The Mother of all Black Swans

One of the main reasons Clinton was able to balance the budget in the 1990s was that Treasury Secretaries Robert Rubin and Larry Summers restructured U.S. sovereign debt to shorter maturities. Did this unintentionally create the conditions for artificially low interest rates, serial bubbles and sovereign debt spiral?  Read on…

Readers are probably aware that the single most important factor in Clinton’s budget surplus was the Treasury’s move to shorter-dated bonds. Short durations almost always have lower interest rates (except when they don’t — more on that in a moment). Governments have traditionally borrowed almost entirely in long-term bonds, such as 10-year and 30-year Treasuries. In the 1990s, the U.S. moved to shorter durations, resulting in instantly lower debt service costs, and a balanced budget.

The risk, which I’ve not seen mentioned anywhere, is that the federal government then becomes remarkably similar in capital structure to an investment bank, depending upon constant refinancing of huge short-term debts just to remain solvent — exactly the capital structure that killed both Bear Stearns and Lehman Brothers. With the U.S. government, it seemingly plays out in two ways.

1. Massively politicizes the Fed.  The Chairman of the Federal Reserve (who is unelected) now directly controls the size of the U.S. budget deficit simply by changing short-term interest rates, which changes the cost of the next rollover. Or, viewed from the other side, there is unprecedented pressure on the Fed to hold rates artificially low, to manage the deficit. (Maybe the serial bubbles and artificially low rates since 1996 result largely from this new pressure.)  This pressure did not exist before, because long-dated bond rates are determined by market prices, not by the Fed.

2. Massively exposes the US to a sovereign bond panic.  Suppose everyone decided for a couple of years that US T-bonds were toxic (perhaps due to war, terrorist attack, or some other unanticipated event).  If the government were mainly financed with 30-year bonds, then no big deal, they can just wait it out. But if the bonds are largely 1-year maturity, there is no way to roll over the bonds, and financial catastrophe ensues.

This is a particularly huge black swan — the move to short-dated bonds created a short-term illusion of stability, while massively increasing long-term exposure to a sovereign wipeout.

It is also very hard to get out of this situation, because the deficits are too large to roll back into more expensive 30-year bonds — just as a homeowner with an option-ARM mortgage is dreadfully exposed to interest rate swings, but cannot afford to refi back into a 30-year fixed.

The biggest danger seems to be that no one even recognizes the risk. According to Nassim Taleb, this blindness is a key feature of a black swan: unappreciated risk of a rare event with a catastrophic outcome.

Because the situation is apparently inescapable due to fiscal pressure, one might argue the United States is already in a sovereign debt spiral, one that will become visible only when short-term Treasury auctions start to fail.

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