The current state of the U.S. economy is described by an anemic growth and a huge debt that is increasing in a fast rate. This situation has led economists and policy makers to debate on the necessity of taking austerity measures, especially in light of countries like Germany and U.K. who proactively and willfully have taken tough austerity measures.
But do we really have two hot potatoes in our hands? My short answer is no. We definitely have one, the anemic economic growth, and, at least until now, we do not really have a U.S. debt problem, if the U.S. debt holders would require higher interest rates or if the CDSs on U.S. debt would start to get dangerously high. However, the last months we have seen the exact opposite. If nothing else, the last debt crisis in the eurozone has helped the U.S. by bringing the long term yields down to extremely low levels. Let me remind you that a few months ago long term yields touched, and even exceeded, the psychological threshold of 4%. At the time, everybody was nervous about it and people started circulating stories about the unattractiveness of the U.S. debt.
The flight to quality (quality meant in relative sense) that started with the resurgence of the eurozone debt fears reversed that trend and since then the long term interest rates have been constantly declining. Today the 10-year yield is a stunning 2.89%. Really, how bad can the outlook out there be so that there are people willing to get a 2.89% for the next 10 years?
At the same time the supposingly inflation protected assets, like gold, silver and other commodities, have not increased in value during this last period. Gold reached a new high at almost $1257.2 per pound and since then it has declined to 1191.6 today. This tells us that the markets do not fear inflation as much, which would be the case if they anticipated that the U.S. would not be able to tackle its debt and resort to printing money.[1] In addition the yield on TIPS is 1.29% for a 10-year security and 1.95% for a 30-year security. If anything else, the markets are telling us that there are big problems out there, but the U.S. pilling debt is not one of them. At least not for now.
Three Schools of Action
And the question is: should we wait until it really becomes a problem? Should we wait until the bond vigilantes take notice of the bad debt outlook of the U.S. and start requiring higher rates? There are three schools of thought about it.
The first wants everybody who even silently thinks on the issue to stop thinking! This is the most extreme view and the loudest of the three schools out there. There are people who get annoyed by even thinking or talking about it, which is incomprehensible to me.
Some of the people in the first group argue that we have time in the following grounds. For the U.S. to start having problems investors have to dislike the U.S. debt and to also like other securities, like other countries’ debt, stocks, commodities, cash and TIPS. Since this is not on the horizon right now we can wait.
This approach is risky. It basically relies on optimally timing the behavior of the investors, something that it is not very easy to do. Also, it requires we know and monitor the return behavior and flows to all the assets that could be substitutes to U.S. bonds.
The second line of thought is consisted of people who stand on the other extreme, demanding measures on fighting the mounting debt. According to my understanding, they are not so many or forceful about their views.
And the third school is consisted of people who want to start thinking and discussing the policies that eventually we will need to take at some point, sooner or later. These people encourage a healthy dialogue that will get us prepared and ready to face the Armageddon that is coming. There is a consensus among the people in this school that the mounting debt is an issue that we cannot ignore. On the contrary, it is an issue we need to start addressing right now.
The last group advocates that deciding on and laying out the policies that we will have to take when time comes, has many benefits. By having the policy makers committing on a set of policies to fight debt, will (a) alleviate the fears of bond vigilantes, therefore interest rates will not skyrocket, (b) calm the central bankers that the government will not go on with an inflationary policy, and (c) will alleviate the concerns of the public sector and hopefully they will not hold on on consumption and investment more than it is necessary based on the plan to fight debt. The performance of the economy is based on expectations. Therefore, laying out the plan, showing sternness and sturdiness in solving the problem, is as important as actually fighting it.
My view is closer to the one described by the third group. It is more prudent to, at least, start thinking about the problem, even though we may not have a problem right here right now. Since the problem is lurking, growing at a fast pace, and since we do not know how far from today the problem is going to arise, therefore how much time we have, it is sounder to decide on the policies and actions to be taken when time comes. The benefits from doing it are great, the risks from not doing it are even greater and there is no reason not to decide on policies now.
[1] I do not include the strengthening of the dollar during this period in my calculations which could explain some of the decline in the price of gold in dollars.
