Garett Jones  

Treasury Bondholders: Winning in the Senate?

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Many are convinced that the U.S. government will likely either default or hyperinflate its way out of debt.  I disagree: I think Treasury bondholders will win. As I wrote in Econ Journal Watch:

A U.S. default is unlikely: As a demographically young nation, the United States will watch other nations face demographic crises years before it faces the full brunt of the same. The spectacle will furnish salient examples of the short-run shame and suffering caused by default.

Right now, the U.S. Senate is allegedly trying to broker a long-term deal with some mix of tax increases and entitlement cuts (combined with marginal tax rate cuts).  It's along the lines of the Bowles-Simpson proposal, which Arnold has discussed.  

I don't know if some form of this plan is going to pass after the election, but if the probability of serious reform passing is, say, 30% this year, and 30% in every lame duck session for the next decade,  then we've got a better than 80% chance of reform in the next ten years.   And remember, lame duck deals are only one path to bondholder paradise--there are plenty of other roads that get you there.  

That means Treasury bondholders can agree that Congress will "probably fail this time" while still agreeing that the federal government will probably get its act together someday soon.   

I still think default is possible, and if it happens, it will probably be caused by the noblest of motives. From my abstract:

[T]he GOP offers a uniquely American path to default: An unwillingness to raise taxes. Bondholders the world over will be watching to see if "starve the beast" is a pathway to "default on the beast."

We'll see if the House GOP gives Treasury bondholders a case of heartburn this fall.  

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COMMENTS (13 to date)
egd writes:

I'll admit, I only read the abstract. But I wonder why you only focus on the GOP refusal to raise taxes.

The Democrats also refuse to raise taxes, particularly in ways that would be likely to actually reduce the deficit: taxing the middle class. Taxing according to the President's stated plan won't generate the kinds of savings that can more easily be achieved by cutting spending.

I suspect the real concern isn't "the GOP is blocking this tax increase," but rather "if we get the GOP to cave on this tax increase, we can get them to cave on future tax increases."

Thucydides writes:

What a disappointing post - there is nothing about spending here; it's just a question of not enough tax revenues. Our fundamental problem is not a lack of tax revenues, it is unsustainable mass entitlements.

Chris H writes:

An interesting post, but I think one that might have a bit too limited a view of default. A default strictly speaking is failing to meet obligations you've promised to meet. This includes promises made to the recipients of social security/medicare/pensions/other entitlements. It is frankly inevitable that the government must default on these groups regardless of how they treat bond holders.

If the government decides to default on bond holders first, this will dry up the loans which the entitlement programs rely on. If the government tries raising taxes, the amount they would have to be raised in order to pay for these commitments would be so high that they wouldn't be able to actually raise the revenue. Tax avoidance would greatly increase and the hit to economic growth would mean both increase reliance on social services and fewer sources of revenue. The result is still default at least on the entitlement recipients (and possibly the bond holders).

Default of either entitlement recipients, bond holders, or both is now inevitable. The only question is which group will get defaulted on first and how comprehensive the default will be.

As long as US govt debt is denominated in US dollars, the Treasury can always meet its obligations (although it must remain concerned with inflation). Funding of the entitlement programs is therefore a choice about how much of federal spending should be devoted to such programs. Regardless of the current "fiscal cliff" resolution, deficits are seemingly headed lower in the coming years.

In support of Garett's conclusion (with which I agree), we should also consider how an aging population will alter investment portfolios. Currently only ~20% of US investments are in bonds, while ~60% is in stocks. As the demographics shift, that divergence may very well decrease.

With declining deficits and an again population, the real fear for bondholders (IMO) is whether or not private credit growth will expand sufficiently in the coming few years such that the Fed is pressured to materially raise rates. I remain doubtful of that outcome and believe bondholders will recognize competitive returns in the coming few years.

John Thacker writes:

It's true that both sides were fighting over a trivial amount of money with the debt ceiling. But doesn't that mean that the Democrats were equally willing to let the government default rather than cut spending (which really meant "avoid having spending increase by as much as the previous 10 year budget plan mandated")?

The final budget agreement was a surrender by the House GOP that didn't cut spending in reality. This reflected the truth that the Democratic Party was in the end better at brinksmanship and more willing to let the government default rather than cut spending.

I don't understand blaming solely the GOP. Their demand at the time of debt ceiling debate wasn't for enormous cuts or anything close to a balanced budget in a small number of years, but for modest symbolic reduction in planned increases. Yet the Democrats claimed a willingness to default on the debt rather than compromise on that demand.

