By David Ignatius
Sunday, June 14, 2009
You don't have to be a "bond vigilante" to suspect that there's a collision ahead between fiscal and monetary policy: Last week, the Obama administration was touting its $787 billion stimulus program and concocting ambitious plans for the General Motors bailout and health-care reform. Meanwhile, the Federal Reserve was worrying about the potential inflationary impact of all this spending -- and thinking about when to put on the brakes.
The bond vigilantes, as they're called, provide a reality check: They look at the Treasury's enormous financing needs over the next few years, and they see a big risk of inflation. So they balk at buying new Treasury issues unless they receive a higher yield to compensate them for the inflation risk. Over the past several weeks, analysts have been recalling James Carville's quip in 1993 that if he were reincarnated, "I would like to come back as the bond market. You can intimidate everybody."
Financial markets are always in oscillation, to be sure, anticipating the next crisis even as they are recovering from the last one. But we appear to be approaching one of those inflection points where policies that were essential in one phase of the cycle become dangerous in the next.
In the simplest terms, the bond market is troubled by an imbalance of supply and demand: Because of all the government rescue spending, there's a huge supply of new Treasury securities to finance the debt. Demand for these securities is soft, so bond prices fall -- driving up yields. The rate on 10-year Treasurys has surged over the past year from a low of 2.078 percent to Friday's 3.80 percent. But as these interest rates rise, they risk choking off the fledgling economic recovery.
This financial squeeze is the unfortunate consequence of running an estimated $1.8 trillion deficit this year. To get a sense of what that number means, it's equivalent to about 13 percent of gross domestic product -- or roughly quadruple the pre-crisis ratio of debt to GDP.
Last week alone, the Treasury had to raise $65 billion through new issues, according to Fed estimates. Between now and the end of the fiscal year in October, the total in new financing will be at least $1 trillion. And over the next five years, the issuance of new Treasury debt is likely to total an additional $3.8 trillion.
Where is that money going to come from? Fed Chairman Ben Bernanke insisted in congressional testimony June 3 that he isn't simply going to print it. "The Federal Reserve will not monetize the debt," he told a House panel. "Either cuts in spending [or] increases in taxes will be necessary to stabilize the fiscal situation."
The massive federal debt, however necessary to deal with the recession, is spooking many financial experts. Their voice on the Fed has been Richard Fisher, a former hedge fund manager who is president of the Dallas Federal Reserve Bank. In a recent speech to money market managers, he discussed the government's debt problems, which he described as "a looming budgetary threat to our long-term economic prosperity."
Fisher warned in his speech that in addition to all the new Treasury borrowing, there's the enormous overhang of unfunded entitlements, such as Medicare and Social Security, whose present value he estimated at $104 trillion. That's roughly 20 times the size of the new debt the Treasury will accumulate between 2009 and 2014, Fisher estimated.
These are very big numbers. The standard response of debt-laden countries -- running the printing press -- "cannot be allowed to happen in America," Fisher said.
The Fed and the Treasury had looked as if they were in collusion in March, when the Open Market Committee announced that it would fund up to $300 billion in Treasury securities, over the protests of inflation hawks such as Fisher. But the easy (and potentially inflationary) alliance may be waning. Bernanke's strong statement this month about not monetizing the debt suggests that he's in no mood to extend the $300 billion purchase plan any further.
There are no simple options as we begin to crawl out of the recession. If the politicians take Bernanke's medicine, we can look forward to modestly higher interest rates, higher taxes and reduced government spending. If the politicians balk at Bernanke's austerity diet, we can look forward to higher inflation, a falling dollar and sharply higher interest rates. The recession has been painful, but the recovery won't be any picnic. The problem with borrowing is that it costs money.