Last Sunday in Long Beach, California, an unusual event took place: it rained for the second weekend in a row. Residents here would affirm that such occurrences are rare.
We’re not complaining, though—without the rain, we might not have discovered the hole in our shoe. This raises the point that the seemingly impossible happens more often than we think.
For example, last August saw something astonishing: as the world braced itself for simultaneous mass inflation and deflation, the market showed gold prices soaring to $1,820 per ounce, while 10-Year Treasury yields dipped to 1.98 percent—an extreme and bewildering price disparity. If we hadn’t witnessed this for ourselves, we would have deemed it impossible. Yet, it occurred.
This stark juxtaposition has highlighted the impact of the Federal Reserve’s monetary policies. When vast amounts of money are borrowed into existence and used to purchase government debt, the immediate effect often sees gold prices rising and bond yields declining. The impending question is: what will follow these manipulations of money?
We may soon discover the answer.
This year, stocks have been climbing almost as quickly as gas prices, with the S&P 500 gaining over 12 percent. In contrast, gold has recently fallen to the mid-$1,600 range.
More worryingly, on March 19th, 10-Year Treasury yields spiked above 2.37 percent. Might this indicate an impending end to the government debt bubble that has inflated for over 30 years?
Valuable Lessons from Japan
The Federal Reserve is clearly committed to preventing such a crisis. They have pledged to keep the federal funds rate near zero until late 2014. However, despite their determination, success is uncertain, especially with signs of economic recovery.
Years of heavy intervention by the Fed have engendered a paradox. They seek low interest rates to stimulate the economy, yet a recovering economy can drive capital away from treasuries, pushing investors to seek higher returns in riskier assets like stocks. A rapid exodus from government debt could trigger a panic among treasury investors, leading to soaring yields and a dampened economic outlook.
Ultimately, an ideal scenario for the economy would be a growth rate between 1 and 2 percent, paired with a stable stock market. Anything less could prompt the Fed to print more money to fend off debt deflation. Conversely, anything more could destabilize the treasury market.
Before the situation spirals out of control in the United States, we may find ourselves looking to Japan for insight.
For context, Japan’s public debt is an astonishing 200 percent of its GDP, double that of the United States. However, unlike the U.S., Japan has financed this debt domestically.
Japan’s ability to sustain its debt without relying on foreign borrowing stems from its positive trade balance. By exporting more than it imports, Japan has historically used its earnings to bridge budget gaps. However, this scenario may be changing.
Japan Will Take the World’s Breath Away
Decades ago, during the New Deal era, U.S. government debt skyrocketed, prompting a reassessment of public debt’s implications. Spearheaded by John Maynard Keynes, economists devised a theory that remarkably downplayed concerns over governmental borrowing.
In a 1958 speech, William F. Buckley Jr. reflected on this shift:
“Illustrating the ironic political ramifications of Lord Keynes’s discovery, a cartoonist from the Washington Times Herald depicted a jubilant FDR on a throne, celebrating as advisors danced around him, chanting the mantra, ‘WE OWE IT TO OURSELVES.’”
With those five words, they sidestepped concerns surrounding deficit spending. Anyone who fretted over increasing national debt, they suggested, simply lacked understanding of modern economics: why worry about government debts if we owe it to ourselves? The spending could continue unabated.
Here at the Economic Prism, we share Buckley’s skepticism regarding Keynes’s perspective. However, that’s a separate issue. The pressing concern is that, unlike the United States, Japan has primarily owed its massive debt to its own citizens. That dynamic may now be shifting.
In 2011, Japan recorded a trade deficit for the first time since 1980. Furthermore, in January, the country faced a staggering $5.4 billion trade deficit, marking its largest monthly deficit ever. If this trend continues, Japan may need to turn to foreign investors to finance its government debt, meaning the nation will cease to owe it exclusively to itself.
With a debt-to-GDP ratio of 200 percent, the question arises: who in their right mind would purchase Japan’s government debt, especially when its 10-year bond yields merely 1 percent?
When the time comes, it’s likely that the Bank of Japan will resort to monetizing the debt. What follows could truly take the world’s breath away.
Sincerely,
MN Gordon
for Economic Prism
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