Of Bubbles and Treasury Debt

Over the last decade our economy has been buffeted by what appears to be an accelerating series of economic bubbles. It is more than coincidence that this has occurred while government interference in the economy has increased.

That is not to deny that free markets are fully capable of producing economic bubbles, as market participants miscalculate investment risks and rewards and copy-cat each other as they do so. These market participants, however, if left to their own devices will also pay the price for their mistakes. Knowledge that they are at risk acts as a moderator and corrector, limiting the degree of risk investors are willing to take in the first place (and the willingness of lenders to provide money to support the bubble), and leaving the way clear for other investors to come in and pick up the debris (at a profit) when the bubble bursts.

When government is involved non-economic factors are inserted into the calculation of risk, and they affect who pays for the risk. With the existence of federally-supported mortgage guaranties, investors paid very little attention to whether mortgage lenders verified the ability of borrowers to make payments. A government guaranty always means that risks will be undervalued and that someone else (usually the taxpayer) gets to pick up the tab for the miscalculation.

It is neither exaggeration nor hyperbole to recognize that for more than a year the government has been handing out guaranties at a rate never before seen in the history of mankind. That is to say, that mountains of financial risk miscalculations have been made and are being made every day, and the unavoidable consequences are accumulating.

Perhaps the most dangerous miscalculations are those involving the debt issued by the U.S. Treasury. Investors are mistakenly acting as if there is no risk in placing their money in Treasury securities. These investors overlook the risk that buying Treasury securities--with an effective interest rate of 4 one-hundredths of one percent (the rate last week for 1-month Treasuries)--puts investors at risk if interest rates rise even a little bit and exposes the investors to even mild inflation.

Inflation is unlikely to remain mild. Along with all those government guaranties there has been a mountainous accumulation of new money provided by the federal government. All that money has to go somewhere. Right now it is awaiting some slight shock to send it avalanching down on the economy. Much of that money is for the moment being hoarded by investors and businesses afraid to spend it or put it to work while economic prospects remain unsettled and policymakers keep confusing the markets with one economic policy, regulation, restriction, or plan after another. No one wants to play the game while the referees are adjusting the rules.

So the government money makers keep pushing more money out to fund investment even while they toy with new disincentives to investment. People park the money instead in bank deposits (which are growing at record levels) and Treasuries (driving Treasury interest rates down to almost nothing).

That will not continue. At some point, the willingness of investors to hold dollars in accounts earning practically nothing will have played out. They will get their fill of Treasury securities. Foreign investors are already there, in recent weeks reducing their holdings of U.S. Treasury debt. Treasury interest rates will have to rise to attract investors, but as Treasury interest rates rise those who invested in Treasuries at very low interest rates will be on the losing side of their investment. They will start unloading their Treasury investments, further driving Treasury prices down and interest rates up, causing even more losses to those who invested in recent months in the Treasury bubble.

The spiral will be hard to stop, particularly as the Administration will be desperately trying to borrow more money, unheard of new amounts of money, to fund their planned multi-trillion dollar deficits. Interest rates will have to go up very high very fast in order to fund that voracious new appetite of the government for debt. The high interest rates will choke off many new sparks of economic recovery, leaving a lot of money around chasing after fewer goods and services for sale.

The Treasury bubble will likely end in a race that we have not seen for more than a quarter century. The race will be on for which will go higher, inflation or interest rates.