Methinks writes:

What you're really betting is that there's an 80% probability of the government turning Americans into hardworking slaves of the state. Fat chance. Particularly since they're aiming for the people who have the most options.

Steve Sailer writes:

All this talk of "demographic crisis" due to aging focuses solely upon quantity. The quality of the demos matters, too. The subprime catastrophe was focused in demographically "vibrant" parts of the four Sand States: inland California, Nevada, Arizona, and southwestern Florida, with lots and lots of young families moving in, many from Latin America.

How'd that work out for us?

MingoV writes:

The 80% probability value is worthless because the outcomes are not binary. Instead, the legislative possibilities are:

no reform
optimal reform
less optimal reform
even less optimal reform
partly effective reform
ineffective reform
counterproductive reform
markedly counterproductive reform
etc.

And, if one legislative session enacts a reform, it can be revised or undone by a later session. I can envision a legislature enacting a near-optimum reform that is followed by intense grousing and lobbying by people and businesses (and even state governments or federal government departments) that dislike the reform. To keep their jobs, federal legislators will gut the previous reform bill. Look at Greece today: every modest attempt at fiscal reform has met with massive (and often violent) resistance from the voters. It will be the same in the USA.

Les Cargill writes:

egd: The only free variable left is taxation. The budget is spent and spent again. I believe Dr. Jones' wry comment is that "starve the beast" is a very specific rhetorical flight of fancy which has no real referent in any political behavior we can actually observe. It is a fiction which only has electoral uses. That's *the* public choice elephant in the room.

Nobody really wants to go after Social Security. Nobody really wants to go after Medicare. It is only important that Paul Ryan can claim to have a plan. He need not bore us with the details, and he doesn't.

So what do the bond markets say? Why, they say the bond markets would likely prefer *more* spending. So we cannot even have a "Bill Clinton and the bond vigilantes" moment.

Methinks writes:

@Les Cargill,

Nobody really wants to go after SS or Medicare or (let's add) Obamacare, but nobody wants to pay for it either. And they're not going to.

The bond market is NOT expressing a preference for more spending. The bond market is expressing a preference for U.S. sovereign debt over the sovereign debt of the EU in chaos.

We're the cleanest dirty shirt with the largest and most liquid (read: easy to move money in and out of in a flash) sovereign debt market in the world, bar none. There is no other sovereign debt market large enough to absorb the flight from European debt. Not even close. When the bond market believes a particular European Fix Fantasy, participants stampede out of Treasurys and yields spike.

egd writes:

@ Les Cargill

Tax increases are the only "free variable" if you've excluded all others.

People like Medicare, Social Security, or any other social program if you sell it to them as a benefit. Not so much if you sell it as a cost.

Ask people if they support increasing the payroll tax to support Social Security and Medicare and you get a very different result.

Imagine you're a bond holder at a company in a reasonably competitive market: spending is increasing at twice the rate of revenue and the company is deeply in debt. Do you favor increasing the price of goods or cutting spending?

Matt C writes:

> I don't know if some form of this plan is going to pass after the election, but if the probability of serious reform passing is, say, 30% this year [...]

Sounds high to me. If I made up a number it would be below 10%.

I don't doubt that our leaders will *talk* about serious reform, and they might even pass something *called* The Serious Reform Act Of Something Or Other, but it will be a major deviation from trend if that is actually substantive reform.

See MingoV's comment.

On the maybe-I'm-wrong side of things, Krugman apparently sees the idea of reform as a plausible possibility:

http://krugman.blogs.nytimes.com/2012/09/30/a-public-service-reminder-simpson-bowles-is-terrible/

John David Galt writes:

The Europeans have seen hyperinflation before, too; 1923 comes first to mind, but there are others more recent. Like ourselves, the Greeks and others in the same boat can't yet get enough votes to take corrective action in time for it to do any good. This seems to be an inherent bug (or feature) of democratic governments.

What they have managed, so far, is to get the other eurozone governments to commit to share enough of the burden that if Greece defaults, the rest, including Germany, will be brought down too. I'm not confident that they will use the time this buys well enough to matter, but they may; and when it runs out, there are still the IMF and World Bank as potential rescuers.

But no organization is anywhere near big enough to rescue the United States when it happens to us. That's the big difference between us and Europe.

Even if this election were between Obama and Ron Paul, it would probably be too late to save us.

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