Will Tired, Indebted America Go Bankrupt?

America’s stock market is in freefall, its GDP in decline; amidst the instability, the unemployment rate is the only thing on the rise. The $700 billion rescue package passed by Congress in response to the financial turmoil caused by the subprime lending crisis seems like a drop in the bucket. The effects of Obama’s recovery plan remain to be seen, but it is likely to break through the trillion-dollar mark. These days, China has become America’s biggest creditor. America is still not through with borrowing money, going around the world in search of sustenance. Capitalism’s credibility has apparently hit rock bottom, and it seems that America is perhaps already entering bankruptcy!

This is an auspicious moment to criticize the American system. In the eyes of domestic intellectuals, Wall Street’s main line of business of late seems to have been financial trickery. A few have held their tongues on the crisis, as if they have lost the threads of the free-market argument. Some mainstream economists have suddenly lost their voice on the subject of the current U.S. economy. Pessimism has flooded American society. The left wing complains that Bush has already bankrupted the U.S., with the public and private sectors both under a mountain of debt and no money left to borrow; the right wing attacks each and every government intervention as economic heresy that would disrupt spending patterns and bankrupt the nation. It seems that the parties’ differences boil down to the question of whether America is already bankrupt, or is only about to be.

However, both the left and the right are subservient to current events, and both are overlooking a fundamental issue: America’s mountain of debt surely presents a crisis, but its capacity to bear such an amount of debt manifests the system’s state of health. Large-scale government borrowing to increase public expenditure is not necessarily a violation of market economics. On the contrary, this behavior is perhaps determined by the rules of the market economy.

Governments borrow money, just as businesses access credit – it is not necessarily a bad thing, and can indeed be sound and essential economic behavior. When people discuss America’s debts, they usually ignore a key question: what is the cost of the debt? Businesses consider interest rates when judging the right time to take out a loan. Accordingly, we need to take a look at the market for American debt.

As everyone knows, issuing bonds is a crucial means by which governments cover their debts. These bonds have fixed yields and can be freely traded on the market like stocks. To illustrate: you buy a ten-year, $100 bond with an annual yield of 5%. When it matures in ten years, you receive both the interest and the principal. Before the bond matures, you could also sell it on the market for the going rate – a price that could be above or below the bond’s face value, depending on the sentiments of the market. However, yields are inversely correlated with demand; the greater the demand for bonds, the lower the yield. When demand is at its hottest, yields can drop practically to zero; if no one is willing to buy at this rate, then the government has no choice but to increase its competitiveness in the financial markets by raising yields.

Looking back on 2008, America’s housing market collapsed and its stock market crashed, but the value of American bonds rose. There are two reasons for this rise: first, with the economic outlook dim and excessive risk in the stock market, people turn to the security and fixed yields of bonds. Second, the government’s credibility is intact, and the U.S. cannot possibly default on is obligations. If its debts were too high, the government could just raise taxes to pay down its debts. This is simply a flight to safety. In other words, faced with a massive economic crisis, many people would rather place their money in the hands of the government than in those of the private sector. Consequently, a flood of hot money has gone into the bond market, driving prices up and yields down – even 10 year notes have fallen from 4% (as of this summer) to nearly 2%, their lowest value in 50 years, and currently hover below 2.5%. For short-term debt, such as one-year bonds, yields are only slightly above .04%. Some economists are even saying that a bubble has already formed in the bond market!

This situation really gives the American government an extremely strong hand. To use an example: you buy a house with a $500,000, thirty-year mortgage with an interest rate of 7% (if your credit’s good); when you settle up thirty years later, your combined payments come to more than $1.4 million; if your credit risk is higher and you pay a 12% interest rate, your payments total more than $2.1 million. On the other hand, what if the government buys the exact same house, financing the purchase with bonds? Given that thirty-year bonds currently have only a 3% interest rate, the government’s total payments would finally only come to $1 million, not even half the figure for those paying 12%. Take another example: building a bridge. If private firms face interest rates of 7% and up, versus only 2% for the government, then whose spending will be more effective? How can we say, then, that a surge in government investment would go against the laws of the market?

In fact, during recessions, especially as financial turmoil leads to the tightening of the money supply, people lose confidence in the private sector and lose their nerve for the stock market; businesses are unwilling to lend money or expand production. With no one spending money, the economy naturally declines. If the government’s credibility is good, then the public’s idle capital can be invested in government bonds. Although the government may take on a large amount of debt, the financial burden may not be great (thanks to the bonds’ low yields) while the government receives a large buildup of allocable funds. The principles of small government do not necessarily correspond with the laws of the market; on the contrary, the government should fully utilize its ability to spend money in order to stimulate the economy. However, the government must spend responsibly and operate within the restrictions of the financial markets. If its credibility is limited and its spending irresponsible, then the government’s revenues will be overtaken by debt, touching off a bankruptcy crisis. This would lead to panic in the markets, then a crash in bond values, followed by a spike in yields; the cost of debt service would be unbearable.

The performance of a system depends on its moments of crisis as well as its moments of prosperity. In a sense, the value of bonds reflects a government’s political credibility. Today, Wall Street is jittery, but the U.S. federal government continues to stand tall; the bond market is solid, leading the Federal Reserve Bank to cut interest rates, shoring up capital without triggering inflation. Following a massive economic crisis, government bonds are able to maintain their value; this system is deeply embedded in the West, having evolved since the 13th century through a series of market frameworks that are echoed in the constitutional model. In contrast with the economic stagnation of the 1970s, the current crisis is a small storm. In the face of the turmoil on Wall Street, we not only need to learn the lessons of the moment, but also to learn from experience.