Monday, November 4, 2013

Neither side serious in fiscal debate

The following appeared on November 4 in the Knoxville News-Sentinel In financial markets the interest rate on Treasurys is considered the "risk free" rate where "risk free" refers to risk of default and not interest rate risk. This means that the debt obligations of the US government can - like any other financial instrument - change in value as market conditions change. If demand and supply conditions cause the interest rates of the securities to move, then their prices will move in the opposite direction. This is interest rate risk. However, the securities issued by the US government are said to be free from default risk because the government can always pay its debts. It can issue more debt and use the proceeds to pay current obligations or create money to pay off those obligations. In the case of issuing more debt, why would a rational person or institution buy the bonds of a bankrupt institution teetering on default? The answer is that most would not, especially if the likelihood exists for repayment in inflated dollars. However, the government could buy the bonds it issues and use the proceeds to pay off current obligations. That is the Treasury could sell its bonds to Social Security (the largest holder) or to Medicare (9th largest holder) or to the Federal Reserve (the second largest holder). Interestingly enough, in the budget debate there has been no consideration of banning Treasury sales to other federal entities. Yet without doing so there is no fiscal discipline - other than the debt ceiling - to inhibit the government from continuing to spend out of control. In a macro sense, given the size of the budget and tax inflows, the government needs to borrow an additional 25 percent to make ends meet and this difference will continue to grow as entitlements grow. If there is a shortfall, the Treasury can decide who to pay and who not to pay. It could pay all the principal and interest owed on the debt, social security, medicare and the military and then decide to default on other obligations. This is highly unlikely given our political climate. Indeed, when both the republicans and the democrats announced that the 800,000 federal workers who had be furloughed in the latest "shutdown" would receive all back pay and benefits - in essence a paid vacation - I knew that neither side was really serious about addressing the problem. That was confirmed when we got a budget deal reinstating government spending without a cap until January 15, 2014 and allowing the debt ceiling to rise until February 7. Thus, the proverbial can was kicked down the road for the umpteenth time. Maybe this will give the congress and the administration time to come up with a viable solution to address the root causes of the problem but don't hold your breath since the majority of our elected officials simply do not have the will or the discipline to just say no.

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