What is the difference between the and those? If you are Barack Obama, it may determine whether you have a successful presidency, and at the very least it defines how much maneuverability you will have in the financial markets. To give an example, suppose I said ”œDamn the deficit! Full speed ahead.” This is an altogether different statement than ”œDamn those deficits! We have enough debt.”
The first sentence is how the global bond market has approached the U.S. financial condition for the past fifteen years. The focus is short term and singular ”“ the market looks at the deficit racked up in the past fiscal year. Year by year goes by, and nobody notices how the annual deficit creeps higher and higher. When economic conditions worsen, the market says ”œI don’t give a damn about the deficit ”“ go ahead and borrow more.”
The second sentence was how the bond market used to approach the issue; the concern was on the cumulative deficits, or in other words, the total debt. In this second mode, the market penalizes each incremental borrowing because it expands the total debt and is seen as hurting investors.
Obviously the first approach is a very indulgent view of U.S. borrowing and has allowed for an enormous expansion of the federal deficit. How did we get into this situation? There are quite a number of biases that helped create this tolerance.
1. Reagan taught us that deficits don’t matter.
This is the operative fiscal philosophy of Dick Cheney, as related by former Treasury Secretary John W. Snow. Not that Ronald Reagan intended to teach this lesson. He came into office with an economic team that was composed of a new breed of economists ”“ supply-siders ”“ who felt that tax rates were so high they were stifling economic growth, and if you cut tax rates the subsequent growth in the economy would generate sufficient tax revenues to cover any deficits. There was a more sinister motivation as well, best expressed by anti-tax zealot Grover Norquist, who famously said he wanted to shrink the federal government so that it could eventually be drowned in a bathtub. As the deficit ballooned following massive cuts in the tax rates, the pressure would be so great to balance the budget that the federal government would be forced to shrink drastically. Et voila! No more New Deal or other ”œwasteful” social programs.
What went wrong with this theory is that Ronald Reagan never had the guts to cut federal spending. He just let the debt grow, and in a dramatic fashion. Dick Cheney somehow took from this experience the belief that you could grow the federal debt forever without consequences; the economy would flourish and things would miraculously work out in the end. Cheney was speaking for virtually all the Republican Party, because today’s Republicans would rather slay their first born child than ever raise anybody’s taxes or do anything about deficit spending.
The end result of this crackpot economic theory is that when the Republicans are in power, there is no check in the White House on deficit spending, and when they also control the Congress the door is wide open to pork barrel budgets and rampant growth in the national debt.
2. The Federal Reserve imposes no penalty on the administration or Congress when deficit spending is out of control.
We need to qualify this statement somewhat. The Federal Reserve from the 1980s to most of this decade has been under the helm of Alan Greenspan. He is a deficit hawk when Democrats run the White House or Congress, but he loses all fears about the national debt when Republicans are in power. We saw this during the Clinton administration. Greenspan kept interest rates high and said many times publicly that he was unable to lower them unless something was done to reduce annual deficits. He obligingly began lowering rates in the 1990s once Clinton introduced much stricter controls over spending, and Congress adopted a pay-as-you-go policy that required new revenues to be found for any proposed spending. When George W. Bush came to power, Greenspan had a miraculous change of heart. He kept interest rates low when Bush began giving away the budget surplus he inherited, and then he lowered them further when Bush moved into full-scale deficit spending, with a complicit Republican Congress helping him every step of the way. The effect of all this was that there was no independent check from the Federal Reserve on deficit spending when Republicans were in power, and in fact monetary policy abetted fiscal policy by goosing up the economy artificially with low interest rates and massive deficits.
3. The bond market itself exercised no discipline on the U.S., because two big purchasers of federal bonds arose to soak up much of the new paper being issued.
Quite conveniently, Japan and China came to the rescue of the U.S. just as George W. Bush was about to plunder the Treasury. Both of these countries are export powerhouses, China being the more recent arrival in this area, and both of them embraced a symbiotic relationship with the United States as the biggest consumer in the world. Japan and China would sell all they could of manufactured products to the U.S., but instead of being paid in goods or services of equivalent value, they were content to be paid in paper ”“ U.S. Treasury securities, and large amounts of ”œagency” paper issued by Fannie Mae and Freddie Mac.
