this time around forcing the government to actually buy those bad assets.
The same problems exist with the old plan, and no matter how it’s attempted, it will require a lot of money. In addition to this new Plan B, the new stimulus package will require additional outlays for infrastructure investment, as well as for the additional stimulus plans that are still to come.
Here’s where the aforementioned cruel twist of economic fate comes into play. The government will spend trillions of dollars of additional taxpayer money that hasn’t even been collected, yet. Even so, the Treasury Department will have to issue more debt. That means the Federal Reserve will have to print and spend more "worthless" paper money in order to pump liquidity into the failed U.S. credit system.
In spite of all that, of course, the stimulus package should eventually revive the U.S. economy.
And when it does…the hugely inflated bubble in Treasuries will burst.
Investors poured money into safe-haven Treasuries and accepted yields so low that in any normal market they would be unacceptable. When the investing horizon looks more promising, investors will dump their low-yielding Treasuries and venture back into the markets for real estate, the domestic equities, international stocks, corporate bonds, junk bonds, emerging economies, and all the other usual investment nooks and crannies that offer greater return potential.
The cruelest twist of economic fate would be that the Treasury Department will eventually have to raise interest rates to generate demand for the debt they have to continue to issue. And higher interest rates are the last thing our struggling economy needs.
While the Treasury has been issuing huge quantities of debt and the Fed has been printing money, the credit crisis and recession have reduced tax revenue across the board. As the recession deepens and unemployment rises, there are fewer taxpayers contributing to the income tax base. Furthermore, as fewer goods and services are produced and consumed, there will be less sales tax and other tax receipts for the states and federal government to collect. As we all know, if there is less revenue coming in, we’ll have to issue more debt to make up for the shortfall.
In addition to bailouts and projected stimulus spending, the administration’s package includes tax breaks for businesses and, eventually, promised tax reductions for the U.S. middle class. While lower taxes, theoretically and historically, have a stimulative effect over time, in the short run, there will be still less government revenue at a time of increasing government expenditures. Investors will come to fear that, without an expanding tax base, the government will have to continually roll over its debt or will print still more money to pay off creditors.
If it appears as if we’re in a vicious cycle that’s spinning out of control, it’s because we are.
Boosting debt even as we print more money will have a devastating effect on the U.S. dollar. While a devalued dollar makes U.S. manufactured goods and services cheaper overseas, it also makes the goods and services we import more expensive, as it takes more dollars to buy the same amount of imported products—especially oil.
The United States is a net importer and runs a huge current account deficit with its trading partners abroad. At some point if the dollar falls too low or collapses, the government will have to raise interest rates to support the dollar. If interest rates in the U.S. market rise relative to other countries, investors buy dollars and deposit them with U.S. institutions for higher yields. But, again, higher interest rates are exactly what the United States must avoid as it works to stimulate domestic production and consumption.
The problem with huge deficit spending and with printing money to pay for anything—particularly "troubled assets"—is that more money floating around in the system eventually spells inflation. If there’s more money in the system and there are fewer goods and services being produced, when the demand for those goods and services inevitably returns, the prices will be bid up.
While the present concern for policymakers is how to combat deflation’s detrimental effects, overspending on a new stimulus plan could cause the bursting of the Treasury bond bubble, and create immediate consequences that can only complicate recovery plans.
The trillion dollar question is this: Can a stimulus plan address the credit crisis, fund recovery spending, reinvigorate confidence, lay the groundwork for revenue enhancement and not throw taxpayer money down a black hole?
The answer is yes. There is a much quicker and safer way out of the credit crisis that takes us forward toward an economic recovery. The problem is that no one wants to hear it because no one wants to swallow the politically devastating harsh medicine that’s necessary to cure the plague we’ve infected ourselves with. As usual, there are too many vested interests protecting the same old turf.
Throwing good taxpayer money after badly wasted taxpayer money will not fix anything. But throwing out overly leveraged, overly greedy, overly dependent banks and bankers is a good start.
This article has been reposted from Money Morning. You can view the article on Money Morning’s investment news website here.