The Final Bubble

The Final Bubble

In our era we had the stock market crash of 1987, the Dot com bubble in the 90’s, the Real Estate bubble and the stock market bubble of 2007. Now we are facing the final, and perhaps the most traumatic bubble, the mother of all financial bubbles…..the bubble in the U.S. treasury market.
Where the Dot com bubble and the stock market bubbles effected stock investors, and the Real Estate bubble effected the middle and upper class the final bubble, the U.S. treasury bubble will be the one that engulfs our economy and society, leaving vast devastation in its wake.

That might sound like a wild claim, but it is important to think through all the ramifications of this and the ripple effects on our economy, our society and the world at large.

Right now, as of June, 2010 the U.S. government owes 14 Trillion dollars in U.S. Treasury securities. This is the "published" national debt. But in addition ther are "off the books" debts. The U.S. government is liable for a large quantity of Fannie Mae, Freddie Mac and Ginnie Mae securities plus the liability for the future expenses of social security, medicare and medicaid. In addition the Federal government has an estimated 2 Trillion dollars of liablities in the coverage of bank failures under FDIC insurance. The grand total of the actual federal debt, including all of these “off the books” liabilities are estimated to be around $61 Trillion dollars.

Due to the economic downturn that was started by the Real Estate crash and the financial meltdown that took place in 2008 the Federal Reserve entered the financial market, at that time, in an extreme way in an attempt to rescue the economy. On the Federal Reserve balance sheet they now own $5.259 trillion dollars worth of U.S. Treasury Bonds and Bills. Just for perspective just prior to the crash the Federal Reserve owned less than one Trillion dollars worth of Bonds and Bills. Right now the Federal Reserve is the single largest holder of U.S. debt, with private investor, brokerage houses, investment banks coming in second $1.193 trillion, China coming in third (900 billion). Japan is fourth with 795 billion, mutual funds hold $663 billion, state and local government $531 billion, U.S. pension funds $513 billion, the United Kingdom $321 billion.
The U.S. government is in a unique position in that it can create money out of thin air. The Federal Reserve did not have to raise taxes to come up with the four Trillion dollars in new U.S. debt purchases it made recently. Instead it just gave the U.S. treasury a credit in their account and literally the money was created…..out of thin air. This flood of new U.S. dollars into the economy during any other time in the past 40 years would have created an instant massive boost to inflation…..but because the economy is so depressed the effect, for now has been muted.

In response to the fear and mounting losses in the U.S. stock market and the U.S. real estate market private investors, retirees, hedge funds, mutual funds, and pension funds have all frantically entered the U.S. treasury market. Since the stock market crash of 2008 close to 480 billion dollars has fled the stock market and the same amount of money has entered the U.S. treasury market with the idea that their money would be safe.

What many private citizens don’t seem to realize is that the bond market can be subject to the same turmoil that has roiled the stock and real estate markets. While the federal government can print or create new dollars, that expansion of the money supply, will, over time create intense inflationary pressures. In times of crisis the Federal Reserve can print or create new dollars to solve the immediate problem of liquidity, the problem comes when the crisis passes. As the economy recovers those new dollars will, if not withdrawn from the market devalue the value of money itself, or in other words create inflation.

Even if some miracle could occur and through magic the Federal Reserve could keep inflation under control the bottom line is that the rapidly expanding federal debt creates a problem in itself, the mounting cost of the interest on the debt.

Right now the Federal government is financing most of its borrowing needs by selling short term U.S. treasury bills, with terms ranging from one month to two years. At present, the interest rate on these short term loans is low, however if interest rates should rise then when these short term loans are refinanced the new interest rate could be considerably higher.

At the current spending and borrowing rate of the federal government we are adding at least one trillion dollars worth of new debt each year far into the forseeable future. If interest rates should rise that amount of new indebtedness would rise as well, since we are, in effect using the Visa card to pay minimum payments on the American Express.

In the news over the past week the Federal Reserve has begun putting out feelers on ways to try to recapture some of the vast quantity of new dollars it has created, in order to reduce any future inflation in the economy. If the Federal Reserve withdrawals liquidity too soon from the money supply or too rapidly the economy could go into another nose dive. If the Fed waits too long inflation could begin to rapidly accelerate.

Since the gimmicks we are currently using to manipulate the economy are very similar to the gimmicks used by South American countries in the 1970’s to stimulate their economy, and continue to win elections, it might be useful to look at their experience.

The initial reaction of their economies to massive borrowing and a flood of new currency was initially positive. The Latin American economies experienced a surge of economic activity. Business started or expanded, new employees were hired and the surge of new currency created waves of spending and investing. However these artificial stimulations to the economy wore off quickly and inflation quickly began to appear. In Latin America those counties borrowed even more heavily, printed money more rapidly and continued spending quite freely. In response the inflation rate continued to accelerate until it hit inflation rates of over 20%, then 30% then 50% then 100%. Governments continued to print money, float bonds and spend. To do otherwise would have provoked a coup or even a revolution. Inflation rates exploded in some countries reaching over 1,000% a year. Governments defaulted on their loans. International banks refused to continue lending to South and Central American governments. Liquidity dried up and the economies of those countries collapsed.

In reading this you might think, “This can’t happen here”, but it can. Right now the U.S. government has relatively good credit, but our spending habits, funded by high amount of borrowing using short terms Treasury Bills cannot continue for much longer. The U.S. government may be powerful, but the financial markets are bigger and more powerful. Retirees and pension funds that are lending money to the federal government for less then ½ of 1 percent are barely getting any compensation for what could turn out to be a very risky investment. Many are invested in bond mutual funds. With a bond mutual fund there is no expiration date on the bonds. If the bonds decline in value the bond fund declines in value. In a bond fund you cannot hold the bonds to maturity.
Many company retirement programs offer two choices: a stock fund or a long term bond fund. Right now both are lottery tickets, which may or may not pay out.

The Federal Reserve has made it very clear over the last week that interest rates must eventually go higher and the flood of new dollars that it created must be brought back under control, whether that is next week or next year is uncertain, but rates must increase.

The sad part is that those retirees, pension funds and private investors who fled the risky real estate market and dangerous stock market may have accidently stumbled into a market that is equally dangerous.