Rope Limit

I remember the debates from the late 70s or early 80s about government borrowing out private borrowing. At that time, I thought it was likely, but it was seemingly proven false. If nothing else, the long time of survival after that is proof enough.

Now with the US government borrowing more and more, and guaranteeing more and more debts of Fannie (FNM) and Freddie (FRE), it really looks like the US Government is running up against its rope limit, i.e., that amount that it can borrow without raising its interest rate significantly.

Think of all that they are implicitly guaranteeing, and $500B+ deficits going out as far as the eye can see. All of the programs the US government proposes relies on the idea that larger deficits will be readily absorbed by the rest of the world, as well as some US investors.

Think of the Fed buying $1 trillion of MBS, and the US Treasury buying $220 billion of MBS. Why should our government borrow to own mortgage loans? (For these purposes, I count the Fed as a part of the government.)

The government is trying to support residential real estate prices, rather than letting the system clear by letting prices fall further, and letting the financial system absorb large losses. Many financial firms would fail, and have to go through bankruptcy, but after the crisis was past, the US economy would grow rapidly, unencumbered by bad debts, as it grew rapidly after 1941.

Government actions tend to prolong large crises rather than resolve them. Small crises are another thing — the government seem to help, but merely builds up the problem of bad debt for a larger crisis.

As the US government has stretched to bail out the residential mortgage market over the last three months, is has faced a situation where additional support for the residential mortgage market did not matter. Additional borrowing by the US government did not matter, because the US Government is increasingly a bank or a hedge fund, borrowing to buy residential mortgages. The borrowing is becoming so great that government debt investors are looking at the residential mortgages to understand what value truly lies behind the promises of a US Treasury security.

This is just my gut felling but as the US government has acted over the last month, borrowing and offering guarantees with abandon, amid economic weakness and a wide yield curve, I have been surprised by the continued widening of the yield curve.

It is as if the US Government has finally reached its “rope limit,” the line in the grass where the dog can go no further. If true, we are near an inflection point in the markets, though with little idea of where we go, because central banks could act in favor of inflation or deflation.

I wish I could say more here, but a barbell of long Treasuries and money markets could offer some protection of purchasing power. The inflation argument is the easy one, but I can’t say that will happen with certainty.