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The Trouble with Treasuries

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The world is rapidly getting poorer. According to the International Monetary Fund, worldwide losses from the financial crisis already measured $1.4 trillion through November.

Although it is equivalent to more than 2 percent of the world’s GDP, this figure does not even come close to reflecting the size of paper losses incurred as a result of the collapse of asset prices. Some $7.5 trillion has been wiped out on Wall Street since October 2007. Worldwide, equity market losses approach $30 trillion. The value of American residential properties fell by another $5 trillion, and some 12 million American households now have negative equity in their homes, meaning that they owe more on them than the houses are worth.

The destruction of value in the real estate sector can’t be fully estimated yet. In addition to the face value of distressed mortgage-backed securities, which currently are not traded, there is the $63 trillion notional value of contracts insuring such bonds from default.

Domino Theory

The extraordinary thing about the asset price meltdown has been how bubbles first inflated and then lost air one after another. First the U.S. housing market began to weaken in mid-2007, sending a massive wave of speculative liquidity sloshing around the world. It quickly inflated a bubble in stocks, at which time the Dow Jones Industrial Average touched 14,000. A year later, the Dow was down some 40 percent, while in some overbought emerging markets the losses were in the 60 percent to 70 percent range.

Commodities were next, as gold surpassed $1,000 per Troy ounce in May and oil hit $147 per barrel in July. Less than six months later, oil prices were down by two-thirds, and metals, chemicals and other commodities tumbled across the board.

Now, one more bubble has been created, this time in U.S. government debt. Since the advent of the subprime mortgage crisis, the yield on the 10-year Treasury bond has been cut by more than one-half, from over 5 percent to 2.5 percent. At the long end of the yield curve, the 30-year bond now pays just 3 percent, while at the short end investors snap up T-bills at zero percent interest.

The rally in Treasuries has been driven by two considerations. First, investors are looking for safety as they flee the carnage in various asset markets. One-to-three month T-bills are certainly the safest asset there is. Second, investors fear that the looming recession could be open-ended, resulting in a deflationary spiral. If consumer prices start to decline, a nominal yield of 2.5 percent to 3 percent could translate into a pretty substantial return in real terms. This happened during the Great Depression, when shrinking demand fed consecutive rounds of layoffs, whereas rising unemployment in turn depressed demand and drove down consumer prices.

Mismatched Supply and Demand

However, both these expectations could prove wrong. T-bonds may not offer the kind of safety investors are looking for; nor are inflation trends likely to prove so benign for savers and holders of riskless U.S. government bonds. On the contrary, the T-bubble may be the next one to burst, and bond prices may plunge just as spectacularly as house, commodity and stock prices have done earlier in the current financial debacle.

The U.S. Federal Reserve is cognizant of the experience of the 1930s and is unlikely to repeat the mistakes of the past. Fed Chairman Ben Bernanke agrees with the late Nobel Prize economist Milton Friedman, who believed that the Depression could have been avoided if only the Fed had drowned the U.S. financial system with liquidity. As a result, in line with Friedman’s recommendations, since the advent of the crisis the Fed has been pouring money liberally into the banking system. At the same time, the incoming Obama Administration will be taking no chances and will supplement massive monetary stimulus with public spending.

Washington is already awash in red ink. The Federal budget deficit reached a record $237 billion in October, the first month of fiscal 2008. For the fiscal year as a whole, the deficit is expected to hit at least $1 trillion, and the government will need to raise $1.5 trillion in new debt according to ex-Treasury Secretary Henry Paulson. This is likely to be a very conservative estimate.

Just as the supply of Treasuries is expected to rocket, demand may slip. Actually, private sector demand for Treasuries wilted a long time ago, both at home, where the savings rate is hovering close to zero, and abroad.

Central banks in China, Japan, Russia and other nations around the world that have been running large trade surpluses have been key buyers of U.S. government debt. Now, however, their trade surpluses have started to shrink, whereas their own economic situation has suddenly started to look worrisome.

Russia, which used to have nearly $600 billion in hard currency reserves, has spent a third of its cache since August. Japan is in a recession and China has introduced a $586 billion fiscal stimulus package, which it will have to finance by selling its dollar-denominated assets, including Treasuries. Other foreign central banks have been selling their Treasury holdings as well, in order to support their flagging currencies.

Not So Safe Haven

Economists arguing about this mismatch between supply and demand have mainly concluded — rightly, I think — that there is still enough demand for U.S. Treasuries to prevent the market from collapsing. Even if there is no outside demand for Treasuries, the Fed could continue to finance Federal debt directly by issuing more and more paper dollars.

Nevertheless, the risk of a yield spike in the U.S. Treasury market remains substantial. So far, the money the Fed has already been printing in vast quantities has not had the effect of starting up the economy. On the contrary, economic activity continues to contract and demand continues to shrink. Consumers are staying away from shopping malls, homebuyers are not looking at houses and businesses are not investing. True, they want to save money for a rainy day but, even more important, they have developed strong deflationary expectations. Everyone believes that he can get the same thing a lot cheaper if he only waits a few more months. In an environment of shrinking demand, such expectations become self-fulfilling prophesies.

This picture will eventually change, and it can change quickly. An inflationary jolt could shake the global economy. It could take the form of an oil shock, if OPEC succeeds in curbing production sharply or, more likely, if a major oil producer, such as Venezuela or Nigeria, suffers political turmoil that would curb its production. A supply disruption in China could also send a wave of price increases through the global economy.

But even without some unexpected shock, if output continues to shrink and money keeps accumulating, eventually the monetary overhang will come into play. More and more pent-up demand will be freed up, and plentiful money will start chasing a shrinking quantity of goods and services. Money will begin to lose value and prices could rise sharply. Inflationary expectations will prompt consumers and businesses to start spending money more quickly, driving up prices.

The shift from deflationary psychology to inflationary psychology could be very quick. It should be recalled that as recently as mid-2008, many central banks around the world still believed that inflation was the enemy and kept raising their interest rates.

The current crisis is a debt crisis first and foremost. There has been excessive borrowing by U.S. consumers that has gone on for a decade, as well as leveraging of assets on an unprecedented scale. Robust growth probably can’t return unless the borrowing slate is wiped clean.

Inflation punishes savers and destroys investment, but it has the advantage of reducing the real value of debt. It also boosts government revenues, since it pushes more taxpayers into higher income brackets. The U.S. government is the world’s largest debtor. It already pays $450 billion a year in interest on its outstanding financial obligations. It will be the world’s greatest beneficiary of any bout of inflation.

The only problem with this scenario is that the holders of U.S. Treasuries, instead of getting hoped-for protection from the current financial debacle, will end up holding the bag.


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