The back-story is well known now. Even Alan Greenspan, former maestro and current scapegoat for the financial crisis, seems at last to acknowledge it. To fend off a recession after the tech bubble burst in 2000, excessively lax US monetary policy led straight to two even bigger bubbles, in house prices and their next of kin, the credit markets.
The bursting of these two bubbles, in the US and elsewhere, has had profound consequences that are not yet behind us. Not least, it has pushed the US and Europe to the brink of deep and prolonged recessions that we expect them to enter next year.
And again, as in 2001, the question now is how to avoid or at least mitigate the effects of a recession.
This time, monetary policy may not work. Despite deep cuts to interest rates, the Fed has been unable to stave off a serious credit crunch. In fact, virtually all the world’s major central banks are now on the rate-easing path. But with commercial banks and other lenders focusing on reducing their own debt and replenishing their own balance sheets, liquidity remains frozen and money is still not finding its way to the public.
With credit channels for businesses and private borrowers still blocked, governments will probably have to turn to fiscal policy measures next. Here again the US paved the way, starting last spring with a 150 billion US dollar impulse program, mostly in form of tax rebates. Another fiscal program is currently being prepared. Other countries, most notably the UK and France, are now considering similar measures. The recently-scorned ideas of John Maynard Keynes are back, alive and kicking, much to the chagrin of many economists.
But how will the US government pay for its high-ticket interventions? The answer is simple: it will just increase its debt. Today, everyone’s chasing the safest and most liquid paper, which is government debt, especially from the US. With roughly a 3.5% yield on 10-year US Treasury paper, financing its budget deficit has become especially cheap for the US government. So far, so good. There is nothing wrong with profiting from good financing conditions.
But is this also a good deal for the investor? Here, we are far less certain. Once the financial crisis begins to fade, the risk premium on asset classes like equities or corporate bonds will fall. Investors might suddenly become nervous about the towering deficit and debt-to-GDP ratio accumulating in the US. And this realization might lead them to exit the US government bond market as fast as they entered it. This would turn today’s favorable picture on its head and lead to sharply higher interest rates and lower bond prices.
Some economists would cite Japan as proof that low interest rates are not inherently incompatible with an extremely high government debt-to-GDP ratio (now estimated to be around 180% in Japan). But almost all of Japan’s government debt is financed domestically, while a large chunk of US debt is held abroad. And here lurks a huge risk, in our opinion.
Having financed US corporate debt during the tech bubble and then US consumer debt during the housing bubble, we wonder if the rest of the world will line up to finance US government debt. If enough former backers sit this round out, we just might end up with a big, nasty US Treasury bubble.
“Fool me once shame on you, fool me twice shame on me.” Being fooled a third time invites the question, are we investors, or masochists? We think fiscal policy measures may prove to be a bit more problematic against this recession than some government economists seem to acknowledge.
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