Panic About U.S. Debt Might Cause Interest Rates on U.S. Government Bonds to Fall or the People Who Say Such Things Might Just be Confused

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Sunday, 13 October 2013 14:33

When people worry about the security of an asset the price usually plummets, as was the case with mortgage backed securities when the housing bubble burst. It is pretty hard to envision the opposite scenario: that because people get concerned about the security of an asset its price rises.

However this is what Ezra Klein tells us in a column today. The story is that worries over the possibility that the U.S. government is becoming dysfunctional could actually result in the price of U.S. government bonds rising.

"The paradox is that defaulting on our debt could lead to a panic so severe that, in a desperate bid for safety, markets will buy even more of our debt. 'We are the only country in the world where a fiscal mess, rather than increasing spreads, pushes yields lower,' El-Erian said [Mohamed El-Erian, chief executive officer of Pacific Investment Management Co.]. 'If there was another round of debt-ceiling fight with no agreement, we might have lower 10-year Treasury yields, rather than higher.'"

The basis for the idea that uncertainty about the stability of the U.S. government will lead people to buy more U.S. government debt seems to come from the experience in the summer of 2011 when the price of U.S. Treasury bonds soared and interest rates plummeted as we came within days of hitting the debt ceiling.

The problem with this story is that there is a more obvious explanation than people rushing to buy Treasury bonds because they were worried about the instability of the U.S. government. Italy suddenly made the list of euro zone crisis countries that week. While euro zone could have almost certainly withstood a default by Greece, a default by Italy would have almost certainly meant the end of the euro.

The very real risk of the collapse of the euro gives a perfectly plausible explanation for the plunge in world stock markets and U.S. interest rates, even if Boehner and Obama were spending their afternoons having beers together and telling jokes. In other words, the history to date suggests that there is little basis for serious concern about the hostile relationship between the parties imposing a major cost in the form of higher interest rates.

I hate to spoil the efforts at building fear and panic, but this is getting more than a bit overblown. Hitting the debt ceiling would undoubtedly be bad news, but an earth-shaking disaster is pretty unlikely. Everyone will get their money, with interest, even if it is a bit late.

The annoying part of the fear story is the implication that somehow things are okay now. We are throwing $1 trillion of potential GDP in the toilet every year because Congress and the President won't approve enough stimulus to get the economy back to full employment. And millions of lives are being ruined because people can't get jobs and earn enough money to raise their kids properly.

The media want us to get all bent out of shape because we could cross the magic line and then suddenly have to pay a risk premium of 5-20 basis points on government debt for years into the future? Sorry, for those of us who know arithmetic that doesn't come close to the disaster we are already seeing.