As a new capital markets associate at Lehman Brothers in 2001, I was thrown into the summer program mating ritual known as rotations. That’s when you spend time working in various areas of an investment bank before being assigned to a department. The least popular assignment at the time was the government bond trading desk. Why? Because the U.S. was running a budget surplus, and everyone knew there would be no more government bonds to trade because the government’s borrowing needs would drop if there was no deficit to fund.
As we know, government bond trading survived. Fiscal discipline went out the window after the Sept. 11. attacks and people were no longer squeamish about spending money if it was for counter-terrorism purposes. A whole new government agency — the Department of Homeland Security — was created out of thin air. And there went the surpluses.
We have a much different problem today: too many bonds. It looks like trillion-dollar deficits are going to be a staple of the U.S. economy for the foreseeable future. Very few people outside of Wall Street understand the implications. Very few politicians understand, either. If you spend any time studying the entrails of a government bond auction, it is easy to see how the supply of bonds can overwhelm the demand, resulting in lower prices and higher interest rates. And that’s not just for the government, but for companies and consumers as well.
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Nobody has spent much time thinking about this, because following the financial crisis the Federal Reserve was buying government bonds by the bucket load and everyone wanted — or needed, because of new regulations — safe assets. But now, things are changing. China and Japan seem to be staging a buyer’s strike, and there isn’t much domestic demand because people are preoccupied with stocks and stuff such as Bitcoin. That’s a not-so-fancy way of saying risk preferences have changed.
We should care very deeply about interest rates, but we don’t. That’s probably because rates have been low for so long that the deficit hawks and bond vigilantes have fallen asleep. Nobody in politics today is really capable of speaking articulately on the need for less public borrowing. It has been a long time since anyone has uttered the phrase “crowding out,” but that is essentially what happens when the government runs large deficits: Public borrowing crowds out private borrowing, and rates rise for everyone because there’s only so much money to go around.
If 10-year Treasury note yields go from 2% to 3%, and mortgage rates go from 3.75% to 4.75%, there will be a class of homebuyers who can’t make the math on the monthly payments work. That family will be denied homeownership because the government wanted more aircraft carriers or more food stamps or something else. Most economists probably think households are better at deciding what to spend money on than the government, so the economy will suffer in a roundabout way.
But the bigger risk, in the short term, is market risk. It is an axiom in the markets that if rates go back up by 2 percentage points, stuff starts blowing up. It happened in 1994 when the Fed began hiking rather unexpectedly: Procter & Gamble; Orange County, California; and Mexico. That was a heck of a year in capital markets, but the potential is for much worse today since the entire economy is dependent on low rates.
Markets are experiencing a breathtaking amount of volatility, which is directly attributable to the prospect for higher rates. President Donald Trump and Treasury Secretary Steven Mnuchin need to be careful: The White House’s not-so-dire deficit projections are based on very optimistic economic assumptions. If there’s even a mild recession, then the government will have to borrow even more, which in turn could cause rates to rise, exacerbating the recession. In countercyclical fiscal policy, you’re supposed to run deficits in bad times and surpluses in good times, not run deficits in good times and bad times.
If you’re familiar with former Fed Chairman Alan Greenspan’s old essays, he was no fan of government debt. He thought that if the debt got large enough, then the government would be tempted to compel the central bank to buy it in order to put a lid on rates. That’s known as debt monetization. People are already beginning to ask the government would do if rates got out of control. The idea is almost too terrible to contemplate. We’re not close at this point, but it’s not an irrational fear.
It’s interesting that we were all deficit hawks in the 1990s when debt-to-gross domestic product was about 50%, but now that it exceeds 75%, as measured by the Congressional Budget Office, nobody seems to care — in either party. The only people who care are the libertarians, who seem horribly out of touch.
The only thing that surprises me is that some think the government ramping up debt and deficits is a surprise. Trump campaigned on spending and lower taxes. No one thought it was a good idea to ask about the deficit. My sincere hope is that one day people are as passionate about debt as they were in the 1990s.
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