Gap management. A very easy and straight-forward concept that has been butchered by countless firms, laid bare by the financial crisis. Funding long-dated assets with short-dated liabilities? A profitable strategy when everything is rosy, but potentially fatal when conditions turn negative. Consider Bear Stearns. Lehman Brothers. AIG. Washington Mutual. They all share the same underlying problem: assets with durations and liquidity characteristics out of step with how they are financed. Good banking, getting back to the basics, was all about gap management. Acknowledging the risks taken, quantifying the risks, and dynamically managing them based upon market conditions. At some point the combination of greed, laziness and complexity caused managers of financial institutions to stray, sewing the seeds of the troubles we are encountering today. The US Government generally, and the US Treasury specifically, are being asked to spend our way out of the crisis. But once one gets over the ideological hurdle of bailing out busted constituencies – banks, finance companies, mortgage holders, assorted industries – to begin with (no mean feat), the question that must be asked is: how is the Government going to finance this largesse? And is it going to make the exact same mistakes as those institutions it is currently rescuing?
The actions being taken by the US Government do not only have near-term consequences; they are decisions that will stay with us for a long, long time, as will the debt associated with these decisions. And given the macroeconomic risks posed by the stimulus package, I think it makes sense to spend some time thinking about how all this spending will be paid for. Raising taxes? A bad idea from a policy perspective, as well as a shrinking well from which to tap due to the sharp downturn in our economy. Lower incomes. Smaller corporate profits. Fewer capital gains. All of these point to a sharp reduction in tax revenues, and the tax increases President Obama has in store will nary make a dent, and may well cost more than they generate over time. We could cut spending. One thing we can take away from the annual budget process is that true cuts, net reductions in spending, almost never stick. If this is where we are placing our hope we are living in fantasy-land. So the only other place money can come from is if we manufacture it. Sell Treasuries. Borrow and spend. The Great American Pastime.
But if we’re going to do it, let’s think about that old guidepost, gap management. The US has a tremendous amount of long-dated liabilities. Social Security. Medicare. Massive infrastructure spending as contemplated by the new stimulus bill. Near-term revenues (read: taxes), are going to be under pressure due to weak economic conditions. Treasury rates are near historic lows, due to both the economic downturn and a “flight to quality” as we are crumbling at a somewhat lesser pace than other developed and emerging economies. This makes it the perfect time for the Treasury to push the limit and issue as much long-dated paper as it can. Bring out a 40-year issue. Gauge demand for a 50-year and perhaps a 100-year issue, as News Corporation and Disney did in the late 1990s. This is akin to raising synthetic equity for the US Government, at a time when securing this kind of financing has never been cheaper. Even if we had to pay up due to abnormally long maturities, it will look dead cheap once inflation rears its ugly head (as it will) and the cost of rolling short-dated Treasury paper may well be in the double digits. Further, by issuing a slug of ultra long-dated paper we’ll be better matching our obligations with our financing horizon. Hurrah!
Treasury Secretary Geithner, it is a no-brainer. Get your team working on a financing package that takes advantage of the US Treasury’s current position as issuer-of-choice before inflation spikes, the dollar craters and rates skyrocket. And let’s see you do a better job of gap management than those dope firms you are bailing out. It may cost you a little more to get this kind of a financing done but trust me, you’ll thank me in the morning.