April 01, 2011


By William Gruver

One of the most dangerous threats to our country gets no respect. And that threat is the bond vigilantes — the omniscient market participants who ruthlessly bring down countries with unsustainable economic strategies.

Our country's economic strategy has been to have a weak dollar to promote exports and get us out of the Great Recession. That has resulted in our national debt increasing almost 50 percent during the last three years to $14 trillion. That's $120,000 for every family in America. The interest cost on that debt for each family is $2,500 a year. We have taken on a burden that amounts to 100 percent of our gross domestic product.

The debt has been that high only one other time in history. In 1945, after World War II and 16 years of the Great Depression, our debt equaled 120 percent of GDP. The debt is now growing at 10 percent a year while the economy is growing at only 2 percent to 3 percent a year. By 2015, we will cross the line and be more indebted than ever in our history.

The bond vigilantes don't like a lot of debt because it brings on inflation. But to determine if a large debt is necessarily bad, you have to ask: Who holds the debt?

Of that $14 trillion that we owe the world, nearly $1 trillion of it is held by China. Several of our top 10 lenders are the oil-producing states of the Middle East. Having your debt held by autocratic, anti-democratic, potentially unstable regimes limits your options in world politics. Another reason that large debt is counter to our national interest is that it erodes discretionary spending by the government. Currently, our debt service is seven times greater than what the federal government spends on education. This is not a winning strategy.

The other danger is if the buyers of our debt decide they don't want to buy anymore. In that scenario, the U.S. would have to lower the price. When you lower the price, you drive up interest rates. If we drive up interest rates, we'll be spending much more than seven times as much as we do on education because we won't have any money left to spend on education.

So, how do we defeat the bond vigilantes? By convincing them that we have a sustainable economic strategy — one that demonstrates that we have learned our lessons from the 2008 financial crisis There were four causes to that crisis, and our current economic strategy adequately addresses none of them: interest rates being kept low despite clear evidence of a financial bubble in real estate, excessive leverage in the private and now public sectors, inadequate regulation and Wall Street compensation being misaligned to the extent that it creates a moral hazard.

The Europeans, having already been attacked by the bond vigilantes in Greece and Ireland, have had changes forced upon them by the vigilantes. They are materially reducing their government deficits, lowering their debt burdens and beginning to pay executive bonuses in the form of contingent convertibles that much better align incentives with compensation for institutions deemed too big to fail.

With all of Europe's problems, the euro should have depreciated against the dollar. But the bond vigilantes have extracted measures from the European Union that gives them confidence that those countries are addressing unsustainable economics. They're going after their large debt levels and forcing governments to impose tighter fiscal policies. As a result, the euro has increased by 15 percent over the dollar in the last nine months.

Furthermore, in times of international crisis, the dollar traditionally strengthens, but during the recent turmoil in the Middle East, the dollar has weakened while the euro has strengthened even further. The bond vigilantes are telling us something through the foreign currency markets. They're giving us one last chance to put forward a better economic strategy than the current weak dollar. And, because of that short-term rollover of our debt, we have to deal with it now, not later.

The template for a new economic strategy has been built. It has been bipartisan in its creation and is a matter of public record. It's called the Simpson Bowles Commission, and its recommendations would address many of the above problems and get the bond vigilantes off our back. But those recommendations haven't been included in any of the budgets that have been put forward. No one wants to take on the third rail of entitlements; no one wants to take on getting our $1.6 trillion annual deficit under control.

Until we do, the biggest threat to America is not the growing strength of China as a super power. And it's not terrorists. It's the bond vigilantes.

Posted April 1, 2011

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