Arnold Kling  

The End of the World

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Tyler Cowen writes,


When it comes to the mortgage agencies, there is no real choice but to bail out the debt holders. The alternative is a run on the dollar and collapse of faith in U.S. government securities and the end of the world.

Think of the U.S. government as the world's biggest hedge fund. One thing a hedge fund does is engage in credit arbitrage. When you can borrow risk-free, you can make a profit holding risky assets. That is what Congress is hoping will happen with the Freddie-Fannie bailout.

We have grown accustomed to the assumption that the risk of default of U.S. government liabilities is zero. That in turn allows Congress to act like the biggest hedge fund on the block.

But over a ten- or twenty-year horizon, are Treasuries really default-free? Or could the U.S. government suffer a loss of confidence among investors, as happened to Fannie Mae and Freddie Mac?

Consider the long-term obligations of the U.S. government: Social Security, Medicare, the Pension Benefit Guaranty Corporation, public employee pension plans. Add to those the risks of the securities that the government is effectively choosing to guarantee in the Bear Stearns merger, the Freddie-Fannie prop-up, and other steps that are being taken or will be taken in the mortgage and financial market. It seems to me that in order to achieve short-term stability we are piling on long-term fragility.

A lot of my portfolio is in inflation-indexed Treasury securities. At some point, though, I am going to start thinking that there is some default risk in those securities, and I will be looking for a new risk-free asset. My guess is that the closest thing will be a highly diversified portfolio, one that includes a lot of foreign securities.

There is a reason that Tyler calls this scenario "the end of the world." If people do not have confidence in the long-term financial stability of the U.S. government, the chances are that they will not have much confidence in the long-term stability of U.S. corporations, and so you would see a collapse of long-term investment altogether.


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The author at PrestoPundit in a related article titled IS THE U.S. GOVERNMENT writes:
    THE NEXT FREDDIE MAE, THE NEXT INDYMAC?... [Tracked on July 28, 2008 10:52 AM]
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JimSaco writes:

Whenever I tell people my belief that in 5-7 years the DJIA will be 5000 and falling, and the interest on the 10 year note will be 10% and rising... they look at me like it's impossible, that it could never happen.

The Federal govt isn't just the world's largest hedge fund, it is in certain respects the world's largest insurance company (though a very unsoundly run one).

Wasn't it Andrew Mellon who said "liquidate liquidate liquidate"? Or was that Mises?

Nathan Smith writes:

Couldn't the US government always just print more money to pay its debts? Obviously, that would cause inflation and creditors would be paid back in devalued dollars. But why should the US ever just default on dollar-denominated debt?

floccina writes:

Give that the US government can always just print more money to pay its debts, I do not see default as a possiblity. Loss of vale sure, default, no way.

Some assets like new energy efficient windows or a new air conditioner have very little risk and a rapid pay back.

shayne writes:

I wonder what leads Tyler to believe that bailing out the debt holders will somehow preclude a run on the dollar, collapse in faith in U.S. securities [currency] and the end of the world?

I have to believe that at some point the nation's creditors are going to stop loaning money to be used to pay the price for bad decisions and exorbitant promises. As Arnold and others have pointed out here (and elsewhere), there are far better investments to be made.

And I know of no organization that is "too big to fail", whether it's Fannie/Freddie or the U.S. government. Quite a few folks think it's a good idea for the U.S. government to bail out Fannie/Freddie and any number of other entities that have made poor investment decisions. I just wonder who is going to step up to the plate and bail out the U.S. government (taxpayers) when the bill for this, Medicare, Social Security and all the other promises comes due.

Matt writes:

Short term legislative hedges meet long term obligations, simultaneously, as is happening in Zimbabwe.

In our case, we know that the latest bailout will be paid for by upper class wealth, which, even now, pays about 7-10% more in taxes then would be dictated by their percentage share of wealth. (Compare the share of wealth held with share of taxes paid).

After the next election, these over payers will be in Washington asking why Bill Gross and PIMCO are getting a huge gain on the government bailout. The result will be very sever pressure to cut the federal government, more severe than we have seen.

This is not rich vs poor, this is one set of wealth stealing huge amounts from another set of wealth via government intervention. The over payers will be stuck with the tab, and they will extract a very sever price in terms of government cuts.

floccina writes:

Does fractional reserve banking make these problems and bail outs inevitable? In a fractional reserve banking system will large failures that lead to bank failures tend to contract the money supply taking down inocent bystanders? Is it true that people are comfortable with a certain level of risk so that bank insurance ane regulation will only cause more risky behavior?

Kurt Brouwer writes:

I disagree that the U.S. government is like a hedge fund. I don't know of any hedge funds that have the right to tax 304 million folks to pay the bills.

Another disagreement I have is the common, but fatal flaw of tallying U.S. debts and potential future liabilities without an offset for U.S. assets and potential future income. It's accounting 101. Assets and liabilities should be viewed together to determine the health of a balance sheet.

Certainly, the power to tax is an asset, but the government also owns vast tracts of land, mineral deposits, buildings, bases and many more assets. Though many of these are not likely to be turned into cash, the mineral deposits should. And, millions of acres of land could be sold or developed if needed.

In addition, spending on entitlements is a very fuzzy number when you extrapolate out 5-10 years, much less 75 years as some like to do.

When it comes to the budget deficit, the current projected deficit is not extreme by any historical measurement. The 40-year average budget deficit is 2.2% of GDP, which would be just under $300 billion. At $500 billion, we would be between 3-4% of GDP, which is not at all unusual in our history.

I fail to see why this is considered so dire. And, I literally laughed when I read of the solution -- buy foreign securities. Just take a look at the debt of other countries compared to GDP and you will see that the U.S. looks very good indeed when compared to many developed countries such as Japan, Germany etc.

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