Something very important has been missing from the debate about fiscal stimulus. There are two really good reasons to oppose the Obama stimulus bill.
First, it's got be to just about the most hasty and poorly thought-out piece of legislation ever to come out of the US Congress. (Isn't it ironic that it also happens to be the biggest expansion of government spending ever?) This bill is so full of waste, earmarks and pork-barrel spending that Obama will have to use all his charm and deception to blow it past the American people.
Second, and this is what you hear from a lot of Congressional Republicans, the bill expands the Federal deficit tremendously.
It's being suggested by many sharp observers that global investors (like the Chinese) will be unwilling to fund this stimulus package, and will demand much higher interest rates on US debt.
Not quite. This deficit will be a lot easier to fund than many people think. It's what comes later on that we have to worry about.
First, it's got be to just about the most hasty and poorly thought-out piece of legislation ever to come out of the US Congress. (Isn't it ironic that it also happens to be the biggest expansion of government spending ever?) This bill is so full of waste, earmarks and pork-barrel spending that Obama will have to use all his charm and deception to blow it past the American people.
Second, and this is what you hear from a lot of Congressional Republicans, the bill expands the Federal deficit tremendously.
It's being suggested by many sharp observers that global investors (like the Chinese) will be unwilling to fund this stimulus package, and will demand much higher interest rates on US debt.
Not quite. This deficit will be a lot easier to fund than many people think. It's what comes later on that we have to worry about.
The thing that many people miss in the debate, is the role of private borrowing. It turns out that credit formation in the private sector went into reverse in 2007, and the decline continues to this day. In fact, it will probably continue for a long period of time as financial assets deflate and housing values keep falling.
On a net basis, the private sector is paying off its debts rather than borrowing more. But there's been no measurable reduction in global demand for debt securities. That gives the government the opportunity to greatly step up its borrowing, at what appear to be very low interest rates.
The trillion-plus dollar deficits of the Obama years will add greatly to the public debt of the US (now at about 40% of GDP), but will probably NOT measurably increase long-term interest rates anytime soon.
The Obama stimulus plan, on top of already-huge deficits caused by the recession, should push the public debt up to about 60% of GDP by the end of next year. After five years, it'll probably be about 100% of GDP.
To repeat, this isn't going to be accompanied by any easily-noticeable distress. In fact, the additional government spending will increase reported GDP and reduce unemployment in the near to medium term. Obama will take credit for what will appear to be a success.
The distress will come later on. The government's share of total US indebtedness will NOT be able to fall. That's because it's in the nature of government spending that it's not efficient and does NOT give the economy the equipment to produce at higher levels. (The only way to achieve that is to increase the real rate of return on private investments, which no one is talking about at all.)
That means the aggregate productivity of the US economy will not rise as a result of all the government spending. The private sector will need to start investing again, if we're to replace the share of aggregate demand that the government is creating.
But after a few years, when it's time for that to happen, we'll suddenly notice that private sector borrowing has no room to come back. The government will be soaking up all the available capital, and real interest rates will be extremely high. (Remember, in a deflation, even a 4% interest rate can easily be too high to catalyze private investments.)
That's when we'll all realize that the government is the economy and the private sector won't have the ability to borrow and invest on a large scale. This will depress consumption and investment permanently.
What could forestall that outcome? Aggressively reducing taxes on business income and capital gains, right now. Will that happen? In your dreams.
Welcome to America's version of Japan's lost decade.
On a net basis, the private sector is paying off its debts rather than borrowing more. But there's been no measurable reduction in global demand for debt securities. That gives the government the opportunity to greatly step up its borrowing, at what appear to be very low interest rates.
The trillion-plus dollar deficits of the Obama years will add greatly to the public debt of the US (now at about 40% of GDP), but will probably NOT measurably increase long-term interest rates anytime soon.
The Obama stimulus plan, on top of already-huge deficits caused by the recession, should push the public debt up to about 60% of GDP by the end of next year. After five years, it'll probably be about 100% of GDP.
To repeat, this isn't going to be accompanied by any easily-noticeable distress. In fact, the additional government spending will increase reported GDP and reduce unemployment in the near to medium term. Obama will take credit for what will appear to be a success.
The distress will come later on. The government's share of total US indebtedness will NOT be able to fall. That's because it's in the nature of government spending that it's not efficient and does NOT give the economy the equipment to produce at higher levels. (The only way to achieve that is to increase the real rate of return on private investments, which no one is talking about at all.)
That means the aggregate productivity of the US economy will not rise as a result of all the government spending. The private sector will need to start investing again, if we're to replace the share of aggregate demand that the government is creating.
But after a few years, when it's time for that to happen, we'll suddenly notice that private sector borrowing has no room to come back. The government will be soaking up all the available capital, and real interest rates will be extremely high. (Remember, in a deflation, even a 4% interest rate can easily be too high to catalyze private investments.)
That's when we'll all realize that the government is the economy and the private sector won't have the ability to borrow and invest on a large scale. This will depress consumption and investment permanently.
What could forestall that outcome? Aggressively reducing taxes on business income and capital gains, right now. Will that happen? In your dreams.
Welcome to America's version of Japan's lost decade.
Francis,
During a deflationary period, bonds initially look attractive because the PV of your FCF are far more attractive than initially meets the eye -- as you said, the real interest rate is much higher than the coupon. On the other hand, companies will have a tougher time meeting interest payments and refinancing at affordable rates, increasing defaults. Which side typically outweighs the other -- higher PV or increased defaults? Are there other major factors to consider?
I'm not asking for specific investment advice, just the general wisdom on bonds during a deflationary period.
Hope you're doing well.
Also, government debt for other major economies, particularly the UK, Germany, and Japan, has had a really strong day, particularly on the long-end. Will these other governments play much of a role in absorbing private capital?
Dave, thanks for visiting the site. What I'm seeing is that high-grade corporate debt is very strong in the aftermarket. When you're getting paid 20% for pretty decent names, it's a pretty no-brain decision.
I think, however, that new issuance of corporate debt is very low because it's so expensive. That's a no-brain decision for the CFO, because even under normal conditions, he can't get an adequate return on borrowed money. And these aren't normal times.
So as the quarters roll on, you'd expect to see some supply pressure come into this market.
But the risk-free markets are just strong, strong, strong. I don't see anything that can really change that, although a lot of investors will move left on the curve.
What are you seeing from where you sit?