GOPideas... ideas done right

For those who worry that spending can go unchecked, meet your new best friends: the bond market vigilantes. These are investors in fixed income securities (bonds) that swap cash today for a security (bond) that entitles them to the principal that was loaned and a rate of interest, determined by the market. Like any investment, higher risk entails higher reward, so investors demand higher interest rates when they believe that the probability of being paid back is lower. This is where the term “junk bond” is derived: the companies that offer them are the highest risk, thus they must offer the highest yield.

For years, the US Treasury T-bill was (and still is) considered the safest investment on the planet. In turn, this allowed the US government to borrow at cheaper rates than the rest of the world --- meaning that our recent spending spree was not only profligate, but also financed by people around the world, for the cheapest rates anywhere (talk about a deal!). However, with deficits accelerating and no plan to abate them, some investors are getting nervous and beginning to demand higher interest rates on government debt. The Federal Reserve has responded with “quantitative easing” --- which essentially means that they are printing money and swapping dollars for other assets (like the toxic junk on banks’ balance sheets). In turn, this is allowing banks to run a carry trade, minting themselves money at the expense of the taxpayer.

Here is how the scheme works: The Fed prints money from thin air. Bank A borrows that money at a zero interest rate. Bank A buys U.S. T-bills yielding 3% with that money. Viola! The bank gets 3% return for no risk, the US government can continue to deficit spend and everyone lives happily ever after.

Not so much. This only works as long as banks are willing to buy US bonds, which they will not do when they feel that they can get a better return elsewhere (when the economy improves). Also, unless the country starts running surpluses, there is $12 trillion in outstanding debt that will come due and will need to be refinanced. This is where the vigilantes come in.

What would happen if investors were no longer willing to loan at 3%? What if they refused to buy the bonds unless the yield was 5, 7 or 10%? It would mean that the debt service of the US would double or triple --- pushing deficits higher, which makes the countries finances riskier to investors, which enables them to demand higher yields, which increases the deficit … you get the picture. Also, do not be fooled if you hear that it can’t happen: it already is happening in England

This is why the bond market vigilantes may become the Republican’s best friends: they will enforce spending discipline, as they did when Bill Clinton has grand dreams of universal health care and huge spending plans. Let’s hope they don’t show up too late.