Do We Have Another Financial Bubble On Our Hands? Or Three?

Multiple debt markets are facing big trouble because of excessive borrowing and the Fed’s easy-money policies.

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More than two years ago, economists started talking about a bubble in Treasury bonds that would eventually burst, just as the dot.com bubble and the housing bubble had. If that happens, the prices of long-term bonds could fall by 10% to 20%. So far, that bond bust hasn’t materialized. But one of the characteristics of bubbles is that they often go on longer than anyone expects. What is most troubling now is that the problem is spreading beyond Treasuries. Excessive borrowing and ultra-low interest rates are now distorting all the debt markets. As a result, there is no longer just one bubble – there are many.

The details vary, but debt bubbles have two things in common. First, there is a big increase in borrowing often promoted by government policies and sometimes accompanied by a decline in lending standards. Second, there is a huge increase in the amount of money available that keeps interest rates low. Sometimes the cash comes from the government and sometimes it is provided by the banking sector, as it was during the housing bubble. The current debt market bubbles are largely the result of Federal Reserve Chairman Ben Bernanke’s decision to pump huge amounts of money into the banking system.

Because of the recession, interest rates would probably have fallen somewhat anyway. And because bond prices normally move in the opposite direction from rates, prices would have risen. But the Fed’s policies over the past couple of years have depressed interest rates and pushed up bond prices far more than normal. Only trouble is, the Fed can’t keep this up forever. Rapid money growth can be absorbed if the economy is slack. But once a recovery picks up speed, consumers start spending more exuberantly and businesses become more willing to invest. Excess cash then begins to encourage inflation unless the Fed turns around and drains money from the banking system. Interest rates are likely to rise either way, whether the Fed allows inflation or restrains money growth.

(MORE: Why the Fiscal Cliff May Cost You $6,000 in 2013)

Higher interest rates cause the value of existing debt to fall and also make it harder for borrowers to get new loans. In other ways, though, the major debt bubbles are likely to play out somewhat differently. Here’s a look at the three most important:

Treasury bonds. Because the deficit has more than doubled over the past four years, the Federal Government has been forced to borrow more and more money by selling Treasuries. Ordinarily, the government would have to pay higher interest rates to convince investors to keep lending it money. But instead, yields on long-term Treasuries have fallen to 50-year lows, and the prices of those bonds have run up by about 30% in just the past two years. A large part of the reason is the Fed’s easy money policy, known officially as quantitative easing. Basically, the Fed is authorized to create money, essentially out of nothing, and then use it to buy bonds sold by the Treasury (thereby lending money to the government). Buying all these bonds drives up their prices, and that reduces the bonds’ yields. If the Fed stops buying Treasury bonds in such massive amounts – stops artificially holding down interest rates, in other words – yields would likely jump up and the prices of Treasury bonds could plummet like Wile E. Coyote running off a cliff.

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Municipal bonds. Many State and local governments are borrowing a lot, too. But their bonds carry an additional risk that Treasuries don’t. The Federal Government can use the Fed to create enough dollars to meet any obligation. But lower levels of government are not able to create money and so it is possible for them to be forced to default on loans if they borrow too much. Some states manage their debt better than others: Texas has a stellar credit rating, for example, while several cities in California have gone bankrupt. The muni borrowers with the biggest problems tend to suffer from runaway public-sector spending, especially on pensions and other benefits. And even if they go bankrupt, they may not have the legal right to cut those benefits. For munis, therefore, the risks include not only a price drop caused by an upturn in interest rates, but also the danger of default. Bond prices could also be hurt if credit-rating agencies warn that an issuer’s finances are getting worse.

Student loans. The cost of a university education has risen 60% or more over the past decade, and the average college senior now graduates with debt of $27,000 – and as much as $55,000 at the most expensive private colleges. Graduate or professional school can push that sum into six figures. The share of young people going to college has nearly doubled, and government policies have boosted the funding available. The result: Total student loans outstanding are around $1 trillion and, more ominously, the delinquency rate is up to 11%. This bubble won’t burst, exactly, because student loans are much harder to escape than credit card debt, say, even in bankruptcy. So there will probably have to be a long painful deflation of the bubble. Moreover, experts have been warning that the burden of making payments on these big loans is forcing many young people to delay buying homes and cars – or taking entrepreneurial risks – and thereby acting as a serious drag on the economy.

