As I watch the $900 billion stimulus bill wind its way through Congress, knowing this will be piled atop the estimated 2009 deficit of $1.19 trillion, the longtime banker in me keeps asking the same worrisome question: How the devil are they going to finance all this rubbish?
A report released Wednesday by the U.S. Treasury Department's Borrowing Advisory Committee on the government's borrowing plans gave me the answer I expected: With great difficulty.
Truth be told, recent market developments have already provided a warning - though I'm not altogether certain that message has been received. In fact, much of the market may be focusing on the wrong problem.
Treasury Debt Worries
According to a MarketWatch.com news story also released Wednesday, analysts are worried that the interbank market is becoming tighter again, since the three-month London Interbank Offered Rate (LIBOR) has risen from a low of 1.09% on Jan. 13 to 1.23% Wednesday, while the benchmark Federal Funds rate has remained in target range of 0.00% to 0.25%. They fear that banks are once again becoming nervous about the health and stability of their sector brethren, making them even more reluctant to lend to one another.
However, if people are worried about the creditworthiness of banks, they're a lot more worried about the U.S. Treasury. The 10-year Treasury bond yield bottomed out at 2.07% on Dec. 17. Wednesday's closing yield was 2.93%.
Thus, while LIBOR has increased by 14 basis points, or 0.14%, the 10-year Treasury bond yield, which is supposed to be less volatile than short-term rates, has risen by 86 basis points, or 0.86%.
This is not entirely a panic reaction by investors fearful that the U.S. government will go bust (although credit-default-swap spreads on the U.S government debt have widened recently, and are higher than on Germany). It also represents two other factors:
- The fear of inflation.
- And the increasing difficulty the U.S. Treasury is likely to find in financing its gigantic borrowing requirements.
The Treasury Borrowing Advisory Committee paints a bleak picture. The average maturity of Treasury debt has declined from the 60- to-70-month average that was the rule from 1986 to 2002, all the way down to the 48 months that's been the norm of late.
And that's at a time of exceptionally low real interest rates, which the Treasury could have locked in for decades to come if it had borrowed long-term. From 2001 to 2007, Treasury abolished the 30-year Treasury bond, financing only shorter-term during a period in which rates were low and the budget deficit was exploding upwards. We're not talking great foresight here!
This tactic - borrowing short-term and hoping for the best - is still being used. All the existing issue maturities - in two, three, five, 10 and 30 years - are being increased and the 30-year issues are being moved from quarterly to monthly.
However, the advisory committee recognized that even these changes would not be enough to fund the U.S. Treasury's borrowing requirement, which the Committee estimated could be as much as $3 trillion to $4 trillion between now and September 2010.
(In addition to the official budget deficit, the federal government's various "investments" in the U.S. banking system, the automobile sector and elsewhere must be financed somehow).
A Mismatched Strategy?
The committee didn't take the opportunity to recommend issuing 50-year bonds, which Britain has done very successfully, and which would have had the advantage of postponing the maturity beyond the problems caused by Baby Boomer retirements and medical needs (by 2059, the youngest Baby Boomers would be 95, so there won't be many left). Instead, the government decided to issue seven-year bonds, hoping for some unexpected additional investor demand in the range between five years and 10 years.
The committee's schedule will cause real problems with refinancing. The plan to issue $540 billion annually in two-year notes and $420 billion in three-year notes brings huge refinancing problems in 2011 and 2012, precisely when the budget deficit will still be gigantic and credit will be needed to finance the (hoped-for) early stages of an economic recovery. By keeping debt maturities so short, the committee raises the risk of serious market indigestion, which would force yields much higher and cause major damage to the economy.
This financing problem is the hidden side of stimulus packages. The federal budget deficit is likely to run around 10% of U.S. gross domestic product (GDP) in 2009 and 2010, and should continue close to that level for several years thereafter (because the government could not risk killing a fragile recovery by pushing too hard to get the budget back into balance).
With Treasury bond issue maturities being so short, producing large refinancing needs, the impact of such huge financing demands on the economy will be huge.
What's the "Right" Size For the Stimulus?
Followers of the great British economist, John Maynard Keynes, like to brag about the supposed "multiplier" of government spending, by which $1 in spending produces, say, $1.50 of extra output. However, if the deficit-financing problems become severe, $1 of spending would produce less than $1 of net extra output. Indeed, too much stimulus could even reduce net output by driving up interest rates and "crowding out" private sector borrowers from the market. That would make the Keynesian multiplier negative.
As the winner of the 2008 presidential election, President Barack Obama has a right to alter spending priorities to reflect his victory and the desires of his supporters. At this point, however, I'm starting to believe that he should do so by replacing other spending on a dollar-for-dollar basis (raising taxes in a recession is also dangerous). Since the U.S. budget deficit - before any stimulus - is already predicted to be $1.19 trillion in the fiscal that ends in September, the economically ideal size of a stimulus package may well be negative.