L'Ombre de l'Olivier

The Shadow of the Olive Tree

being the maunderings of an Englishman on the Côte d'Azur

26 February 2009 Blog Home : February 2009 : Permalink

A Dollar For A Default?

Something I've been wondering about recently is who will buy all the government bonds that the US (and UK etc. but this is primarily a US-centric post) governments will have to issue shortly to pay for all the banks they just bailed out. Once upon a time US banks and other investors used to buy them - perhaps they still will but one wonders how much disposable dosh they have available. Until recently there were a couple of major foreign buyers of US bonds - Asian governments and the sovereign wealth funds of oil-rich states. Both bought because - in large part - that was one way to handle the trade surplusses they had with the world and the US in particular.

[Basic economics says that total currency flows have to balance so if you've just sold a wodge of stuff and got a load of US dollars you have to buy something in US dollars of equal amount (or keep it under the mattress I guess). While global trade is not a zero sum game (see Ricardo et al) currency transactions are, hence the fall of currencies no one wants. Hence, if a state wishes to sell stuff to the US at a good local currency price then it helps if it's currency is relatively weak compared to the US$. One way to make sure the US$ remains relatively strong is to stimulate demand for US$ products like treasury bonds].

But there's a tiddly little problem. The current credit crunch and the resulting recession means that the Asian countries aren't exporting much to the US anymore and the collapse of the oil price means the sovereign wealth funds have less money to invest. So umm the US government, if it wants these people to continue to invest in US goverement bonds it needs to make them more attractive.

Typically thise means increasing the interest rate. But here is where the train starts to derail. The US government (and everyone else) wants low interest rates because high interest rates will be the final nail in the housing market and also kill all those businesses that run an overdraft (which is practically all businesses). So since the government really really wants people to contine to lend to US businesses and would be home owners it has to keep US bonds low because no sane investor is going to lend to a business or individual at a lower rate than it lends to the government (and insane investors with lots of money to invest are thin on the ground).

This is a bit of a bugger. The US government needs lots of people to buy its bonds so that it can stimulate the economy and rescue banks and so on. But it also needs people to continue lending to the rest of America and there's a lot less money floating around looking for a home. And this money is simply looking for the best return at the lowest risk. So if US treasury bonds (risk == 0) are at a higher rate than riskier loans to US homeowners or businesses then no one is going to lend any money to the latter.

Which makes the whole recession thing worse.

The only way I see to square this circle is for the perceived risk of US treasury bonds to be higher than that of deadbeat mortgage borrowers and businesses. And so I'm very very glad to see this Samizdata article warning that under some circumstances the US citizenry might decide to let their government repudiate a chunk of its debt.

Of course if the US government does in fact default on some or all of its debt then we'll be seeing a bunch of painful consequences elsewhere (including the collapse of the US$) so I'm not sure how realistic this sort of warnign is. But if it is sufficiently credible to keep people actually buying US treasury debt its probably worth it,