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U.S. Could Be Pushed Into Debt Overload by the Treasury

Today is different for two reasons.

Interest rates are at historic lows with the 10-year rate at about 2%. FRNs make sense if you think interest rates are heading down. It seems very unlikely that rates will stay at 2% for the next 10 years. The U.S. government's leverage is significantly higher today than in 1993. The federal debt is $15.4 trillion and our GDP is $15.5 trillion. When you have high leverage, you do not want to take extra risk on funding (the risk being interest rates going up). We have seen this movie played multiple times already -- in Europe.

The Case for Floaters

The TBAC minutes of May 1, 2012, state:

"The Committee again unanimously recommended that Treasury pursue an FRN program, citing the merits of expanding the investor base and providing a cost effective means of extending the average maturity." Read the minutes.

There are three issues: bringing in new investors, cost effectiveness and extending maturity. Let me tackle each one.

New Investors

This is a weak argument. Essentially, the FRNs pay a coupon that reflects the Treasury bill rate. So why not just invest in Treasury bills? Treasury bills have been around a long time. The only difference is that you need to roll over the Treasury bills, say, every 90 days. However, this is routine and institutionalized. To be clear, there is no economic difference between the cash flows of investing in Treasury bills and investing in FRNs.

In addition, FRNs are not new. It is easy to create a FRN by buying a fixed rate Treasury and entering into a swap agreement (you pay the coupon to an investment bank and they pay you a floating rate). There is a very minor amount of counterparty risk. It is minor because you hold the bond. If there was a problem with the counterparty (which seems unlikely given the history of bailouts), your principal (the bond) is not at risk.

Cost Effectiveness

It is true that the short-term costs are less for FRNs than for fixed rate bonds. The Treasury bill yield is a fraction of 1 percent -- whereas the Treasury bond yield is 2%. So you save money immediately. However, it is not clear you save money in the end. Consider the choice between a 10-year FRN and a 10-year fixed rate Treasury bond. With the fixed rate bond, you are locked into to 2% for 10 years. With the FRN, the rate fluctuates. Maybe it is 1% but maybe is grows to 8% -- it depends on future interest rates and inflation. Who knows? This is exactly what I mean by funding risk.

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