The audacity of borrowing (Obama budget edition)

By Phil Levy

This week’s budget sketch from the Obama administration has stirred lots of partisan debate: A liberal dream come true! A conservative nightmare! For all of its occasional tedium, one of the nice aspects of economics is that markets often let you keep score in real time. And markets seem to be sending an unambiguous signal that the U.S. economy is now headed in the wrong direction.

At the heart of the debate, President Obama believes that massive spending and borrowing will ultimately strengthen the country. He regards the new proposals in health care, education, and energy as investments. Critics counter that these massive programs will bankrupt the country.

A first temptation is to look to the stock market for a verdict, and the stock market did not seem pleased. It has shown a tendency to swoon with almost every landmark moment of this administration. But supporters of the administration have argued that the stock market is too focused on the short term, that it is driven by other factors, that the market is more of a moodring than a carefully reasoned verdict. 

Fortunately, there are other markets that give a cleaner reaction. In particular, one can look at the government bond market, which is now giving the Obama plan a decided thumbs-down. The interest rate on the 10-year U.S. Government Treasury note helps set borrowing rates for corporations and households. It is not the very short term rate that the Fed has pushed near zero. It covers the same time frame that the Obama administration has now picked for its budget outlook. Unlike the stock market, there are no questions of dividend cuts, consumer fads, new competition, or management failures to muddy the picture.

This clarity led to the classic James Carville quote from early in the Clinton administration: "I used to think if there was reincarnation, I wanted to comeback as the President or the Pope or a .400 baseball hitter, but now I want to come back as the bond market. You can intimidate everybody."

A bond investor need only consider a few particular risks. There is the risk of inflation, which cuts into the spending power of the dollars investors receive later on. For foreign investors, there is the risk of a falling dollar, since they will ultimately need to convert their bond returns back into their own currency. Then there is the risk of default. That has been an important consideration for shaky businesses and emerging market basket cases, but not for a country like the United States. Until now.

In November and December, as investors panicked worldwide and rushed to the safety of U.S. government bonds, the interest rate on 10-year government bonds plunged to near 2 percent. From a low on December 30, the rate has rocketed back up to over 3 percent today, reflecting a sharp drop in the value of bonds. This is not because the rest of the world has solved its problems.

An even clearer negative verdict on Obama’s approach comes from the much-maligned market for credit default swaps. These swaps function like insurance contracts that pay off if a borrower fails to make good. That insurance gets more expensive when the likelihood of default increases. The idea of a U.S. government default has recently gone from "unthinkable" to close to 10 percent over the next five years. 

So what is scaring the bond traders? Perhaps they spent last weekend reading a timely report by the distinguished economists Alan Auerbach (UC-Berkeley) and Bill Gale (Brookings). The upshot is that the United States has serious long-term fiscal challenges, between the downturn, an aging population, and major entitlement programs. None of the options for getting out of the mess looked particularly palatable. And that was before the president spoke of an extra trillion dollars for health care.

Despite claims of a new realism, the administration’s budget is loaded with optimism. It assumes the economy will have a quicker and more vigorous recovery than most private forecasters predict. It assumes that individuals won’t change their behavior much to avoid new, higher tax rates. It assumes that sacred cows such as mortgage interest deductibility and agricultural subsidies are ready to be made into hamburgers. And even with all this optimism, the administration predicts red ink as far as the eye can see.

Meanwhile the administration is trying to pretend the crises in the financial and housing sectors will go away on their own. Although a storm is already raging, the administration is not setting much aside for a rainy day. The IMF recently predicted potential bank sector write-downs of $2.2 trillion globally, perhaps half of that in the United States. Nouriel Roubini (NYU) suggests $3.6 trillion. Any such loss would leave the administration with a choice: borrow even more to fill the holes, or watch tax revenue shrivel up as the financial sector crumbles and the economy asphyxiates. If they continue to borrow, at some point we will test the limits of the world’s willingness to lend and call into question America’s status as a financial safehaven. Higher interest rates will then make a bad situation worse.

I can’t say for certain that this is what is scaring the bond market. But I know it’s what’s scaring me.