By the autumn of this year, the federal debt had exceeded $10 trillion for the first time, and had more than doubled in the eight years of Bush’s administration (he has added more to the national debt than all other presidents combined, which includes the previous profligate spending of Ronald Reagan). If you subtract from the $10 trillion any Treasuries owned by agencies of the U.S. government itself (largely the trust fund for Social Security), you find that nearly 50% of all publicly held U.S. debt is owned by foreigners, mostly central banks, and mostly China and Japan, which hold a half trillion dollars each. These numbers do not include hundreds of billions of dollars of agency securities owned by these governments, which were betting correctly that these securities were really the full faith and credit of the U.S. government (they were proven correct when the U.S. government nationalized both Fannie Mae and Freddie Mac this year).
So instead of having a bond market that penalizes excessive spending by demanding higher interest rates, we had a distortion for at least a decade of two countries buying all the debt they could, just to keep their exporters in business selling to the very country issuing all this debt. The U.S. sat back and let its financial fate drift increasingly to two foreign powers, because as we all know, ”œdeficits don’t matter.”
4. Once the Democrats got into power, they abandoned fiscal discipline.
Pay-as-you-go never made a comeback even though the Democrats took over at least part of the Congress in 2006. This may have been because it wouldn’t have mattered anyway with Bush discovering the power of the veto, and the Republicans still able to derail any bills in the Senate. Still, the Democrats never displayed any concern about the national debt, and now that the U.S. economy is flirting with an economic depression, everyone is reaching into the FDR/Keynesian toolkit that requires large amounts of federal deficit spending to pull the economy out of a prolonged and serious economic slump. Whereas Congress has spent a decade arguing over the cost of national health care, which could run as much as $100 billion dollars, suddenly it is easy to spend $700 billion on a bank bailout, another $300 billion rescuing Citibank, about $100 billion taking over the commercial paper market, and in excess of $1 trillion nationalizing the two housing agencies. Some of these amounts are promises to pay in the future if necessary, but of the total, at least $1 trillion has been added to the national debt as the U.S. Treasury has had to issue new bonds worth at least that amount.
5. The Credit Crisis has created unexpected public demand for Treasuries.
One thing the Credit Crisis has taught the general public is that it pays to worry about getting your principal back, even from something as basic as a checking or money market account. The collapse of Lehman Brothers and Bear Stearns, along with the merger and disappearance of Washington Mutual, Merrill Lynch, and numerous hedge funds has shown how it is possible to lose all of your principal in a credit default. Even the rich are not immune, as evidenced by the Bernie Madoff scandal.
As a consequence of these fears, hundreds of billions of dollars has fled the banking system and been put into U.S. Treasuries, to the point now where the public is willing to pay interest on its own deposits (which is to say, buy Treasuries earning negative interest). This is the sort of fear one sees in depressions and deflations, and it has occurred conveniently when the United States is issuing enormous amounts of new debt.
When Will the Bond Market Change its Mind?
In the financial markets, it is true that the same situation can go on for a long time. The United States has enjoyed at least 15 years with no checks and balances on its fiscal excesses. The American government, the American consumer, the global bond market, and various central banks are all co-conspirators in this effort to allow consumption in the U.S. to be based entirely on borrowing as a means of payment.
Another economic truism is that nothing lasts forever. The financial markets can ”œturn on a dime”, especially when it comes to trillions of dollars at stake. The United States enjoys a halo of financial respectability built on many decades of economic growth, and based on its role as the linchpin of the global financial system (starting with the U.S. dollar itself as the world’s reserve currency of choice). One day, though, the world notices that the halo is gone, and then everything changes.
What does this mean in practical terms for the United States? It may mean that domestically a national deficit scold will appear on the scene, and like Ross Perot in the 1990s, change politics so that it becomes fashionable again to worry about the federal deficit. More likely, though, it means that our symbiotic friends Japan and China will reach their saturation limit for buying new Treasuries. What the United States asks of the world is not just that it hold on to the Treasuries it owns, but that it add $1 billion more a day, day after day, year after year. Japan and China may no longer be able to shell out $1 billion a day to buy our paper.
When Fannie Mae and Freddie Mac were in serious trouble earlier this year, Japan and China were quick to demand protection from the U.S. government. They wanted assurances that their agency paper would not default, and that the U.S. government would step in and take over responsibility for these debts if necessary. Not only did they get such assurances, but the U.S. Treasury now backstops agency debt, and owns and manages both of these companies under the nationalization program. Existing debt, therefore, is secure as far as these central banks are concerned.
