ARE U.S. TREASURIES REALLY RISK FREE ? / SEEKING ALPHA ( A MUST READ )

Are U.S. Treasuries Really Risk Free?

July 9, 2012

by: Mariusz Skonieczny

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The conventional wisdom is that the investments with the lowest risk are U.S. Treasuries. If you ever took a course in finance, this is one of the first things that you learn. Consequently, many investors choose to hold U.S. Treasuries because they are afraid, and they believe that these vehicles represent a safe haven.

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The problem with people choosing to hold U.S. Treasuries is that they most likely do not understand what they are. If they did understand them, they would not hold them. When you buy U.S. Treasuries you become a lender to an entity called the U.S. government. Consequently, you must be bullish on this entity and/or you think that you will get your money back.

If you wanted to lend money to a really bad company, what kind of characteristics would you look for?

• Consistently losing money, meaning spending more money than you are taking in


• Increasing expenses every year
  
• Borrowing money to cover losses from operations and interest payments on previously borrowed debt
  
• Issuing (i.e. printing) shares to cover losses that borrowing did not cover
  
• Incompetent management

If you are lending to the U.S. government, it is like lending to a company with these characteristics. The U.S. federal government consistently loses money almost every single year. In 2012, it will receive approximately $2.3 trillion in revenues and it will spend approximately $3.8 trillion. This means that it will have an operating loss of $1.5 trillion.

This represents 65% of revenues.

This kind of deficit would not be possible if it wasn't for the continuous increase in expenses from year to year. In 1996, the expenses were approximately $1.6 trillion. Now, they are $3.8 trillion.

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To cover the losses, the government has to borrow money. Consequently, the total debt continues to increase. In 2000, the total debt was less than $6 trillion. Today, it is approaching $16 trillion. Over the course of about a decade, the government took on an additional $10 trillion worth of debt.

Because the government cannot borrow the entire deficit/losses at a low cost (interest rate), it has to print money to cover the difference. The way this happens is the Fed buys a portion of U.S. Treasuries with money that was created out of thin air.

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None of this would have been possible without our incompetent leaders. I want to be clear here that I don't believe that they are evil. They just don't understand economics. They are politicians. What do you expect?

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If the current fiscal situation continues to follow the same course, by 2015, the U.S. will have $20 trillion in debt. If interest rates on this debt increase to 5%, the cost of servicing it will be $1 trillion.

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Remember, the government only takes in about $2.3 trillion in revenues. Therefore, at an interest rate of 5%, approximately one half of total revenues will go to interest on the debt. If interest rates go to 10% (if you don't believe this can happen, check out the rates on Portuguese government debt), the cost of servicing it will be $2 trillion or almost 100% of total revenues.

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To balance the budget under such circumstances would require the elimination of all government expenses, which would mean no more Social Security for retirees, no more Medicare, and no more defense for the country.

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With that being said, who said anything about balancing the budget? To balance the budget today, expenses would have to be cut from $3.8 trillion to $2.3 trillion, which is equal to the revenues. Can you imagine someone running for the president with the following message?

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"If you elect me, I will cut government spending by $1.5 trillion. This will require severe cuts to Social Security, Medicare, and defense. Unfortunately, many of the things that you have been promised by my predecessors will have to be revoked. We will have to learn how to live on less and pay off our creditors. But we need to do this for future generations."

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This is never going to happen. Our country is not educated enough about economics to ever elect a president with such a message. To me, it is pretty clear that the government will not be able to balance the budget and the total debt will continue to increase.

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Then, the level of interest rates on this debt will determine how bad things will get. If interest rates increase, the U.S. government will not be able to pay its bills. If they don't increase, we are also in bad shape because of the things that the Fed will have to do to keep them there. Here is what I mean.

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Currently, interest rates are extremely low and this is why the government's debt is not such a big problem yet. When interest rates increase, the government will not be able to afford the interest payment. What controls the level of interest rates?

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Interest rate levels are determined by the demand from investors around the world. If there are a lot of investors who want to buy U.S. Treasuries because they are scared of keeping their money anywhere else, they drive up the prices of U.S. Treasuries. As a result, they are willing to accept lower and lower interest rates, which allow the U.S. government to borrow cheaply.

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As long as the demand for U.S. Treasuries stays high, interest rates can stay low, keeping the U.S. government from bankruptcy. But the problem is that it is increasingly more difficult to keep the demand high as the total debt continues to increase and because there is not as much demand as there was in the past.

For years and years, foreigners kept buying U.S. Treasuries, but because the world is facing an economic slowdown, they are not buying as much as they used to.

Despite this lower demand for U.S. Treasuries, interest rates are still at record lows. The reason for this is the fact that the drop in demand from outsiders was replaced by a new "magical" buyer - the Fed. In other words, the government is borrowing money by selling Treasuries, and one of the buyers/lenders is the government itself. This is the same as printing money.

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Going forward, as more and more debt piles up, the interest rates are going to increase or the Fed will have to buy even more Treasuries (i.e. print even more money). If interest rates go up, the government will not be able to afford them. If the Fed keeps interest rates artificially low, it will destroy the value of the dollar by creating inflation or hyperinflation.

