By Martin Hutchinson
The insouciant approach which President Barack Obama and the US budget negotiators have taken to the federal deficit, adding around US$900 billion to deficits over the next two years with no countervailing spending cuts, has been greeted by a sharp rise in Treasury bond yields.
This brings into focus a very delicate question: at what point does the US government’s credit cease being the world's "safe haven" and become merely a much larger and more dangerous version of Greece?
For the past two years, anti-Keynesians such as this columnist have warned that massive federal deficits run the risk of crowding out the private sector, especially the small business private sector, which has the most difficulty accessing funding.....
With dollar interest rates generally declining and Chinese and other foreign investors happily piling in to fund budget deficits of $1.3-$1.4 trillion, this had appeared a purely theoretical problem. However, with commercial and industrial loans (including small business, but also including the relatively active leveraged buyout sector) declining by 25% to $1.22 trillion in the two years since 2008, the problem has been a real one.
With the supply of long-term government debt so overwhelming, the yield curve between short-term and long-term interest rates has been artificially steep for over two years. Thus banks have been able to borrow in the short-term markets and invest in long-term bonds, picking up a 3% interest spread for doing so, which they leverage 15-20 times.
In normal markets, such a policy would carry a fearful risk of enormous capital losses as interest rates rose - the First Pennsylvania Bank, a very substantial institution, was bankrupted by such activity in 1980. However with Ben Bernanke chairman at the Federal Reserve, banks feel they can afford to take the risk - and after all, if it goes wrong, all the big banks will get in trouble simultaneously and taxpayers will have to bail them out.
As for small business, lending to this sector requires far too much effort and is not particularly profitable. Medium-sized and smaller banks, which would normally make the majority of such loans, are struggling with the remnants of their daft housing and real estate lending in 2003-07. Just as theory would suggest but by a somewhat different mechanism, small business is being crowded out of the financial markets.
After two years of stasis, the bond markets have recently begun to move. Bernanke's announcement on November 3 of the second round of quantitative easing - "QE2" - with an additional $600 billion of Treasury bond purchases, had a perverse effect: it pushed up Treasury bond yields, particularly at the long end of the curve. Fed purchases are being concentrated in maturities of less than 10 years, presumably to mitigate somewhat the gigantic principal risk on the Fed's balance sheet; so naturally Treasury bond yields at the long end of the curve have increased.
The second trigger to bond market movement has been the tax cut deal reached last week between Obama and congress. Not only does this extend the 2001 and 2003 tax cuts, which had been assumed repealed in 2011 by the Congressional Budget Office projections, it also adds a temporary 2% payroll tax cut and other tax reductions for corporations and middle-income individuals.
Together, these will add about $900 billion to the budget deficits in fiscal years 2011 through 2013, making deficits in 2011 and 2012 remain well above $1 trillion. While there is some likelihood of spending reductions from the incoming Republican congress after January, the reality is that those reductions will be small in 2011 and probably not much larger in 2012. Thus in the next two years both fiscal stimulus and monetary stimulus are likely to be operating at full blast.
The short-term effect on the US economy should be quite beneficial. Fiscal stimulus that takes the form of lower taxes is much less damaging than additional government spending because it does not divert resources into unproductive uses. The Keynesian multiplier for fiscal stimulus, below 1 on almost all government spending and far below 1 when deficits grow to their current magnitude, is much closer to 1 for tax cuts, although the growth in deficits will continue to exercise a major drag through "crowding out".
If the tax cuts had taken the form of long-term supply-side cuts, such as a reduction in the tax on dividends (preferably through making them tax-deductible at the corporate level) and the deficit had been modest, the stimulus would have generated very substantial additional economic activity. Economic activity would also have been increased by a revenue-neutral tax change that increased incentives. For example, abolishing the home mortgage interest deduction and the charitable deduction - both of which divert resources into unproductive activities - and using the revenue for dividend tax reduction and a tax rate cut would be thoroughly beneficial.
In this case, the new tax cuts have no positive supply-side effect; they merely avoid the adverse supply-side effect of increases in marginal tax rates on high incomes, dividends and capital gains that would otherwise have happened on January 1.
