It seems that most people do not understand how our government funds its budget deficits. Since we don’t have enough revenue (taxes) to pay for all of our expenses (Social Security, defense, Medicare, etc.), the government must borrow the extra money by selling bonds to investors. Investors buy U.S. Treasury Bonds from our government with yields of around 4% (for 10 year bonds) and our Government gets the money it needs to fund its deficits.
The government sells these bonds at auction. Investors bid for the bonds – and the government chooses the winning bidders. In recent months, we’ve seen yields drop and prices rise as more and more investors buy Treasury Bonds because they are considered some of the most risk free investments on the planet – since they are backed by the U.S. Government. Investors include individuals, institutions and foreign governments – to name a few.
With the economic problems in the U.S. – there is a growing fear that our government will someday hold a Treasury auction – and there will not be enough buyers. If you were a foreign nation (or any investor) and took a hard look at the finances of the U.S. – and could see that we are insolvent and that our economy is heading south – you can see that this is an entirely plausible scenario. The fear is that the Government will eventually go bankrupt – and unable to pay its debts. This would obviously cause us all kinds of unpleasant problems – including skyrocketing interest rates as the Government offers higher and higher yields to get the money it needs.
The dialog below is taken from a forum on Chris Martenson’s website. Chris explains what we could expect if an auction did fail.
I have a suspicion that Chris is right when he says it’s possible the Federal Reserve is the ‘buyer of last resort’ for recent auctions. This means that auctions are already failing – but the Fed is disguising this problem by buying the Treasury Bonds themselves. As Chris mentions below – this is a serious problem. Why? Because the Fed doesn’t have existing money to buy with – they create money. They would be printing money and giving it directly to the U.S. (this would be a similar process to the U.S. needing hard currency – but on a much bigger scale) – which could eventually lead to the destruction of our currency (see Zimbabwe: inflation hit 11.2 million percent in August 2008). Let me put this in perspective – a loaf of bread cost over one trillion Zimbabwe dollars in August. Anyway – you get the picture – runaway interest rates, runaway inflation – very bad things happening.
The following graph shows the assets of the Federal Reserve. The blue line is labeled ‘other assets’ – this is the asset category Chris references below. We don’t know what ‘other assets’ refers to – yet.
jg – Nov 12, 2008
Recent Forum postings:
Chris, I assume you still agree that there is still a risk of what amounts to an “auction failure” of US govt. bonds? If so, I’m wondering if you could sort of help us play it out in our minds:
Is this a possibility you put on the near-middle-long term horizon?
What would be the warning signs?
What would it look like?
What would be the consequences and how quickly/slowly would we see it play out?
Thank you so much!
My Response (Chris Martenson):
This is exactly in line with the piece I am writing for the next Martenson Report.
Sooner or later (and I am starting to think ‘sooner’ at the rate things are hustling along) that there will be an auction failure.
The warning signs are simple enough.
The “Bid to Cover” ratio slides down in danger territory (below 2:1). This ratio measures the amount of bids that are received at auction for whatever bolus of Treasuries are being offered at that auction. At 1:1 there are exactly as many bids as there are bonds being sold, but trouble starts well before then. Remember, this is an auction where bids are placed on the bonds. So let’s imagine the Treasury is offering a bunch of 10 year notes at 4%. Some eager participants might bid 3.95% (over asking price) while others may bid 4.25% (below asking price). The government will, naturally, select the best possible bids and chuck the rest. By the time we get to 1:1 on the offers it is a near certainty that the bids are going to be at worse prices than hoped. So the first warning sign is a falling bid-to-cover ratio.
Along with this, everybody is keeping a careful eye on the spread between the offered rate and the actual rate. A slipping yield means the government is not getting its desired price for the offered debt and is a sign of either reduced demand (as also reflected by a falling bid-to-cover ratio) or reduced availability of money for the amount of debt being offered (falling supply of money). So the second warning sign would be auction yields slipping higher and higher.
The final part of this act is an actual failed auction where the bid-to-cover ratio falls below 1. That is, fewer bids are received in total than there were bonds offered. An example would be $800 million in bids received for $1 billion in bonds offered. That is a failed auction.
At that moment all hell breaks loose. The government cannot afford a failed auction because it needs the money. So it will simply offer the bonds again at a higher, more attractive yield and will keep raising the yields until it attracts enough bids. The impact of an auction failure will be rapidly rising interest rates.
But once that dynamic starts the incentive is there for market participants to “wait and see” if even more attractive yields are in the offing which can start a spiral of higher and higher rates.
This is why I am so anxious to find out what is on the Federal Reserve balance sheet. I want to put to rest my uncomfortable suspicion that they’ve already been the “buyer of last resort” at the past few Treasury auctions.
Once a central bank begins making up for funding shortfalls by printing money directly in exchange for government bonds then you are well on the way to destroying the value of the resident currency. Think Zimbabwe and you get the idea.
Given the fact that the Fed is refusing to let anybody see exactly how and where it applied that $1.2 trillion over the past 6 weeks, and given the fact that the US government is on track to issue more new debt this quarter than all last year COMBINED, and given the fact that banks are apparently out of capital, I am wondering how it is possible that each auction has managed to go off without a hitch.
Fueling this concern of mine is that fact that the Treasury International Capital (TIC) flows have shown a steady erosion of foreign money from our shores over the past 2 months reported (July and August, so we are anxiously awaiting the September data).
IN summary, no money from overseas, impaired capital on our own shores, record government debt issuances and a Fed that is suddenly quite shy about revealing its recent purchases.
As I said, it makes me very suspicious that the Fed is directly buying those securities themselves. If true, this is explosive news and could serve to severely undermine faith in the Federal Reserve Note, a.k.a. “the dollar”, and so I completely understand why that information would be hidden if it existed.
If I were doing this (meaning I was the Fed), I would want to hide my tracks to every extent possible. One way to do that would be to crush commodities as hard as possible and work with my foreign CB friends to assure the dollar looked strong. This would serve to help convince market participants that direct monetization of government debt was not being done because, if it were, the exact opposite would happen.