The U.S. government bond market is the last of the great asset bubbles. We know this, first and foremost, because no one in any position of power in America is willing, and perhaps more precisely able, to enact the painful policies required to ever repay current/future obligations - and yet the market does not, as yet, seem to care. We also know that U.S. debt is the last great bubble because those bullish on U.S. bonds are bullish for reasons that defy common sense. U.S. bonds are not lauded because the rates of return are attractive on a relative or absolute basis, but for other, oftentimes rather uneconomic, reasons: because the U.S. currently prints the world’s reserve currency, the Treasury market is the most liquid in the world, the Euro is toast, China (and others) need to keep buying lest they wreck their own economies, the U.S. is following the steps of Japan, the U.S. has the guns, etc, etc…
Suffice to say, there is a ‘new economy’ feel that has permeated into the very idea that is U.S. debt. And not unlike the recent asset bubble episodes there is the belief that this time things will turn out differently. The contrast between the dramatic increase in U.S. government borrowing and shockingly low U.S. interest rates is not cause for alarm, but, in some peoples' minds, celebration.
DeLong Longs For an Even Bigger Bubble!
Brad DeLong is a professor of economics at the University of California at Berkeley. He is also a Keynesian foot soldier that in recent months has repeatedly taken aim at U.S. interest rates as proof of his convictions. The argument, put forth by DeLong and his cohorts like Krugman, is that historically low interest rates alone indicate that the U.S. can enact ever escalating waves of fiscal stimulus. The argument goes that so long as U.S. interest rates remain low there is no reason to fear a viscous attack from the bond vigilantes.
“If fear of large future government deficits is undermining market confidence--as it is in Greece right now--interest rates on government debt are high and rising. That is not the case right now. If there are massive amounts of unemployed resources and if expected deficits are not undermining confidence, then there is a very strong case for making today's spending level higher and today's tax levels lower in order to create jobs and put the unemployed to work.” Delong
The first problem with Mr. DeLong’s theory is that it relies on a handy conflation between "market confidence" and market vigor. This phrase ‘market confidence’ – a term that Delong attempts to flippantly, and perhaps also disingenuously, exploit - is not synonymous with economic health, as any economist worth his salt will tell you. After all, is Mr. DeLong really arguing that anyone – meaning anyone – has more confidence in the long-term health of the U.S.’s fiscal position today compared to 5-10-or 20-years ago? Again, and if otherwise unclear, does anyone really believe that U.S. debt is a safer idea today than at any time since say Nixon closed the gold window? (since rates are at historic lows DeLong insinuates that this the case). Then there is China, which has vocally expressed a vote of no confidence in the U.S. ‘s borrowing policies - despite being compelled, at least for the time being, to continue to purchase Treasurys to sterilize its reserves and keep its most important trading partner stimulated. As for another Treasury purchaser, namely the Fed, it can easily be said that the Fed has and will continue to try and manipulate Treasury yields lower because it has no confidence in the U.S. recovery. Question is, at what point would someone like DeLong admit that Fed purchases are masking a complete lack of confidence in U.S. Treasury market - $1 trillion, $2 trillion, $3 trillion?....
Finally, there is the question of Greece. DeLong and others like him avoid the Greek precedent when highlighting how low U.S. interest rates justify further U.S. government deficit spending. Sure, they like to mention Greece in passing if only to note that “We are not like Greece!”. And of course this is true if the comparison is between the US today and Greece today. However, extend the time horizon and the comparison begins to look less farfetched. In particular, note how quickly and viscously the Greece debacle unfolded following an extended period of flat or falling interest rates:
That the 756 bps spike in Greek 10-year bond rates happened in just over 100-sessions is telling not of confidence slowly being undermined, but of confidence simply imploding. At the end of the spike, the rate of interest that Greece was forced to pay on its 10-year went up by 86% in less than a month. The lesson, if otherwise unclear, is that the path of interest rates can abruptly change.
To be fair, there are legitimate reasons to speculate that U.S. interest rates will remain at historically low levels for the foreseeable future. Moreover, the case can be made that further government stimulus actions from America will not ignite a dramatic spike in interest rates (as academia has often pointed out, the correlation between interest rates and government deficits is loose). But while making these speculations it is crucial to note that the U.S. government bond market is no longer a market that functions upon fundamental investment rationalities. Rather, U.S. bonds have been assigned a greater than merely market power, one that feeds on (as in any bubble) animal spirits and fear rather than on an appreciation of intrinsic worth. Until this aura bursts, the DeLongs of this world, not unlike the Cohens during the stock market mania and the Lereahs during the housing bubble, will continue to look like talented seers. However, whether 2-years from now or 20*, when Delong’s theory of perpetual U.S. government borrowing bliss breaks, it is likely to do so with a vengeance. The consequence will, quite literally, be a reshaping of the global financial system.
* Incidentally, if 20-years for now the great U.S. bond bubble is still blowing we will have to concede that the world is haplessly incapable of ever finding a solution to USD hegemony.
Please note: this is not a recommendation to short U.S. bonds. As per Keynes, remember that the markets can remain irrational longer than you can remain solvent.
