The Inundation of Debt and Its Toll on Our Economy

It is the crux of our economy. It is the all-important foundation upon which economics is built. It is supply and demand and the constant attempt to reach an equilibrium that our policymakers are now dealing with in their attempt to revive our economy. To fund the astronomical size of the stimulus packages the White House has authorized, as well as to finance the budget deficit, the government has had to issue record amounts of debt.

As the government sells its debt and increases the supply of bonds in the marketplace, it must lower the price to find sufficient buyers, driving interest rates on the debt up. On Friday, the yield on 10-year Treasury notes rose 13 basis points to 2.89%, as the price dropped $11.25 per $1000 face amount to 98¾.

The fear that the Federal Reserve has flooded the market with debt and thrown the supply-demand relationship out of balance caused the Fed to announce that they will buy back up to $300 billion in Treasuries, the first time they have done so since the 1960s. They have already begun the buy back process, purchasing $31 billion so far. On the other hand, the government plans to sell $59 billion of debt split among Treasury Inflation Protected Securities (TIPS), 3-year notes, and 10-year notes in the upcoming week.

Concurrently issuing and buying debt has policymakers working at cross purposes. The Treasury must continue to issue debt to stimulate the economy, but the Federal Reserve wants to monitor the supply of debt so that interest rates don’t rise too high. The problem that arises when the government must issue so much debt and increase the supply in the market is that they must lower the price and increase the yield to entice buyers. When the yield goes up, this increases the cost of debt for corporations who want to finance new projects, which in turn lowers the Net Present Value of those projects, making them less likely to accept the projects. When the government raises interest rates through its use of fiscal policy, it crowds out others looking to invest.

With the credit markets as tight as they are, corporations are already having difficulty raising funds and rising interest rates on top of that will only hinder corporations’ willingness to invest, which is the real source of economic growth; the government cannot spend trillions of dollars in perpetuity to keep our economy afloat. If the government continues to issue debt and crowd corporations out of the debt market, it will increase our reliance on the government, simultaneously prolonging our recession.

This “crowding out” is the reason that the Federal Reserve is now getting involved in buying the Treasury’s debt. By announcing that they would buy up to $300 billion in debt, the Fed was hoping to increase the demand for debt in the market, lowering the yield on debt.

There are three reasons that the announcement of buybacks failed to accomplish its goal of lowering yields:

1. $300 billion of government debt is just a small drop in the pond. Goldman Sachs (GS) estimates that the government needs to issue $3.25 trillion of debt this year, and in all reality the government can just continue to issue as much debt as it needs regardless of how much of its debt the Federal Reserve buys. What we have here is another AIG-like situation where the government gave them $180 billion and the $170 million that was doled out in bonuses was an insignificant proportion. $300 billion compared to $3.25 trillion is an insignificant amount and might not even make a difference.
2. Even though the Federal Reserve has already bought back $31 billion of Treasuries through five buyback operations and has five more planned over the next two weeks, the government is working against them because it will be issuing approximately the same amount in new debt over the same time period.
3. Eventually, the Federal Reserve will have to sell these Treasuries back into the market. They cannot hold onto the debt forever. So, when they sell the debt back, the same supply issues will occur, prices will go down, and the crowding out will occur all over again.

These last two reasons, coupled with the market’s reaction in that yields did not go down, lend credence to the Rational Expectations hypothesis, because potential investors realize that even if yields go down now, they will eventually have to go back up in the future. It is my estimation, however, that the more likely reason that yields failed to drop was that the $300 billion was just too small an amount to make a difference, especially if the government can just continue to issue more debt.

On an international level, the Chinese government has expressed resentment at the Fed’s actions. As one of the largest holders of the United States’ debt, China is upset that the Federal Reserve is attempting to increase demand, driving prices higher, only to deflate prices later as the Fed eventually sells the debt back. China’s concern stems from price fluctuations on the debt that they hold as well as the value of that holding in the face of a dollar with diminishing value; as the United States issues more debt, inflation becomes a growing concern which would decrease the value of the dollar and subsequently the value of their investment.

It will be interesting to see if the Federal Reserve can keep interest rates low enough to entice corporations to invest as the government continues issuing debt in its attempt to stimulate the economy, especially with the need to steady foreign relationships in the mix as well.

- Christopher Holden

Disclosure: None.

Comments

[Dave Wrixon:]

You can keep kicking the can down the road, but, if you will excuse the pun, the Buck stops with the Dollar. When it goes, it is going to seriously implode. The problem is that it is a matter of perception. Not only is the supply side being grossly inflated, but the demand side is susceptible to loss of confidence as a direct knock-on over the over-supply. The day of reckoning is at hand.