(MORE: Will Japan’s New Minister Start a Debt Crisis?)

To gauge the likely impact of these three debt bubbles, one has only to look at what happened in the aftermath of the housing boom. When the market went bust, the value of mortgage loans fell, as did the value of the assets they were used to finance, namely houses. Afterwards, the amount of available funding was reduced and lending standards were tightened, locking many potential borrowers out of the market. In the case of today’s debt market bubbles, the same risks exist if there’s a bust – higher borrowing costs, more demanding lenders, and intense pressure for cost cutting.

Some economists argue that it’s a mistake to worry about debt while the economy is still weak and jobs should be a greater concern. But initial steps need to be taken to bring these bubbles under control now, before the recovery accelerates and demand for funds creates tighter debt markets. A deal on the fiscal cliff would be only a down payment.

5 comments
OzarkGranny
OzarkGranny

By keeping interest rates at such a low level, and with real estate values in sharp decline and now stagnating, the only choice has been to put money in stocks, hence the stock market's strong rebound from 2008.  If interest rates go up, people will have less reason to invest in stocks. 

bryanfred1
bryanfred1

What goes unmentioned is that the Fed holding long-term Treasuries below real interest rates with its purchasing programs is artificially supporting housing prices.  With mortgages generally priced at a spread over the 10-year, lower rates mean lower payments means higher prices.  I'm concerned once rates start to rise - and they inevitably will - housing prices will start to slide again.  Not to mention that the Fed had never shown a deft hand at proactive containment.

rjsigmund
rjsigmund

interest rates on treasuries have been falling for 40 years...they're now back in the range they were at during the 40s thru the 60s...it was the 70s that was the bubble..

MarkPashCfp
MarkPashCfp like.author.displayName 1 Like

First,  the U.S. is a monetary sovereign nation.  It can create its own money without creating debt.  See Article 1, Section 8, Clause 5 in the Constitution.  Just because Congress in 1913 licensed the creation of money through debt does not mean they can not take it back.  The fiscal cliff-tax&spend debate was not the cause of the severe down turn.  Therefore, it is not the solution.  They are not even debating the solution of improving our monetary system.  See www.monetary.org and www.cpe.us.com in the Monetary Reform Section on the right of the home page.

The current money creation is basically not going into the economy.  It is sitting as reserves in Central and Commercial Banks along with insurance companies and sovereign funds.  How is the current commercial banking system going to but money in the economy when its borrowing is limited to only several items?  Also people don't want to borrow because the economy is to scary! Then add government restrictions to borrowing.  In fact, trillions of dollars of loans were paid off since 2008, reducing the supply of money in circulation.  When money flows we grow and when it stops we flop !

Student loans are a lengthy, complete other discussion which I won't take on here.

Center for Progressive Economics

LiberatedCitizen
LiberatedCitizen

@MarkPashCfp 

Congress could but it won't because then they would have to balance the budget

Once you understand the details of modern central banking, you are able to step back and see that it truly is a way for the government to use the printing press to pay its bills. FULL ARTICLE by Robert Murphy

http://mises.org/daily/4029

Sounds like Cronies scratching one another's backs to me the Fed monetizes our debt and in turn they keep recapitalizing their member banks at taxpayer expense. Since 2008 they have been paying interest on those excess reserves costing taxpayers billions.

How Bernanke Can Get Banks Lending Again

If the Fed reduces the reward for holding excess reserves, banks will have to find something else to do with their money, like making loans or putting it in the capital markets.

snip

The Fed sees this as a radical change. But remember that it paid no interest on reserves before the 2008 crisis and, not surprisingly, banks held practically no excess reserves then. In early October of that year, Congress gave the Fed authority to pay interest on reserves, which it promptly started doing. When the Fed trimmed the federal funds rate to its current 0-25 basis-point range in December 2008, it also lowered the interest rate on reserves to 25 basis points, where it has been ever since

But suppose it doesn't work. Suppose the Fed cuts the IOER from 25 basis points to minus 25 basis points, and banks don't lend one penny more. In that case, the Fed stops paying banks almost $4 billion a year in interest and, instead, starts collecting roughly equal fees from banks. That would be almost an $8 billion swing from banks to taxpayers. There are worse things.

Mr. Blinder, a professor of economics and public affairs at Princeton University, is a former vice chairman of the Federal Reserve.

http://online.wsj.com/article/SB10000872396390444873204577537212738938798.html