Andy Xie: Fed would fool both bond vigilantes and liquidity junkies

Taming the Beast

By Andy Xie, China International Business magazine, Beijing

A tide of fear is sweeping financial markets: fear of inflation. Oil prices have doubled over the past three months, the US Treasury yield has surged by a third in one month, gold is nearing its record high again, and agricultural commodities are all soaring. The rising prices are taking place amid weak demand. Inflation fears are driving the surge.

The market is getting it right this time. The US is targeting a 5-percent-plus inflation rate for the foreseeable future. It’s the only way to speed up relief for indebted American households. Inflation works well when debts are locked into long-term fixed rates and don’t need new financing. The recent wave of mortgage refinancing, for example, has put many American households in an excellent position to benefit from inflation. If inflation surges, American household income will rise with it but the debt will remain locked into the previous low rates. Of course the people who lent to American households will be robbed.

However, the US government isn’t quite ready for high inflation. It has $11.4 trillion in outstanding debt, and this is growing by over $6 billion per day. The average maturity of the federal debt is only four years and, hence, a quarter needs refinancing every year. With $2 trillion net financing for 2009, the federal government needs to raise about $10 billion per day. If Treasury yields continue to surge, the expected interest burden for the federal government may spiral out of control. At some point the market may stop lending to the US government if it expects it to go bankrupt.

The government bond market is usually a Ponzi scheme. Governments rarely run budget surpluses to pay off old debts. They almost always borrow new money to pay off the old and spend the difference. A check of modern history shows that most countries have experienced a government debt crisis. These were related to defaulting government debts accumulated over decades. Government bonds are usually viewed as safe as they rarely default. But this is the case only as long as investors are willing to lend. When the bonds do default, they do so on all the debt they have borrowed. The safety of government debt is a self-fulfilling market expectation. Hence, when interest rates are high and government financing need is great, the expectation bubble can burst.

When the market stops giving money to the federal government, the Fed can step in and print it, to monetise national debt. However, this will almost certainly lead to a dollar crash and hyperinflation. Russia wiped away national debt in 1998 only for investors to shun the country afterwards, with Russia remaining poor for many years. Only surging oil prices have brought prosperity back. Is the US ready to “do a Russia”? I think not. America still has enough credibility to charter a more profitable path that would impoverish its creditors slowly.

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