Apr 19 07:26 AM

[ArkansasAngie:]

The only reason why the Dollar hasn't collapsed is because this current economic down turn is global.

The supposed cure is for the American consumer to get back to consuming. And the moment that imports shoot back up, dollars will rush out of the US for the high growth rate emerging markets.

Interest rates will go up.

Apr 19 07:56 AM

[ECONOMICS 101:]

I agree with ArkansasAngie, interest rates will go up, they have no choice. Their is too much debt, too much paper printed to issue bonds on the world global market said Johnathan John Vrozos a founding member of our local economy board.
The only thing holding the rates down is the fact that the global problem is worse everywhere else. By default and only by default we look good.
Don't kid yourselves things are bad and will get worse. Layoffs are still happening, consumer confidence is terrible.
People are buying ONLY what they need NOT what they want.
Myself included.
By Johnathan Vrozos
johnathanvrozos.ca

Apr 19 08:27 AM

[Steven Hansen:]

my thinking is the fed never intends to sell this debt back into the market and will simply evaporate it. this is the only senario which makes your point three inoperative. i think the fed intends to evaporate up to $2 trillion debt. without doing so recovery will be restrained.

Apr 19 08:56 AM

[ArkansasAngie:]

Now Steven by evaporate do you mean inflation or repudiation of some sort?

Can they get away with it overtly or does that necessarily mean it will be done covertly?

Apr 19 09:09 AM

[osaycanuthink:]

devaluation is the way the feds will try to pay back the debt.. the chinese will be very angry....

Apr 19 09:12 AM

[Ishortyou:]

well you can spice it up a little bit by the adding the fact that most of our basic economy is based on debt, for a car-> car loan, for a house-> mortage, for other->credit cards, so everywhere you look at there is debt, people wanted to buy things they cannot afford with debt, so our economy is based on debt, based in illusionary figures with money that we dont have. The other side of the coin will be buy with money that you really have! but for that you have to work hard and save-invest and be patient, so these three words 'work, save-invest, patience' had been banned from the peoples mentality and thats the reason why we are in ruins now.

Apr 19 09:58 AM

[morph366:]

Only problem with "managed" inflation as the path out of this trap is that it is not a solution. Hyper inflation is another story.

With the kind of managed inflation required to do the job, the coupons that would eventually have to be attached to the trillions of dollars of Treasury bonds that the government is going to have to issue, would need to far in excess of what is assumed in current long term budgets and forecasts.

The higher the debt service costs -> the longer it will take to pay the debt back -> interest will be capitalized -> increasing the debt etc. It's hard (and that's expressing it as optimistically as I can be) to see a way out of this nasty feedback loop.

Apr 19 02:37 PM

[Prudent Man...:]

The debt remains high and the collateral continues to deteriorate.

Markets will do whatever they want to, e.g., early 2000 and 2007, and can move on their own momentum with dependence of The Greater Fool Theory. The "discounting" power of markets is a myth. Greed and fear will always win over reason which to mean buy and sell contra to emotion and stick with the facts not with pundits opinions.

Apr 19 04:05 PM

[donzelion:]

"Concurrently issuing and buying debt has policymakers working at cross purposes."

Not if the purposes have nothing to do with debt/inflation/deflation control. What could they be up to? Well, the only folks I can think of who long/short the same asset at the same time are hedging, which is intriguing. Is the government acting like a "hedge fund?"

Not really - more like a "countergamer." Think of it this way: insurers, banks, hedge funds, and others assumed they could deploy financial (or political) strategies to shift risks to other parties, either overtly or covertly. Risk shifting tactics raise costs - if something goes wrong, you wind up having to get a judge to allocate the risk properly (effectively shifting the costs of the risk to the public). Do that once or twice and there's very little gain - but do that billions of times...

Policymakers can't ban "risk trading" (it's sort of one aspect inherent in every contract), and they certainly can't regulate their way out of it (after all, risk trading assumes regulations exist but are expensive to enforce). Instead of futile controls, "countergaming" is a viable alternative: destabilize efforts to exploit market weakness so that speculators are spooked, rather than creating stronger controls that could stop them (but also wipe out capitalism).

Will it work? No guarantees. But "counter-gaming" is a better explanation of current policy than most others I've heard. Sort of "stress testing on steroids" - the government deliberately games its own system to spook speculators who are otherwise testing its cracks...

