Is There A Government Bond Bubble?

Submitted by Larry Kotlikoff on Wed, 08/25/2010 - 08:43

YES, there is a government bond bubble. And it's huge.

Uncle Sam and his counterparts in the EU and Japan are broke and are, almost surely, going to print vast quantities of money to cover their enormous spending obligations.

The printing presses are already working full time. The Fed, for example, has increased the monetary base by 140% in the last three years. If and when this money gets lent out by the banks (they are now holding much of it in excess reserves) prices of goods and services (the price level) should rise by 140%!

A one-time jump in prices of this magnitude would leave the nominal price of outstanding nominal bonds unchanged, but reduce the real price (the purchasing power of nominal bonds) by 58%.

But what we've seen is the beginning, not the end, of the money creation process, and any increases in the current price level will give rise to expectations of future increases in prices. This will raise long-term interest rates and lower nominal bond prices. And it doesn't take much of an increase in expected future inflation to do a very big number on the prices of long-term bonds.

So current bondholders will get hurt in two ways. The prices of their bonds will fall due to concern about future money creation and the current price level will jump due to past money creation.

Is this for sure?

Nothing's for sure in a very uncertain world in which bond traders and the public are focused on countries' official debts, rather than their fiscal gaps, to gauge the need to print money.

The labeling problem in economics (discussed, informally, in prior blogs and, formally, here and here) renders official debt figures utterly meaningless. But this emperor's new clothes continue to draw lots of attention.

Although I wouldn't touch long-term, US nominal bonds with a 1,000-foot pole, the Fed would scoff at my concerns about inflation. The Fed says it's ready, at the first sign of inflation, to sell huge quantities of bonds into the market to suck out all the money it injected in the last three years. The Fed thinks it can do so without depressing bond prices and raising interest rates. Maybe it can, maybe it can't. But as of last week, the Fed was concerned enough about raising rates to announce it would continue to actively buy bonds (i.e., print even more money).

What the Fed can't avoid, short of Congress' adopting radical structural reforms, is the fiscal train wreak that's coming. Congress cannot forever continue to borrow from Peter to pay Paul, whether explicitly, through the formal sale of bonds, or implicitly, through the expansion of pay-as-you-go transfer programs. At some point foreigners will stop enabling our Ponzi scheme and Uncle Sam will find that he can't "borrow" or "tax" additional resources from younger generations to hand over to older ones because the younger generations will have already handed over everything or almost everything they earn.

Well before this happens, the Fed will come under enormous pressure to lower interest rates, the need for which is the standard handy excuse for making money by making money. As this occurs and inflation takes off, we'll likely see a switch from the dollar to the yuan or to a basket of foreign currencies as the world's reserve currency. All it will take is a couple of big players to signal they've lost faith in the dollar and Uncle Sam's gig will be up and its bonds will be down—way down.

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