But that says nothing about future debt. The appetite for taking on future debt is constrained by several events. For one, if the bond market starts to sell off U.S. Treasuries, yields will necessarily rise in order for the government to attract buyers for any new paper. This means the existing holdings are devalued ”“ if Japan or China were to sell existing debt, they would take a financial loss.
Which leads to the second point. Japan is fast slipping into a deflationary recession, which is beginning to look worse economically than the ”œlost decade” of deflationary stagnation in the 1990s. China is also facing a deteriorating situation, and has promised a $500 billion government spending program to buttress the economy. China can issue new debt to cover these promises, but China’s credit rating is not that good and its debt capacity is limited. Which means China, like Japan, will ultimately have to dig into its reserves and start selling some of its existing U.S. Treasuries. Because they hold such massive amounts of these securities, even a modest sale program would likely drive U.S. interest rates and borrowing costs higher.
So forget about anyone buying future debt, it is the sudden release of existing debt on the open market that is the bigger worry. Not only would bond prices tumble, and yields therefore rise, but to make things worse the bond market would have to deal with a third revelation, which is that the U.S. government itself cannot raise enough money to pay back its debt.
How could this happen? Any national government is financially only as strong as its ability to generate tax revenues from its citizens. Taxing power is the fundamental pledge that all modern governments make to anyone who holds on to the currency of issue, because currencies these days are ”œfiat money”, having no backing in anything tangible or tradable like gold or silver. What is already happening on the municipal and state level in the U.S. ”“ rapidly declining tax revenues ”“ is now creeping into the federal budget. The collapse of the stock market in September and October will severely deplete tax revenue from capital gains in 2009, and rising unemployment will lead to a reduction in take from income taxes. The true danger of this situation will suddenly reveal itself to the market sometime in 2009.
You will then have a perfect storm. The principal buyers of U.S. Treasuries will disappear because they have more urgent domestic needs for their reserves. They will even be selling their stockpile of existing Treasuries. The U.S. government will begin to have obvious problems raising tax revenue to continue to pay on its debt, and while it won’t default on its debt, its Aaa credit rating will be in jeopardy. The bond market will suddenly realize U.S. Treasuries are no longer risk free ”“ that in fact they are quite risky. Everyone will suddenly start worrying about those deficits, and as buyers disappear for U.S. paper, interest rates will head up. The Congress, the White House, and the Fed ”“ hitherto blissfully ignorant of any costs to federal deficits ”“ will have discipline forced upon them.
As this scenario plays out, President Obama will find his hands are tied. Every incremental bit of new debt issued to the market will have a cost in the form of higher interest rates, and probably a weaker U.S. dollar on the exchange markets. An economy already in depression will be in desperate need of fiscal stimulus (monetary stimulus in this situation is already useless ”“ interests rates are close to zero and are not spurring borrowing and lending). But Barack Obama will not be able to issue new debt in any substantial quantity, because it will drive interest rates higher, and the economy deeper into depression.
I suggest that this scenario will occur in 2009, but no one knows for sure. If President Obama is lucky, he can go on issuing debt year after year without much consequence except for future generations. There is a general impression that if things get really bad, Obama can turn himself into another FDR and spend his way to ameliorating people’s pain, if not reviving the economy right away. But FDR came into office with a relatively modest national debt compared to Obama, and he wasn’t fighting a major war at the cost of at least $100 billion a year.
Obama’s situation is in fact much more dire than he realizes, and much worse than FDR’s when he became president. My suspicion is that 2009 will be the year when the American halo disappears completely, and the desperate condition of the country will be fully revealed, at great cost to the U.S. stock market, to the economy in general, and to the well-being of all Americans. Politically, it is not clear that such a tragedy will somehow usher the Republican Party back into power. In fact, the dissolution and disappearance of the Republican Party, or at least its permanent confinement as a regional Southern party, is much more likely, because in the minds of the voters, any political party which has brought about two Great Depressions doesn’t deserve to exist.
But President Obama will not escape either. He will find his maneuverability restricted and the presidency very confining, to the point where the best he can do is become a national cheerleader bucking people up in the face of terrible economic deprivation. His historical epitaph might well be reserved to one observation: ”œAt least he was good at giving speeches.” This might not sound like much, but to the average American about to undergo the pain of this coming depression, any solace will be welcome.
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