The stimulus just keeps looking worse and worse

By Phil Levy

In today’s New York Times, we read this:

“The U.S. needs to show some proof they have a plan to get out of the fiscal problem,” said Ernesto Zedillo, the former Mexican president who helped steer his country through a financial crisis in 1994. “We, as developing countries, need to know we won’t be crowded out of the capital markets, which is already happening.”…

“People are not stupid,” Mr. Zedillo said. “They see the huge deficit, the huge spending, and wonder what comes next.”

I erred in my earlier post on the international aspects of the stimulus bill. I was excessively optimistic. I said we might get away with lots of governments borrowing lots of money all at once for a while, since the private sector isn’t doing anything with the money at the moment. In fact, as Ernesto Zedillo goes on to note in the Times, developing countries are already finding it hard to borrow, as lenders flee to the perceived safety of the U.S. bond market. I’ll stand by my prediction that trouble would eventually come; it’s just coming sooner than I had thought.

The trouble is not restricted to the developing world. The United States just had some difficulty marketing 5-year Treasury notes and 10-year bond yields have been rising sharply. These are not the very short rates that the Fed sets; they are the longer, market-determined rates that drive borrowing costs for businesses and home-buyers. As the crisis unfolded, global investors foresaw doom and piled into U.S. government bonds as a safe haven. The result was a plunge in interest rates and upward pressure on the dollar.

In the past few weeks and particularly in the last couple days, demand for Treasuries has fallen off and interest rates have been rising. There can be many causes, but one concern is how the United States will pay for all its borrowing.

There is a substantial risk here. Bloomberg today quotes a trader from China’s biggest bank as predicting that the "rout" in the Treasury market will deepen and rates will rise. Imagine, for a moment, that he believes what he’s saying. The story notes that Treasuries have lost almost 3 percent this month. The trader thinks more losses are soon to come. Unless he or his international colleagues think the dollar will appreciate, they would be safer selling their holdings and keeping their money in another currency (even if their own bonds have very low yields). If they do all sell their Treasuries, that will drive interest rates up and the dollar down, thereby validating their decision to sell (bubbles are nasty that way).  A weaker dollar might help U.S. exports, if only we weren’t launching a trade war. The higher interest rates won’t help at all in reviving the economy.

But wait, it gets worse! Cognizant of this threat from excessive borrowing, both Jeff Sachs (in his academic capacity) and Larry Summers (in his official capacity) have argued this week that the new spending means we will need tax hikes in the near future. While it is very difficult to see how spending in 2011 stimulates the economy now, it’s easy to see how raising taxes in the future could slow things in the present. From the perspective of any entrepreneur brave enough to invest and create jobs right now, high taxes could create a case of “heads, the government wins; tails, I lose.”

All of this is to say: there are some reasons besides partisan rancor why Republicans might hesitate to support the $819 billion stimulus bill.