Apr 19 05:11 PM

[Friar Hilarius:]

[Quote] If the government continues to issue debt and crowd corporations out of the debt market, it will increase our reliance on the government, simultaneously prolonging our recession. [Unquote]

The Lord be Praised

At last we are finding a way to keep the criminals out of the market and only the very best projects will be able to fund corporate debt

This is the best news I have heard since sliced bread

On second thoughts sliced bread never tasted as good as unsliced bread ...

Which again leads me to ask how do junk food profits help obese Americans and third world children dying from polluted worse

The criminals have had their chance ... how about a century of Government projects only and a decent return on savings

Anything would be better than daylight robbery via cancerous credit growth

Since we are clearly in a Depression and not a Recession it is time that honesty replaced criminality ... and Government control of all funds on behalf of the people is greatly to be preferred to private control of funds on behalf of the criminals

Friar Hilarius

Apr 19 05:14 PM

[donzelion:]

By the way, let me clarify my term "countergamer." In normal markets, you have buyers and sellers - both "gamers" playing to "win" (maximize profits, minimize losses). All participants are "gaming" the system - but most are playing within the rules, rather than trying to figure out how much they can get away with when the referee isn't looking.

A "countergamer" is trying to stop or change a game while it is in progress (e.g., the monk who throws himself into a gladiatorial duel to the death, the hockey audience who goad players on the ice into boxing matches).

Apr 19 05:17 PM

[ArtfulDodger:]

The very sad thing to me is that our government and the fed are trying to cure a debt problem by supplying more debt.

It's treating symptoms and not the cause of the problem.

How can the US win in the end doing such things?

Apr 19 05:53 PM

[SwingTimer:]

Friar Hilarious..

Your comments make a certain amount of sense, but please keep your naive religious frame-of-reference and communist ideology out of it . If you have an opinion, simply address the dynamics of the economics of the situation - not the "children" - if you wish your viewpoint is to be considered seriously by readers of SA.

" Government control of all funds on behalf of the people is greatly to be preferred to private control of funds on behalf of the criminals".

Really...??? This assumes two things: 1) everyone out there is deceitful, and, 2) government bureaucrats are unquestionably competent. Really??? Get real, why don't you! Prospects in the real world aren't as bad as your clostured world of make-believe and imaginary "euphorea".

Apr 19 06:09 PM

[Fighting Yoda:]

Fed is on a dangerous and unprecedented path - it can only end very badly. Fed is suggesting - it will pull out the liquidity at the appropriate time - it has a very poor track record of doing so. More importantly it is not easy - there is no game plan for this, political backlash maybe very high, and it might replunge US into recession.

Fed will simply print more and more money to pay US debts - the market confidence in the currency will drop and the currency would substantially depreciate. US $ has held up for now, being the reserve currency. This will change, not overnight, but next few years certainly. US $ became the reserve currency, at the end of 2nd world war, as US was 40% of world GDP and 80% of world gold was owned by US. All this is changing - China is rapidly growing and will present an alternative - both in terms of stability and growth.

Apr 19 09:12 PM

[Friar Hilarius:]

Swing Timer

Private capital is either deceitful or complicit in deceit

They all go to the same country clubs and it just bad luck that some get caught, while others enjoy their golf after turning a blind eye

If private capital was suitable for the job they had many years to prove they could control themselves. They coudn't

My conclusion is that nothing could be worse than the present mess and any honest and non-complicit private capitalists should send their work record in with their Government job applications

Private capital has had its chance ... now it is Government's turn ... and I see no reason not to quote the moral basis for a new Savings Based economy to replace Credit Cancer ... the sharing in the Early Church which attracted thousands in a short time

The whole private system is rotten to the core ... until it proves otherwise to Government regulators

With Best Wishes

Friar Hilarius

Apr 20 06:15 AM

[Allan Frain:]

This can be viewed more simply.

The Fed can set short term interest rates, but longer term rates are set by the market through bond auctions.

During the bubble years China was driving Treasury prices up (interest rates down) in a vendor finance scheme.

Bernanke set short term rates to zero and wants long term rates to stay low as well. Hence the Fed steps in where the market will not--it buys its own debt.

When one buys a Treasury one must now bid against the Fed. The question is--how long will anyone be willing to accept negative return (denominated in a threatened currency) in such manner ? The end game of such policy is where all money is essentially printed Zimbabwe-style. This is the price of long term interest rate suppression.

Apr 20 09:09 AM

[HarryHope:]

But what about the deflation that is being reported around the world including the US? Isn't that a potential bonanza for the Chinese and a nightmare for the Fed and Treasury?

Value of cash goes up. Wouldn't that pull rates down?

Isn't that the opposite of inflating one's debts away?

Apr 21 01:49 PM