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Monday, November 24, 2008

Bailouts, Spending, the Deficit, and the House of Cards of U.S. Treasury Bonds

In the last seventy two hours or so, the government, both current and incoming, has announced plans for massive new spending. The current administration has just announced plans to extend help to Citigroup. Leaders of the incoming Congress plan to introduce a stimulus package that may cost as much as $700 billion.

Sen. Charles Schumer, D-N.Y., said Sunday that he thinks the economic stimulus package should be between $500 billion and $700 billion.

In an interview with ABC's "This Week," Schumer said, "I believe we need a pretty big package here." He added that Congress is working on getting the economic package to President-elect Barack Obama by Inauguration Day. "I think it has to be deep. In my view, it has to be between $500 and $700 billion, and that's because our economy is in serious, serious trouble."

"It's a little like having a new New Deal, but you have to do it before the Depression. Not after," Schumer added.

All of this spending will inevitably be combined with a bailout of the autos that at some point the Congress will give into. Furthermore, this is all on top of the $700 billion rescue package of the financial industry. By the time we are done, we maybe adding about $2 trillion onto our national deficit.

So, some might ask where does the U.S. government find all of this money. Much like any other powerful organization the U.S. government finds money by issuing debt in the form of bonds, U.S. treasury bonds. Just as corporations issue Corporate bonds when they want to borrow, the U.S. Treasury issues U.S. Treasury bonds.

U.S. Treasury bonds are the safest investment in the world. We've never had one default even though we've issued trillions of Dollars worth of bonds. How did this happen though? The way that the U.S. Treasury pays for debt is actually by issuing new debt. The U.S. Treasury bond market is so robust that the Treasury is able to continue to stay in debt indefinitely. That's because no matter how much debt it issues, through bonds, there is always plenty of buyers for their bonds. Debt is always paid back on time because there is always someone, plenty of someones, willing to take on new debt.

This comes from the perception that our economy and country are vibrant. Furthermore, it comes from the reputation that has been built up from decades of having perfect history of paying this debt back. If the U.S. Treasury ever issued new debt and no one bought it though, the proverbial house of cards would fall.

That is something to think about as our government continues to dig deeper into debt. At some point the market for our debt will say enough is enough. I don't know where that number is and it's almost certain to be a lot higher than our current plans for new expenditures. As we fall deeper and deeper into debt, some think the money just magically appears. It doesn't magically appear, but rather it is created through the issuance of new debt. Furthermore, our entire system of deficit spending is predicated on the assumption that there will always be buyers for new debt. We are entering an entirely new phase of the global economy. It's difficult to know just how much desire there will be in the future for U.S. Treasuries.

Furthermore, the nightmare scenario is not the only one that can cause the United States all sorts of problems. Even if there continues to be enough of a market, all of this newly issued debt will likely cause an imbalance between buyers and sellers. Because the market will need to find buyers for the newly issued debt, there will be less of them in the aftermarket. This will likely, eventually, cause Treasury bond rates to go up. Right now, the U.S. Treasury has to pay little for its debt, just over 3% for the 10 year bond and just under 4% for the 30 year. If rates go up, the U.S. Treasury will have to use more and more of each borrowed Dollar for owed interest. That will of course cause the Treasury to borrow even more. Furthermore, it will cause our borrowing to be much less efficient since much more of it will go to paying interest. All of this borrowing has a vicious cycle effect eventually. It's difficult if not impossible to know at what level it gets triggered, and let's all hope the current rate of borrowing won't get us there.

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