The Debatable Quality of US Treasury Bonds

By Eric Fry

07/12/11 Laguna Beach, California – The European financial markets are unraveling faster than a Donald Trump presidential campaign. Most of the stock markets in the Old World tumbled 2% to 3% yesterday, as bond yields soared. The 151-point selloff of Dow Jones Industrial Average seemed like nothing by comparison.

The euro fell to its lowest level since May, the Italian stock market fell to its lowest level since 2009 and Spanish bond yields jumped to their highest level since 1997. This small sampling of distress in the European financial markets would suggest that a credit crisis is beginning, not ending.

Greek two-year yields soared to 31% yesterday, but that ridiculous number hardly seems newsworthy. Greece is broke and everyone knows it…except the EU and the IMF. Greek bond yields might as well be one billion percent. Does anyone really expect to receive interest payments for the life of the bond?

The new news is not Greece; it is that the Greek crisis is now a genuine European crisis. Throughout the PIIGS nations of Portugal, Italy, Ireland, Greece and Spain, bond yields have spiked sharply since July 5. On that fateful day, the Greek parliament voted to accept the austerity measures imposed by the E.U. and the IMF, thereby opening the door to the bailout funds that were supposed to make everything all better. On that same day, however, Moody’s downgraded the Portuguese government debt to “junk.”

One week later, the financial markets seem to have decided that the cold, hard facts inspiring the Portuguese downgrade are of greater significance than the smoke, mirrors and empty promises that underpin the “Greek rescue.”

The situation in Europe is becoming so frightening that, ironically, investors are dumping the debt securities of Europe’s most indebted nations in order to buy the debt securities of the world’s most indebted nation.

While Spanish and Italian bond yields are spiking to multi-year highs, US bond yields are falling (i.e. bond prices are rising). This “flight to quality” move into Treasurys seems laughable in the context of a US government that is running trillion-dollar deficits and is three weeks away from a possible default.

But we don’t make the rules, dear investor, we merely mock them. If a Treasury bond is “quality,” Thalidomide deserves a Nobel Prize in Chemistry.

A US Treasury bond may be “quality” for now, but this appraisal is unlikely to survive a full-blown European debt crisis. Initially, the Treasury market may attract “safe haven” buying. But eventually, the obligations of all heavily indebted governments – the US included – will suffer a markdown.

Quality rarely rolls off a government’s printing press. That’s because governments tend to consume wealth, rather than multiply it.

A terrific 2008 article by Brian M. Riedl, a Grover M. Hermann Fellow at The Heritage Foundation, cites the following studies about the ineffectiveness of government spending:

• A Journal of Macroeconomics study discovered that “a 1% increase in government size decreases the rate of economic growth by 0.143%.”

• Public Choice reported that “a one percent increase in government spending as a percent of GDP (from, say, 30 to 31%) would raise the unemployment rate by approximately 0.36 of one percent (from, say, 8 to 8.36 percent).”

• The Quarterly Journal of Economics reported that “the ratio of real government consumption expenditure to real GDP had a negative association with growth and investment,” and “growth is inversely related to the share of government consumption in GDP…”

In short, Treasury bonds are not the sort of “quality” an investor wishes to hold long-term. The quality worth owning long-term is much more likely to ascend up a mine shaft – like gold and platinum – or sprout from the soil – like wheat and soy beans – or spring from the mind of enterprising innovators – like RCA Victor and Apple Computer.

Throughout crises and depressions and all other forms of economic adversity, enterprising innovators somehow find a way to succeed. The 1930s produced some of America’s greatest success stories. Perhaps, the 2010s will repeat the performance.