July 09, 2012

Frank Newman's Six Myths - #6: If the U.S. does not get its fiscal deficit reduced soon, U.S. Treasuries will face the same problems as bonds of Greece and Ireland

Charles Perrottet
Partner

Today we examine the sixth and final “myth” from Frank Newman’s book Six Myths That Are Holding Back America – the worry that U.S. Treasuries could come to have the same problems of lack of demand due to fear that it will not repay the bonds coupled with escalating interest rates.  As with all the myths, Mr Newman attempts to present the mechanisms that drive international finance.  The policy implications are rich and varied and the subject of legitimate debate.  Scenario planning can and should be used to evaluate alternatives.

U.S. Treasuries are widely regarded as the safest investment available anywhere.  They are actually safer than cash, at least than cash deposited in banks.  Bank accounts are insured by the FDIC only up to $250,000 while Treasuries are guaranteed by the “full faith and credit” of the United States for the full amount, whatever it is.  Other countries that have their own currencies would be in similar positions if the market for their currency was as large as that for dollars.  With much smaller and shallower markets, however, currencies of other countries are subject to much larger interest rate swings.

When a Treasury issue is retired, the cash received by the sellers must stay within the U.S. system and, because of risk, will ultimately end up in new Treasury issues at the end of the chain.  That is not true in Greece.  When it issues a bond denominated in Euros, Greece must raise enough Euros to retire the bond when it comes due.  Whoever sells the bond will receive those Euros but they have many investment options outside of Greece for the cash they receive.  They can, for example, invest it in Germany.  In order to raise new funds, therefore, Greece may have to offer higher interest rates than other Eurozone countries that are perceived to be less risky.  As this cycle feeds on itself it is easy to understand how interest rates for Greek bonds can continue to escalate until they are significantly above the growth rate of their GDP.

In summary, the U.S. is unique because of the size of its market, which is a closed system. The Eurozone includes a number of countries and borrowers and investors can choose where to invest new capital.  There is a frustrating tradeoff for Greece.  By being part of the Eurozone they are participating in a much deeper market than they could with their own currency.  Unfortunately, however, their lenders have no need to continue to invest in Greece – they can shift their investment anywhere in the Eurozone.  The resulting uncertainties have become painfully clear and they provide an omen for other countries throughout the Eurozone as well as Europe’s trading partners. 

Frank Newman presents these “Six Myths” as plainly wrong, and his educated counter-opinion to each as simple fact and logic. But many experts may – and do - disagree with his conclusions, compelling though his presentation of them is in this book. A scenario planning approach allows you to play out competing logics against each other to see what the ramifications of each may be. One may be “Newman World;” another, “George Will World” or “Niall Ferguson World.” You can derive the implications of each of them for your own organization using scenario planning.

Thoughts?