Given the size of the budget deficit, they would without Fed "stimulus" result in further crowding out of small business, thus being no more than neutral in the short run. However, the net effect of the tax cuts and QE2 really should act to bring down unemployment, probably quite quickly, as the QE2 money creation will in the short run reduce the Treasury's net funding needs.
We are unlikely to get more than a modest reduction in unemployment in 2011, probably reversing in the latter half of 2012 as a double-dip recession looms, for two reasons. First, there is the combined effect of extended unemployment benefits and intensified competition from emerging markets - the latter factor tending to depress US wage rates ever since cellphones and the Internet came on stream in the 1990s. In the new world of easier outsourcing and more skilled emerging markets, wage differentials will narrow, and it is alas likely that much of that narrowing will come from downward pressure on US wage rates.
In a free market, such downward pressure would quickly be reflected in lower US wages, as those thrown out of work would be forced to adjust to the new reality. With prolonged unemployment benefits, adjustment to the new reality is delayed, at least for those unfortunates whose new equilibrium wage is close to the level of unemployment benefits.
Prolonged unemployment benefits (and higher minimum wages since 2007) may have only a modest effect on the equilibrium unemployment level in a thriving economy. However there can be little doubt that, in a US economy with high unemployment and strong downward pressure on wage rates, they will force unemployment to remain stubbornly high and new job creation to remain stubbornly low.
Second, our discussion so far has ignored the effect on the economy of the Fed's $600 billion money creation. With the new tax cuts, that money creation has not diminished the federal deficit as it would have without them. Hence Treasury bond yields will continue to be pushed up both by the continued demands of deficit financing and by the beginnings of resurgent inflation. The quite sharp run-up in Treasury bond yields we have seen so far will be only the precursor of a much larger reversal of the long-term bond bull market that has been in place since 1982.
Initially, this will merely make borrowing a little more expensive. The 10-year Treasury bond yield has approached 4% on a number of occasions in the past two years, and it is inconceivable that even the over-incentivized, testosterone-crazed denizens of Wall Street and the major banks have not made reasonable contingency plans for a modest run-up to this level. Since as I write 10-year Treasuries yield only 3.25%, there is some room for yields to rise before major adverse effects kick in, although as yields approach 4% there may well be some nasty reported losses on "bond trading" from those who have been too aggressive.
At some future date, almost certainly while the 10-year Treasury bond yield is between 4% and 5%, we will reach a break point. It must be remembered that the Modern Finance models of markets, assuming smooth trading and moderate price movements, are hugely in error. In reality markets move moderately only when they are between crises. In a crisis, the change in market behavior is analogous to that between the fluid dynamics of "streamlined flow" and "turbulent flow". Price movements become much larger, trading volume soars to astronomical levels and risk parameters move far out of their accustomed channels. When this happens, traders' belief systems about the market in which they work are destroyed, and they are forced to seek out another paradigm.
As 10-year Treasury yields move above 4%, there will at some point come a moment at which the comforting "safe haven" theory of US Treasury bond investment is exploded in the minds of traders worldwide.
Traders' view of US Treasuries will not then move to an intermediate level, in which Treasuries are regarded as only moderately risky. Instead, as in the markets for bonds of southern European governments, and in 2007 in the markets for subprime mortgage-backed securities, the traders' view will move with lightning rapidity from "safe haven" to "serious default risk".
At that point, even if US inflation still appears relatively benign, Treasuries will come to exhibit a substantial yield premium not only over risk-free debt such as that of Germany, but even over moderate-risk debt such as that of Colombia. Treasuries will trade as Greek-style junk bonds, in a market where the receptiveness to junk bonds has itself been markedly reduced.
The fiscal and monetary stimulus policies of November-December 2010 will thus impose a huge economic cost, not immediately but at some point, probably in late 2011 or early 2012, when there is a paradigm shift against US Treasury bonds in traders' worldview. When that happens, the US economy may well enter not merely a second dip but a chasm.....