- The Washington Times - Thursday, February 11, 2010


This year marks the beginning of the second year of the Federal Reserve’s zero-interest-rate policy, and there is growing concern that the consequences could be dire. “Excessive global dollar liquidity” sounds arcane until a new area of asset inflation blows up. The time to curtail that possibility is now.

There are signs of a new real estate bubble in Canada, our neighbor and key trading partner. Overseas, even China, another key trading partner that has weathered recent economic storms better than any large nation, is worried. Just two months ago and then again recently at Davos, the Chinese government have accused the U.S. Federal Reserve of fueling “a huge carry trade” that was having a “massive impact on global asset prices.” Remember that it was a low-interest-rate-backed bubble that got us into trouble in the first place.

Over at Treasury, Neil M. Barofsky, inspector general for the Troubled Asset Relief Program (TARP), reports that many of the problems that led to the financial crisis have gone uncorrected and some have grown worse. Moral hazard, the temptation to take business and investment risks with a downside that hits taxpayers, has risen with the government’s increased role in banking and the housing markets. Fannie Mae and Freddie Mac not only remain wards of the state, but now have unlimited access to government largesse - courtesy of the Christmas Eve congressional vote. Meanwhile, the Federal Housing Administration has seen enormous growth as the preferred government-backed venue for subprime lending, a development that soon may require one more taxpayer bailout.

The nascent recovery now under way would surely be cut short by a recurrence of another credit-and-insolvency crisis similar to what led to the economic meltdown of 2008 and early 2009. That the Fed’s current zero-interest-rate policy has exceeded the 12 months of 1 percent interest rates in 2003 and 2004, which contributed to that asset inflation and collapse - from which we are still recovering - suggests a possibility of some kind of replay.

The Fed’s record of heading off inflation and asset bubbles while also supporting economic and employment stability by timely manipulation of the money supply is not particularly good. But even if the Fed can avoid a double-dip recession through deft monetary policy moves, sound fiscal policies are needed to strengthen the economy’s foundation, providing confidence and incentives for private-sector expansion and job creation.

The Congressional Budget Office predicts that ongoing annual budget deficits will drive the federal debt to almost $19 trillion by 2015 - a near doubling from 2008, when government debt broke through $10 trillion because of the TARP rescue. Such debt growth, if inflationary, erodes domestic savings and weakens the viability of the dollar as the global reserve currency. More serious risks also would emerge. A sudden increase in borrowing costs on a rapidly growing debt burden could trigger a crisis in confidence, sharp dollar devaluation and even a stealth default on our long-term U.S. Treasury bonds. A shocking thought for sure, but given the recent panic over deficits in Greece, which precipitated a doubling in sovereign debt rates by 60 percent in a matter of months, it is not out of the question.

U.S. Treasury management has overemphasized the issuance of short-term over long-term debt. Presently, 2.5 times more Treasury bills are issued than 10- and 30-year Treasury bonds. In the current Fed-engineered zero-interest-rate environment, the annual interest cost of T-bill debt averages about one quarter of 1 percent, while 30-year Treasury bonds cost about 4.55 percent annually. The average interest rate of all outstanding U.S. Treasury debt was about 2.55 percent at the end of 2009, as compared to nearly 5 percent during much of 2007 and 6.5 percent at the end of the previous business cycle 10 years ago. The Fed eventually will normalize interest rates, which easily can take the government’s borrowing cost up twofold. A crisis in confidence could abruptly lead to much higher borrowing costs. The trigger for the sovereign debt crisis that drove up borrowing costs in Greece by more than 100 percent in the past three months was tied in large part to its government deficit exceeding 12 percent of gross domestic product. The expected $1.6 trillion Obama budget deficit for this year is approximately 11 percent of projected U.S. GDP. Unlike Greece, there is no one to bail out the United States.

When the $1.6 trillion budget deficit is added to the $2 trillion of U.S. debt scheduled to roll over this year, the U.S. Treasury faces the need to place more than $3.5 trillion in debt in 2010, a record amount equal to nearly 25 percent of GDP. Where will the money come from at a time when our three largest creditors - China, Japan and Great Britain - have no capacity or willingness to increase their holdings in U.S. Treasury debt? Our largest creditor - China - has flat-out said no to increasing U.S. dollar holdings. The Federal Reserve may have little choice but to monetize hundreds of billions of dollars of debt, which will raise fear of inflation and cause investors to demand higher offsetting interest rates.

The same dynamics of sudden payment increases that forced foreclosure on nearly half a million American homes, financed through adjustable mortgages with low teaser rates, may hit the U.S. government debt market before long. Staying on the present course of increasing our national debt and risking the rapid rise in the cost of financing that debt is the perfect storm that could precipitate a spiraling debt and devaluation crisis.

It’s a cliche to say we need change and a new kind of leadership in Washington. But with the ship of state so clearly heading in the direction of dark and threatening clouds, all hands are needed on deck to shorten the sails and change course. The Tea Party movement was born just a year ago out of concern about fiscal irresponsibility of both parties and the simple recognition that we cannot borrow, tax and spend our way to prosperity. That message led to the Tea Party’s first electoral victory in Massachusetts. Now its compass is set on November.

Scott S. Powell is managing director of AlphaQuest LLC, an alternative investment consulting firm, and a visiting fellow at Stanford University’s Hoover Institution.

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