For decades, finance professors have taught students that the interest rate on U.S. Treasury obligations reflects the cost of money for “riskless” obligations. Other borrowers’ riskiness could be measured by how much more than the Treasury rate they were required to pay.
It is time to revise the lesson plan. Our national finances have deteriorated to the point that many corporate obligations are trading at lower yields than Treasury bonds. This means investors believe their money is safer with the corporations and are therefore willing to accept a lower return in exchange for lending to them. Warren Buffett’s Berkshire Hathaway Inc., Procter & Gamble Co., Johnson & Johnson and Lowe’s Co., have all paid lower rates than the U.S. government in recent weeks. The Treasury is paying a risk premium on its supposedly riskless debt.
Investors also are willing to lend to Germany at lower rates than they demand from Uncle Sam. According to Bloomberg, investors recently were demanding a little over half a percentage point more in yield to own a 10-year Treasury bond compared to a similar German bond. A year ago the situation was reversed.
Some of the yield difference between U.S. and German bonds results from expectations about future currency values rather than from the countries’ relative risk of default. But since American corporations and the American government both borrow in dollars, currency fluctuations do not explain the lower rates being paid by corporate borrowers.
The world is awash in Treasury debt, thanks to the staggering deficits we have run in the past several years. Apologists for our fiscal non-policy will likely blame a temporary imbalance between supply and demand for distorting the credit markets. They can correctly note that the current situation is not unprecedented. It last happened in the early 1980s, which was another era of skyrocketing U.S. budget deficits — though those deficits look like pocket change compared to today’s figures.
Financial markets generally look to the future, not to the present. Right now, the markets are seeing a future in which the ocean of federal red ink only gets deeper. The health care legislation President Obama signed this week will reduce the cumulative budget deficit by $138 billion over the next 10 years, the Congressional Budget Office reported. But nobody outside Washington (and, I’m sure, almost nobody inside Washington) believes this.
The CBO calculation is based on a variety of gimmicks and unrealistic assumptions. In an op-ed piece in The New York Times, Douglas Holtz-Eakin argued last week that, in reality, the health care overhaul will increase federal deficits by $562 billion in the next decade. Holtz-Eakin served as director of the Congressional Budget Office from 2003 to 2005 and now is president of the American Action Forum, a policy institute.
Among other things, the new law includes plans to trim $463 billion from Medicare spending and use those savings to fund insurance subsidy programs. But the legislation contains few reforms that would allow Medicare to operate on a reduced budget, and Congress has already established a custom of overriding scheduled cuts in payments to Medicare health providers. In all likelihood, the $463 billion in savings will never exist anywhere but on paper.
Washington is following the financial philosophy of Wilkins Micawber, the character in Charles Dickens’ “David Copperfield,” who met all adversity with the cheerful confidence that “something will turn up.” It did not work for Micawber, who ended up in debtor’s prison before his eventual redemption, and it is unlikely to work for us.
The emergence of a risk premium for Treasury debt is a warning that the choices we make today will have serious consequences tomorrow. The federal government can commandeer money via taxes, and the Federal Reserve Bank can, if all else fails, create dollars out of thin air to finance the federal debt. Warren Buffet’s business empire can only service its debt the traditional way, by earning money from customers who willingly pay for goods and services.
If Buffet, who has none of the government’s powers, can borrow more cheaply than the government itself, something is seriously wrong. The market is sending our political leaders a message. It is time to start listening.