Greenspan in WSJ: U.S. Debt and the Greece Analogy

History will not be kind to the former Fed Chairman with regard to his understanding of monetary operations.

He understands solvency is not an issues which does seem to put him ahead of most. But he lacks a critical understanding of interest rate determination, particularly with regard to how the entire term structure of risk free rates is set by Fed policy (or lack of it), with US Treasury securities functioning to alter those risk free rates, and not funding expenditures per se:

“The U.S. government can create dollars at will to meet any obligation,
and it will doubtless continue to do so. U.S. Treasurys are thus free of
credit risk. But they are not free of interest rate risk. If Treasury
net debt issuance were to double overnight, for example, newly issued
Treasury securities would continue free of credit risk, but the Treasury
would have to pay much higher interest rates to market its newly issued

U.S. Debt and the Greece Analogy

By Alan Greenspan

June 18 (WSJ) —Don’t be fooled by today’s low interest rates. The
government could very quickly discover the limits of its borrowing capacity.

An urgency to rein in budget deficits seems to be gaining some traction
among American lawmakers. If so, it is none too soon. Perceptions of a
large U.S. borrowing capacity are misleading.

Despite the surge in federal debt to the public during the past 18
months-to $8.6 trillion from $5.5 trillion-inflation and long-term
interest rates, the typical symptoms of fiscal excess, have remained
remarkably subdued. This is regrettable, because it is fostering a sense
of complacency that can have dire consequences.

The roots of the apparent debt market calm are clear enough. The
financial crisis, triggered by the unexpected default of Lehman Brothers
in September 2008, created a collapse in global demand that engendered a
high degree of deflationary slack in our economy. The very large
contraction of private financing demand freed private saving to finance
the explosion of federal debt. Although our financial institutions have
recovered perceptibly and returned to a degree of solvency, banks,
pending a significant increase in capital, remain reluctant to lend.

Beneath the calm, there are market signals that do not bode well for the
future. For generations there had been a large buffer between the
borrowing capacity of the U.S. government and the level of its debt to
the public. But in the aftermath of the Lehman Brothers collapse, that
gap began to narrow rapidly. Federal debt to the public rose to 59% of
GDP by mid-June 2010 from 38% in September 2008. How much borrowing
leeway at current interest rates remains for U.S. Treasury financing is
highly uncertain.

The U.S. government can create dollars at will to meet any obligation,
and it will doubtless continue to do so. U.S. Treasurys are thus free of
credit risk. But they are not free of interest rate risk. If Treasury
net debt issuance were to double overnight, for example, newly issued
Treasury securities would continue free of credit risk, but the Treasury
would have to pay much higher interest rates to market its newly issued

In the wake of recent massive budget deficits, the difference between
the 10-year swap rate and 10-year Treasury note yield (the swap spread)
declined to an unprecedented negative 13 basis points this March from a
positive 77 basis points in September 2008. This indicated that
investors were requiring the U.S. Treasury to pay an interest rate
higher than rates that prevailed on comparable maturity private swaps.

(A private swap rate is the fixed interest rate required of a private
bank or corporation to be exchanged for a series of cash flow payments,
based on floating interest rates, for a particular length of time. A
dollar swap spread is the swap rate less the interest rate on U.S.
Treasury debt of the same maturity.)

At the height of budget surplus euphoria in 2000, the Office of
Management and Budget, the Congressional Budget Office and the Federal
Reserve foresaw an elimination of marketable federal debt securities
outstanding. The 10-year swap spread in August 2000 reached a record 130
basis points. As the projected surplus disappeared and deficits mounted,
the 10-year swap spread progressively declined, turning negative this
March, and continued to deteriorate until the unexpected euro-zone
crisis granted a reprieve to the U.S.

The 10-year swap spread quickly regained positive territory and by June
14 stood at a plus 12 basis points. The sharp decline in the euro-dollar
exchange rate since March reflects a large, but temporary, swing in the
intermediate demand for U.S. Treasury securities at the expense of euro

The 10-year swap spread understandably has emerged as a sensitive proxy
of Treasury borrowing capacity: a so-called canary in the coal mine.

I grant that low long-term interest rates could continue for months, or
even well into next year. But just as easily, long-term rate increases
can emerge with unexpected suddenness. Between early October 1979 and
late February 1980, for example, the yield on the 10-year note rose
almost four percentage points.

In the 1950s, as I remember them, U.S. federal budget deficits were no
more politically acceptable than households spending beyond their means.
Regrettably, that now quaint notion gave way over the decades, such that
today it is the rare politician who doesn’t run on seemingly costless
spending increases or tax cuts with borrowed money. A low tax burden is
essential to maintain America’s global competitiveness. But tax cuts
need to be funded by permanent outlay reductions.

The current federal debt explosion is being driven by an inability to
stem new spending initiatives. Having appropriated hundreds of billions
of dollars on new programs in the last year and a half, it is very
difficult for Congress to deny an additional one or two billion dollars
for programs that significant constituencies perceive as urgent. The
federal government is currently saddled with commitments for the next
three decades that it will be unable to meet in real terms. This is not
new. For at least a quarter century analysts have been aware of the
pending surge in baby boomer retirees.

We cannot grow out of these fiscal pressures. The modest-sized
post-baby-boom labor force, if history is any guide, will not be able to
consistently increase output per hour by more than 3% annually. The
product of a slowly growing labor force and limited productivity growth
will not provide the real resources necessary to meet existing
commitments. (We must avoid persistent borrowing from abroad. We cannot
count on foreigners to finance our current account deficit

Only politically toxic cuts or rationing of medical care, a marked rise
in the eligible age for health and retirement benefits, or significant
inflation, can close the deficit. I rule out large tax increases that
would sap economic growth (and the tax base) and accordingly achieve
little added revenues.

With huge deficits currently having no evident effect on either
inflation or long-term interest rates, the budget constraints of the
past are missing. It is little comfort that the dollar is still the
least worst of the major fiat currencies. But the inexorable rise in the
price of gold indicates a large number of investors are seeking a safe
haven beyond fiat currencies.

The United States, and most of the rest of the developed world, is in
need of a tectonic shift in fiscal policy. Incremental change will not
be adequate. In the past decade the U.S. has been unable to cut any
federal spending programs of significance.

I believe the fears of budget contraction inducing a renewed decline of
economic activity are misplaced. The current spending momentum is so
pressing that it is highly unlikely that any politically feasible fiscal
constraint will unleash new deflationary forces. I do not believe that
our lawmakers or others are aware of the degree of impairment of our
fiscal brakes. If we contained the amount of issuance of Treasury
securities, pressures on private capital markets would be eased.

Fortunately, the very severity of the pending crisis and growing
analogies to Greece set the stage for a serious response. That response
needs to recognize that the range of error of long-term U.S. budget
forecasts (especially of Medicare) is, in historic perspective,
exceptionally wide. Our economy cannot afford a major mistake in
underestimating the corrosive momentum of this fiscal crisis. Our policy
focus must therefore err significantly on the side of restraint.

Mr. Greenspan, former chairman of the Federal Reserve, is president of
Greenspan Associates LLC and author of “The Age of Turbulence:
Adventures in a New World” (Penguin, 2007).

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