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Because it is much easier to print money than to cut government spending to balance the budget and start paying off debt, politicians are likely to choose the printing route. In this scenario, holding U.S. Treasuries will be the surest way to losing purchasing power.

However, some people believe that this is not a problem because the improving economy will take care of these problems. They actually believe that the economy is getting stronger and stronger.

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Under conventional methods of evaluating economic growth, the economy is improving as long as the GDP (gross domestic product) is growing. However, the GDP is mostly a measure of consumption and spending. In other words, as long as consumption and spending are up, the economy is fine.

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This is wrong. For example, going out and buying yourself a new house, a Ferrari, and a couple of expensive suits does not necessarily mean you are doing fine financially. Your neighbors might be impressed, but that would only be because they assume that because you are buying all these toys, you must be doing well financially.

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While you can fool your neighbors, you cannot fool yourself. If the money for these purchases came from a successful business or a job that pays well, then you are doing well financially. But if you borrowed this money because you cannot afford these things, then you are not doing that well.

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Actually, after your shopping spree, you are far worse off because you spent borrowed money on things that depreciate in value and do not produce anything. The debt, on the other hand, appreciates because you will have to pay back the original amount plus interest.

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By looking at this example, you are probably telling yourself, "Of course, this is obvious." I wish our leaders had such common sense. Instead, they judge the economy's health the same way your neighbor would likely judge your financial well-being after observing your purchases.

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Two of the variables that make up the GDP are private consumption and government spending. Because so many of our private consumers are unemployed and up to their eyeballs in debt, they cannot spend enough to keep the GDP growing. So what do our leaders do? They tell us: "To keep the economy recovering, we need to have the government do the spending since the private consumer cannot." What a great solution!

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I don't have a problem with the government spending money. What I have a problem with is the government spending money that it does not have. As I mentioned before, our government is running a deficit of more than $1 trillion each year, which means that they are spending more than they are taking in. The difference has to be borrowed. This is no different than if you bought expensive things, didn't have a job, and charged the bill on a credit card.

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Currently, we have an economy that is barely growing, but the cost of this growth is huge deficit spending and unsustainably large debts. If the government stopped its massive spending, our economy would crumble. Even though the unemployment rate is high, it would go even higher.

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However, the politicians will do everything in their power to keep the economy from crumbling. They will artificially try to prop it up for as long as possible.

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Consequently, they will increase spending by borrowing and printing money. In the long-term, this will likely destroy the value of the dollar. In other words, we will have inflation like you have never seen before.

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This time, the politicians won't be able to do anything about inflation. In the 1970s and early 1980s, we had high inflation in the U.S., and to stop it, Paul Volcker, who was the chairman of the Fed, chose to raise interest rates. This time, we won't be able to raise interest rates to control inflation because if we do, the U.S. government will be bankrupt. This is what happens when you have too much debt.

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As a result of these dynamics, holding U.S. Treasuries is financially suicidal. It might work well in the short run because investors do not really care if the U.S. government can repay its debt. Right now they get their money back because the U.S. government can repay them by borrowing from someone else. In other words, there are enough fools out there that are willing to lend them money. Sounds similar to the dot.com and the housing bubble, doesn't it? During the dot.com bubble, people didn't care what their stocks were worth as long as they were able to sell them to a bigger fool. The housing prices also kept rising because there was always another fool willing to pay more. But at one point, the last person buying at the top is the biggest fool.

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Sooner or later, people will realize that U.S Treasuries are not as safe as they think they are.

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I understand that you might be confused about a lot of the things that I said this article. I urge you to educate yourself on the subject of the economy because we are living in an unprecedented economic climate that will make history. Just as we cannot believe we didn't see the dot.com and housing bubbles coming, a few years down the road, we will not be able to believe we couldn't see the current economic forces taking place today.

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The one book that everybody should read is Economics in One Lesson by Henry Hazlitt. It is a very easy book to read for anybody. I just told my own mother to read it so that she can protect herself. She knows what it is like to live through hyperinflation because this is what we had in Poland when I was a little kid. All of my mother's savings were wiped out.

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At one point, she had enough money saved up for a down payment on a house. But by the time we bought the house, this money only bought us a washing machine. But we were all millionaires. I remember my mom was making approximately 10 million zlote per month (incidentally, zlote actually means gold). The Polish government just kept adding zeros to our currency but these millions kept on buying us less and less.

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Eventually, there were so many zeros that they had a hard time fitting them on one bill. So, they decided to cut off four zeros and introduce new bills.

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If you don't think this can happen in the U.S., then you are in denial. If you wanted to create inflation, all you would need to do is to follow the exact path that our leaders are following - spending more than you are taking in, borrowing excessively, and printing money to cover shortfalls. Inflation is not created by businesses raising prices. It is created by inflating the supply of money. The entity that controls the supply of money, the Fed, is the only entity that can inflate it. If you and I tried to inflate the supply of money, we would go to jail for counterfeiting. But, on the government's level, this is all legal. Because of huge deficits and unsustainably high debt levels, the government is inflating more than ever.