Passover, Brisket and Bond Market Vigilantes

Passover, Brisket and Bond Market Vigilantes

The Fiscal Times

Amid the chopping of dates, nuts and mint leaves in preparation for Passover, the chatter around Council on Foreign Relations President Richard Haass’ breakfast table last Sunday was decidedly domestic. The topic: whether the lackluster demand for Treasury bonds and spike in interest rates was a mere coincidence with President Obama signing sweeping health care reform legislation.

Or, was it “the canary in the coal mine,” as former Fed Chairman Alan Greenspan put it last week -- a sign that investors, notably the Chinese, were finally tiring of funding America’s spending binge for pitifully low returns? Was this the start of a surge in interest rates that could slow the recovery, or worse yet, send the economy into a debt-driven double dip? 

At the Haass household, food and politics are a common pairing. But, until recently, debates over spending allocations in the Quadrennial Defense Review would have been a more likely topic of debate than the latest turn in the U.S. debt market. No longer. “The deficit is the single biggest issue facing America both at home and abroad,” says Haass. “If we don’t do something soon to turn the arrows in the right direction, a crisis is inevitable. The question is ‘when,’ not ‘if.’” 

Of course, the recent spike in interest rates likely has multiple causes, some welcome, some not. On the positive side, there’s growing confidence among investors that the U.S. economy is recovering along with a renewed appetite for stocks over bonds. On a more worrisome note, some believe the Chinese are paring back their Treasury purchases in part to signal their displeasure with recent U.S. trade restraints on Chinese exports and U.S. arms sales to Taiwan.

It’s also plausible that investors saw the enactment of health care reform as a sign that America was just not politically ready to pay for its seemingly insatiable appetite for new entitlements. “I don’t know anyone who believes that the health care bill will reduce the deficit,” says Haass. “The CBO numbers are based on artificial assumptions and are just not plausible. Unless something is done, I can see the debt rising from 84 percent of GDP now to more than 100 percent in the next few years.”

History suggests that such high debt levels can slow growth dramatically. In a recent study, economist Carmen Reinhart of the University of Maryland and Kenneth Rogoff of Harvard studied the effect of debt-to-GDP ratios on growth in developed and developing countries from 1790 to 2009. Of more than 2000 instances examined in the study, growth averaged a measly 1.7 percent in developed countries where the debt-to-GDP ratio exceeded 90 percent. That was a full percentage point lower than in countries with debt-to-GDP ratios between 60 percent and 90 percent, and two percentage points below countries with ratios below 30 percent. 
Haass isn’t worried about the Chinese dumping U.S. debt abruptly. “It’s in the best interest of the Chinese to act cautiously,” says Haas. “They want political stability, which requires high employment, which means exporting to the U.S. They don’t want to weaken our economy. And we need them to buy our debt. In a sense we are in a mutual hostage relationship.”

Haass’ nightmare scenario is that bond market vigilantes will push market interest rates up dramatically, cutting off the recovery and sending the nation even deeper into debt.  That in turn would make it tougher for the U.S. to maintain its defense and foreign aid budgets, and to invest in its people and infrastructure. “Rising deficits mean we cannot invest in our future,” says Haass. “And we cannot remain a world leader if we cannot invest.”

Haass, who served in senior national security positions in both Bush presidencies, is not alone in his concerns. In a recent appearance before the House Foreign Relations Committee, Secretary of State Clinton called the idea that we don’t really need to pay down the debt “outrageous.” Invoking the costly priorities of her own agency, she urged lawmakers to address the deficit and national debt “as a matter of national security, not only as a matter of economics.”
Others have suggested that the debt threatens to undermine America’s leadership role in the world. Think soft power (the power to persuade) as well as hard power (military might). As Harvard historian Niall Ferguson argued last fall in Newsweek, the U.S. is flirting with the same “fatal arithmetic of imperial decline” that notably characterized the waning years of the Habsburg, Ottoman and British empires. “If the United States doesn't come up soon with a credible plan to restore the federal budget to balance over the next five to 10 years,” he warned, “the danger is very real that a debt crisis could lead to a major weakening of American power.”

But does the U.S. have the political will to bring down the debt? “It’s an open question,” says Haass, noting a worrisome disconnect in the American psyche. “People say they are concerned about the deficit. Yet they are unwilling to accept reduced retiree drug benefits, or a value added tax, or a higher retirement age for Social Security. The attitude is NIMBY – not in my backyard.” 

One thing, at least, is clear: American citizens and their elected representatives must begin making sacrifices to reduce the mountain of debt that now threatens the country’s future. “And that mostly means cutting spending,” says Haass, as the rapid, heavy chopping of dates, nuts, and mint leaves grows still louder in the background. “The world is watching.”