The case for selling US Treasuries

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By Charles Tan

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Last week’s anti-climactic resolution to the US government shutdown and debt ceiling impasse brought to mind a witty quote from one Winston Churchill, “you can always count on the Americans to do the right thing – after they’ve tried everything else.”

However, let’s be clear about one thing: nothing has actually been solved.  All that US policymakers have managed to achieve after their weeks of squabbling is simply an agreement to kick the can a little further down the road, and to postpone the day of reckoning.  In roughly three months’ time, we can expect to be treated to a replay of the tragic comedy that is American politics.  All over again.

WHY DOES THIS KEEP HAPPENING?

Well, it depends on who you ask.  Democrats would blame the Republicans for not increasing the debt ceiling more, Republicans would blame the Democrats for spending too much, but in my opinion, both parties are barking up the wrong tree.  Just raising the debt ceiling every time it is breached, as the Democrats want, is like popping a painkiller to relieve a headache caused by a brain tumour – a temporary stopgap which addresses the symptoms but not the root issue.  On the other hand, it is difficult to solve the problem by simply spending less (mainly because of the magnitude of the deficit), but this is especially so when accompanied by the generous tax cuts which are a common feature of Republican fiscal policy.

The reason the US keeps having to raise its debt ceiling is that, despite all their talk, neither party is actually serious about balancing the books and actually paying down debt.  The point that got lost in the political circus of the last two weeks was that the US doesn’t actually have to default once it reaches its debt ceiling.  It just has to live within its means – like all of us do – but such change is hard, and painful, and no self-serving, democratically elected politician would choose to go down that path if he didn’t have to.

MY UNCLE SAM, THE CREDIT JUNKIE

In short, austerity is anathema, and this is because the US is hooked on credit.  A balanced budget would mean withdrawing net public expenditure equivalent to c4% of GDP, the effects of which, when compounded by the multiplier effect, and set against a projected growth rate of just c2.5% this year, would almost certainly bring about an economic recession.  President Obama does not want that on his head.

Furthermore, piling on debt is actually a logical response to current market conditions, from a US policymaker’s point of view.  This is because the interest the US Treasury has to pay its bondholders is so ludicrously low.  The analogy that many people use with regard to the debt ceiling is that of the US reaching the limit on its credit card: most of us can identify with that example and therefore nod in agreement to suggestions that the government should stop spending so much money and pay off its debt.  The key difference, however, is that the US government doesn’t pay 24% p.a. interest on its outstanding balance – the blended average is c1.5% p.a. – and if you could get money that cheaply, you probably wouldn’t be in much of a hurry to pay down your debts either.

FEEDING THE ADDICTION

The fault lies with us, really, because it is we who indirectly finance the US deficit year after year, enabling Uncle Sam to shovel yet more debt down his throat despite being aware of his ‘addiction’.  Foreign governments and investors like us own about a third of the outstanding US debt, and this figure is set to keep increasing because the two largest creditors – US pension funds (36%) and the Federal Reserve (11%) – are structural sellers of Treasuries going forward.  Since 2010, Social Security has been paying out more in benefits than it collects in taxes, and the Federal Reserve has indicated an end to quantitative easing by mid-2014.

By continuing to build our holdings of Treasuries despite their paltry rates of interest and accumulating US dollars despite their steadily falling value over time, we are effectively subsidising the US government’s operations (and all its follies) – from an unsustainable system of welfare and benefits, to unnecessary farm subsidies, to a controversial military/espionage programme.  In the process, we are also helping to prop up unprofitable zombie companies that should be put out of their misery and re-inflate a housing bubble with cheap fixed rate mortgages and the return of subprime lending.  This raises objections on so many grounds that I cannot even begin to list them here.

BUY REAL ASSETS, AVOID I.O.Us

The US enjoys its privileged fiscal position for a number of reasons, chief among which are: a) its status as the world’s de facto reserve currency, b) its vibrant, innovative and world-leading economy, and c) the implicit assumption that creditors will always be paid back on time, and in full.  The first two points are unlikely to change in our lifetimes: the euro (and the eurozone) is flawed by construction, while the renminbi is decades away from achieving full capital convertibility, and despite its flaws, the US remains a great country with immense productive potential, a strong culture of capitalism and a relatively open immigration system (all of which breed competition and creativity).  The third point, however, can no longer be taken for granted.

America’s politics is dysfunctional and the fiscal policies, as they stand, are unsustainable.  Therefore, I am inclined to agree with Chinese credit rating agency, Dagong, that the US should indeed be downgraded and deserves no more than an ‘A-‘ rating.  The current political set up means that no matter which party wins the election, creditors to the US lose, because the government is not expected to run a budget surplus anytime in the next 25 years, which is as far out as the non-partisan Congressional Budget Office forecasts go (refer to http://www.marketwatch.com/story/cbo-issues-fresh-long-term-debt-warning-2013-09-17).  In such a scenario, I would prefer that, insofar as we cannot escape investing in the world’s largest economy, our national wealth and reserves be held in real assets such as land, property, infrastructure, or even the equity of selected companies, rather than US Treasuries, which are nothing more than glorified I.O.Us that offer no protection against inflation or currency devaluation.

To our credit, Singapore’s holdings of US Treasuries have fallen rapidly this year, from $109.5bn in February to $81.5bn in July, but in my view, further reductions can be made, and everyone (including China and Japan) should follow suit.  The higher interest rates that result from a bond sell-off will have a purgative effect: forcing the US government to be more prudent with spending, creating a renewed efficiency drive across both the public and private sectors, and taking the froth out of the asset bubbles.  A recession may soon follow, under these circumstances, but the alternative – to have interest rates remain as low as they are – simply sets us up for the next great financial crisis, which is a far less attractive proposition, in my opinion.  Uncle Sam has a dangerous addiction, and we need to stage an intervention before he takes the whole family down with him.