Sunday, June 27, 2010

Uncle Sam Should Tap his Credit Line

[This post first appeared on Seeking Alpha.]

Alan Mulally is credited with saving Ford Motor Company by borrowing as much as he could – $23 billion – in 2006, before the credit crunch hit other US businesses, to fund a major turn-around of the company's business. Uncle Sam needs to take a page from Mr. Mulally's book.

Because our private borrowers cannot absorb all the risk-averse capital our massive trade deficit brings in, the Treasury has an opportunity to borrow long-term at rates that seem ridiculously low in light of our national debt and continuing deficits. The money is just lying there. All the Treasury has to do is pick it up.

The biggest obstacle to this tactic is the skepticism of Republicans and their supporters, skepticism that is not entirely unwarranted (even if to some extent disingenuous) but is in any event ill-timed. Waste has been the hallmark of Congressional spending over the years, and conservatives do not want to give the liberal Congress another nickel to waste. But I think we need to think long and hard before passing up an opportunity this good.

Let me make clear that I'm not advocating purely Keynesian deficit spending, at least not as I use the term "deficit." I am advocating issuing a ton of long-term notes and bonds. The use is a separate matter, although I've got some thoughts on that, too. I am proposing three uses of the funds, only one of which is spending of any sort, and that's on investments that add more value to our national balance sheet than they cost.

Extend Maturities.

Low-rate, short-term debt is riskier to issue than low-rate, long-term debt. Short-term debt has to be rolled over and can become high-rate short-term debt if the market refuses to roll it over and the Fed is not willing or able to buy it. If we can get out of this recession, the Fed will want to raise short-term rates in order to prevent the economy from overheating. Hopefully, depression-expert Bernanke will show more restraint than Marriner Eccles did in 1936, but at some point, the Fed must tighten, and when that happens, the Treasury should not be caught with a ton of T-bills to roll over.

There are about $2 trillion in T-Bills now outstanding. So, every 1% increase in the T-Bill rate adds $20 billion to the deficit. The increase in pay-out seems inflationary even as the increased cost of borrowing is anti-inflationary. 5-6% is not an unusual T-Bill yield when the Fed is tightening. That's $100 billion in additional deficit relative to today just to service T-Bills, if we still have $2 trillion outstanding.

If the need to roll over a large amount of bills will hamper the Fed's efforts to slow the economy when it needs to be slowed, one of the best things that we could do with long-term borrowing would be to retire a significant amount of short-term debt, even at the 3-4% difference in interest that would apply right now. And long-term debt can be "repaid" in part by inflation.

Inflating away the debt is a time-honored strategy. See Aizenman and Marion, "Using inflation to erode the US public debt," 2009.) As this table (Joshua Aizenman and Nancy P. Marion © shows, the US has, until recently, matched the maturity of its debt to the magnitude of its debt: the more we owe, the longer-term we have borrowed, and the more inflation has done to repay it.


With our public debt now approaching 90% of GDP, history suggests that we should be at an average maturity of 100 months or so, not the 50 months currently applicable. Whether we can issue enough long-term debt at reasonable rates remains to be seen, but we can certainly issue more than we have, and we should at least be working our way out the maturity curve as far as we can go. I should add that inflation only works to devalue debt to the extent that inflation is not priced into the bonds in the first place. Only when the real rate of return on the debt is below the nominal growth rate of GDP does inflation actually hurt the investor. But there are times when the market under-prices long-term debt, and when that happens, issuers should move quickly to exploit the arbitrage maturities.

Get Rid of Tips.

As of November, 2009, the Treasury had issued $550 Billion worth of Treasury Inflation-Protected bonds, a/k/a "TIPs," perhaps the dumbest idea anyone in government has ever had. That's about 8% of the outstanding Treasury debt. What, really, were they thinking when they came up with this monster? How are we ever going to inflate our way out of debt that is inflation-protected? (I know what they were thinking – a low coupon in a period of low-inflation.) But still. What hubris to think we would never need to monetize our debt, when our very willingness to issue this financial accelerant shouts from the rooftop that we haven't the brains or will-power to escape that fate.

TIPs put us in the same bind as short-term bills, because, from an economic perspective, that's what they are. Instead of having to roll them over at a rate set by the Fed and/or the market, Uncle Sam has to roll them over at a rate set by the CPI. Either way, the rate is out of the Government's control. (I assume – but cannot say with authority – that the nominal maturity of TIPs is reflected in the table above, which distorts the maturity upward without providing an enhanced opportunity for monetization. The table should be constructed either without reference to TIPs or with TIPS treated as having a maturity of zero months.)

So long as raising interest rates depresses inflation, then TIPs aren't a problem. But, if raising short-term rates proves inflationary because so much of our debt is short term, TIPs will only make matters worse. Thus, along with taking advantage of current low long-term rates to move the nation's debt out the yield curve, the Treasury should buy back TIPs (and stop issuing them) so that when the time comes to raise short-term rates, the Fed will actually have the flexibility to do so.

Upgrade the Infrastructure.

Not all of the money borrowed should be used to replace existing debt. After all, re-funding debt requires no new money, so it shouldn't put much of a dent in the demand for Treasury paper. The whole point of the exercise is to borrow as much new money as possible at these low rates. That new money should be put to work putting people to work – on rebuilding our obsolete and decrepit infrastructure. Roads, bridges, aqueducts, power grid, high-speed rail, air-traffic control, alternative energy all need attention.

With so many unemployed workers, especially in construction, infrastructure projects are the perfect Keynesian antidote to what ails us. We just need the smarts to use long-term borrowing now (when the money is cheap) to fund the work, even the longer-term projects that won't be done until later.

And we need to get cracking, because Medicare is preparing to swallow all of our cash as fast as we can print it. Indeed, one of the best things we can do for our infrastructure would be to upgrade our healthcare delivery systems in advance of the coming crunch. But more about unfunded obligations later. For now, our leaders need to recognize that the infrastructure needs work, and our workers need work. And money is cheap, so if not now, when?

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