Page 12 news that will soon be page 1.
It is no secret that the US government has been running up the credit card of late. So far there do not seem to have been any adverse consequences from the run up, but that does not mean that there will not be any, ever. On the contrary, a crisis is slowly building, and it is one that will erupt suddenly.
This is a story of debt and the dollar.
Before I start, a quick note: US Government debt consists of two forms. Form 1 is borrowed from the public (this debt is held by private citizens, hedge funds, mutual funds, foreign governments etc) and Form 2 is borrowed from trusts funds, like Social Security. At the end of April 2009, Debt held by the public was $6,930,824,942,975, debt held by Social Security etc was $4,307,767,198,983 , for a total debt outstanding of $11,238,592,141,958.
Here is the problem:
In the last 12 months (May 1, 2008 to April 30, 2009) the US government has borrowed $1.7 trillion in net new borrowings from the public. This is equal to 1/3 of the entire debt that was held by the public as at May 1, 2008. That's right, in 12 months the government has borrowed 25% of the total amount it has ever borrowed from the public in 230+ years!
| Public Debt | Social Security etc. | Total |
May 1, 2008 | $5,227,864,606,882 | $4,118,554,496,321 | $ 9,346,419,103,203 |
April 30, 2009 | $6,930,824,942,975 | $4,307,767,198,983 | $11,238,592,141,958 |
1 Year Change | $1,702,960,336,093 | $ 189,212,702,662 | $ 1,892,173,038,755 |
The Good: On the good side is the fact that the US government has been able to borrow $1.7 trillion from the market in one year AND still have interest rates at record lows AND still have the dollar strong. On paper you would think that this would be impossible. Luckily however, for now at least, the US dollar is the world's reserve currency, and the dollar is the "go to" currency when times get scary and people want to keep their money safe. This "generosity" on the part of the market has allowed the government to run a huge budget deficit with little or no consequences to date.
The Bad: The money that has been lent to the US government (all $1.7 trillion of it) has to have come from somewhere. It has come primarily from investors wanting safety and from countries with trade surpluses looking for a place to stash their dollars (think China, Japan, Opec, etc.) and from the Federal Reserve which has been buying up debt (and printing money in the process). So far so good. In fact with rates so low one could be forgiven for thinking that there is still substantial excess demand out there for US government debt. But is that really the case?
Maybe so...but what about the future?
Not only does the US government need to hope that investors want to keep buying US debt, but it also has to keep finding a steady stream of new buyers willing to buy the continuing flood of new debt that it needs to issue to fund the deficit. Let's look at potential sources of this "stream" of cash.
1. Trade surplus countries. While China, Japan and OPEC nations have been big buyers of US debt in the recent past, this may not continue. The recession has hit trade exporters hard and many have seen a dramatic drop in their trade surpluses. No trade surplus, no need for US dollars. China in particular seems to have had other ideas of late. It has actively been buying commodities (copper, etc.) as a way of buying tangible assets with their reserves, as opposed to more US debt.
2. Safe Haven investors. Stock market crashes, bank failures, and Madoff scams are just a few of the reasons that people have decided that they want to keep their money safe, in US Treasuries (after all the US can not go bankrupt as it owns a printing press). So scared have people been that at times they were getting a negative rate of return on their Treasuries, and still bought them. But with fear ebbing, the peak inflow of "scared money" has likely passed. It is unlikely that this can be a major source of new purchases of Treasuries. In fact, some of this safe haven money may actually start to depart in search of higher returns.
3. Social Security. In the past, the government could count on borrowing "easy" money from Social Security every year. This was usually in the range of $250-300 billion per year. BUT...with a recession and more people retiring and fewer people working, instead of "providing" money, Social Security has started to "take" money. Since January 1, 2009, Intragovernmental holdings (primarily Social Security) have been reduced by $25 billion. This is a fundamental change, especially as the government is trying to borrow more and more. Its former biggest single lender has now started to ask for its money back. Talk about bad timing. [Update: As pointed out in the comments, this section as it reads is not technically correct. Instead of "Social Security" it should read "Intragovernmental Holdings". While Social Security makes up 56% of Intragovernmental Holdings, it appears that it is other components of Intragovernmental Holdings that are accounting for the changes noted. So the changes are real, but the source of the changes is not the Social Security Trust Fund as implied above].
4. Savers. As the recession bites, more people are saving. The saving rate is once again positive, which is a very good thing after the debt bubble that we have been through. American savers (individuals and corporations) are actually the biggest new potential pool of capital available to the government as potential purchasers of Treasuries.
5. The Fed. The Fed is the buyer of last resort. If no one else shows up to buy, or if they want too high a return, the Fed can step in and buy. But this is not without impact. When the Fed buys Treasuries it is effectively printing money. Carried to an extreme, it would eventually lead to significant inflation.
The Ugly: This is what could happen if the demand for Treasuries falls short of requirements. It is not pretty, and demonstrates clearly what happens when debt gets out of control.
We know the US government will need to issue a lot of new debt in the next two years at least. What happens if the buyers don't show up?
- If buyers start to be scarce, we will start to see yields (interest rates) on Treasuries start to rise.
- But the Fed wants to keep rates low to stimulate the economy. It can of course step into the market and buy up the extra Treasuries. If it buys enough it can push rates back down (but this would mean that it would have printed a lot of new money).
- Existing holders of Treasuries, seeing that the Fed needs to step in to buy Treasuries, may decide that maybe they want to put their money elsewhere, so they start to sell. This again pushes up rates, and likely hits the US dollar.
- Once the ball starts rolling, it becomes very hard to stop. Either the Fed has to allow rates to rise, or it really starts to print money. This likely would start a run on the dollar.
- What is especially worrisome is that the government these last few years has been borrowing more and more short term money (30 day to 3 year) versus a lot of 30 year in the past. While rates are lower at the short end there is a much bigger risk should there be a "shock". A lot of debt now has to be rolled over regularly. Any shock could easily create a crisis. (Basically borrowing short has made the system more fragile).
What's Next?:
Interest Rates: In the last couple of weeks we have seen rates on 10 year and 30 year bonds starting to move up above where the Fed would like to see them. The 10 year is now above 3% and the 30 year above 4%. This is an early sign that the market is having trouble digesting the supply coming from Washington.
US Dollar: The US dollar index (the US dollar valued against a basket of currencies), has been drifting lower and is on the edge of breaking lower technically.
Conclusion: Pressure from new debt continues to build. The market is starting to show some signs of strain. You should not be surprised to wake up one morning to see that a new crisis has arisen.
Disclaimer: This diary is not meant to argue for or against fiscal stimulus. It is meant to be an objective view of the market as I see it, like it or not.
Update: Yves Smith at naked capitalism has a similar post today on her blog.