O.K., Here is the other side of the story

Despite U.S. deficit concerns, investors still pour money into Treasury bonds

By Neil Irwin
Washington Post Staff Writer
Tuesday, June 1, 2010; A01

The U.S. government debt is rising inexorably, according to the conventional wisdom in Washington, and the political system is too paralyzed to take unpopular actions to rein it in. Privately, many policymakers take it as a given that the situation will change only when the nation faces a Greek-style fiscal crisis.

But apparently nobody told the people who lend the U.S. government money. On Friday, they were willing to hand over their cash to the Treasury for 10 years for 3.3 percent interest, a level so low it implies they consider the United States among the safest investments in the world. Collectively, those investors -- think mutual funds, pension funds and foreign central banks -- could lose hundreds of billions of dollars if they're mistaken and the United States has a debt crisis.

It is the Beltway vs. the bond market, and they can't both be right.

Perceptions inside the Beltway rest on this idea: Although the current large budget deficit is caused mainly by the weak economy and a short-term economic stimulus that will soon expire, in the longer run the government faces a vast unfunded burden, particularly tied to Medicare and Medicaid.

The mix of spending cuts and tax increases that could close the gap are wildly unpopular. With the threat of a filibuster in the Senate hanging over anything remotely controversial, a bipartisan budget accord seems unlikely. And many Republicans have declared they will not vote for a package that includes a tax increase under any circumstance.

This situation led Moody's, the debt-rating firm, to state in March that the U.S. government is nearer to being at risk of losing its Aaa credit rating and that maintaining the rating might require adjustments to tax and spending policy "of a magnitude that, in some cases, will test social cohesion."

Given those realities, the widespread view in Washington is that serious efforts at reducing the deficit will come only when a crisis moment, such as steeply higher borrowing rates, forces the issue.

"You can talk about the deficit until you're blue in the face, but we'll only get political traction on meaningful deficit reduction when there is economic pain being caused by the deficit in the form of inflation or high interest rates or both," said Bruce Bartlett, a Treasury Department official in the George H.W. Bush administration who recently wrote an article predicting that the U.S. government will be downgraded in less than a decade.

In effect, lending money to the U.S. government is like lending to a couple that is spending way beyond its means, and in which the wife refuses to take a second job to increase income and the husband refuses to spend less. No responsible banker in the world would make that loan, but banks and other global investors feel rather differently about U.S. Treasury bonds.

Among economic commentators, there have been rumblings that the debt crisis that started in Greece and increasingly affects such other Western European countries as Spain and Ireland could eventually spread into a crisis of confidence in United States government debt.

So far, the opposite has happened.

The financial crisis and recession drove Treasury borrowing rates to all-time lows -- and in recent weeks, the European debt crisis, rather than make investors fear for the safety of their Treasury bonds, has instead led to an influx of money into the United States, driving rates down further.

On Wednesday, for example, the government borrowed $42 billion in five-year debt for 2.13 percent. During the 1990s, that rate averaged 6.3 percent.

So what are bond market investors thinking? They are looking around the world in search of a safe place to park cash, and the United States seems like the safest -- or perhaps the least unsafe.

Western Europe has weaker economies than the United States, more lavish social welfare benefits, a fragmented political system and a currency union that might not make it out of the current crisis intact. Japan has an older and slower-growing population, and its economy has been stagnant for most of the past two decades. (It also has very low borrowing rates, reflecting in part high rates of savings among its citizens.) Beacons of stability such as Australia, Canada and Switzerland are too small to handle the trillions of dollars in global savings that investors are looking to park.

In the United States, meanwhile, the economy is beginning to grow. There are few signs of inflation, and the Federal Reserve is likely to keep the short-term rates it targets very low for some time.

While long-term interest rates are low by historical standards, they are much higher than short-term borrowing rates, which are essentially zero, a phenomenon known as a steep yield curve. That means that investors feel well-compensated for tying their money up for years.

Moreover, the dollar and Treasury bonds have a status as the safe port in the storm whenever the global economy or financial system looks shaky. Bond investors assume that relationship continues. And many global investors' returns are measured in dollars, so they have extra incentive to have exposures to U.S.-based debt.

And fundamentally, bond buyers discount the risk of a catastrophic fiscal calamity in the United States, noting that the U.S. government has proved able to make hard-but-necessary decisions when it must, such as the passage of the $700 billion bank bailout in 2008 and a deficit-reduction package in 1990.

"It may take longer than anyone likes, but we have a history of getting the message," said Dan Shackelford, who manages the New Income Fund, a bond mutual fund, at T. Rowe Price. "We have come close to hitting the crisis point before, but somehow the government has been able to respond."

In other words, we might not know how, or when, but eventually the U.S. political system is sufficiently strong to make the hard, necessary choices.

But market sentiment can turn on a dime, as the Greek government and former Lehman Brothers executives can attest, so the big question remains whether major action on the budget deficit will come before Treasury bond rates rise significantly.

"There is a tendency for markets to ignore certain things for long periods of time, then suddenly notice them all of a sudden," Bartlett said.

Obama administration officials are aware of the risk of an abrupt change in perception among bond investors. A spike in Treasury borrowing rates could slow or stop the economic recovery and make the deficit problem even worse by increasing the government's costs to roll over its debt.

Thus, the administration has attempted to signal to the bond market that it is attuned to reining in the budget deficit in the years ahead, even as it argues for higher spending in the near term to support the economy. The president's proposal this year to freeze non-defense discretionary spending for three years is one such signal.

And it is uncertain exactly how growing concern about U.S. government debt would be reflected in financial markets. Before the impact of high budget deficits shows up in interest rates on Treasury bonds, it might show up in the form of a lower stock market and higher borrowing costs for private enterprises.

"Markets never price big surprises," said Robert H. Dugger, managing partner of Hanover Investment Group in Alexandria. "That's why they're big surprises."