Obama's Budget May Slam Treasuries

Government bonds don't look so safe amid the shaky recovery and sick state of U.S. finances.
By Peter Morici ,

President Obama's budget and deficit projections don't reveal the sick state of U.S. finances, casting serious doubt on the safety of U.S. bonds.

The Obama budget plans significant initiatives in health care, environment, education, and jobs creation. Yet, the private sector, which must be taxed to finance government, is likely to grow slowly, resulting in too much federal borrowing.

To create jobs, businesses need customers and capital -- without which they can neither sell what new employees make nor buy equipment workers need. Demand for U.S. goods and services remains weak because Americans spend too much on imported oil and other products that don't in turn generate demand for U.S. exports. The gaping trade deficit contributed mightily to the "Great Recession," and the Obama administration offers few plans to turn that around.

After receiving more than $2 trillion in federal aid, the banks still aren't lending enough to businesses. Most of the aid went to around10 big Wall Street banks, which refuse to perform their traditional function of financing loans through some 8,000 regional banks.

JPMorgan Chase

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,

Goldman Sachs

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and others would rather trade currency futures, energy contracts and other derivatives than engage in the boring business of lending to smaller banks and businesses.

Financial sorcery generated $150 billion in bonuses last year; honest banking is for the stiffs. So far, few of Treasury Secretary Timothy Geithner's proposals will resolve that dysfunction.

Reflecting the slack demand and tight credit, economists are predicting substandard growth over the next several years: in the range of about 2.6%, well below what could be expected from productivity and potential labor-force growth. Yet, Obama's budget assumes the U.S. economy will grow 4% a year from 2011 through 2014 to bring his $1.6 trillion deficit down to $706 billion.

The tax base will grow more slowly than the Obama budget projects. Meanwhile, plans to raise taxes on high-income Americans, while exempting the middle class, must pass the Senate. Scott Brown's surprise victory in Massachusetts could curb such populism.

Obama's freeze on discretionary programs will yield a paltry $25 billion a year, and his special bank tax will bring in only $10 billion.

For years to come, federal finances likely will look a lot like Obama's 2010 projection -- the deficit at more than 50% of revenues and the Treasury borrowing $100 billion every month. Based on budget projections such as these, Moody's would be hard-pressed to rate any such government debt as investment-grade.

But the U.S. is different. The Federal Reserve can print dollars, if no one wants to buy new Treasuries, because the dollar is the global currency.

However, U.S. bonds are still risky. Internationally, interest-bearing Treasuries function much like currency. Whether in the form of Treasury notes or as currency, too many dollars floating around will fuel inflation, as the global economy recovers. And the mere fear of inflation prompts investors to demand higher interest rates.

As Washington spends and borrows, the Treasury will be compelled to pay higher rates on new 10- and 20-year bonds, which reduces the value of securities issued in 2010 and earlier in the resale market. That interest-rate risk makes Treasuries lousy investments.

Washington's monopoly on printing dollars makes it difficult to grade Treasuries along the conventional triple-A to D ratings spectrum. Those bonds can't default, but investors' capital remains at risk.

Perhaps we need a special grade: "F" -- for flee now, before you get stuck.

Professor Peter Morici, of the Robert H. Smith School of Business at the University of Maryland, is a recognized expert on economic policy and international economics. Prior to joining the university, he served as director of the Office of Economics at the U.S. International Trade Commission. He is the author of 18 books and monographs and has published widely in leading public policy and business journals, including the Harvard Business Review and Foreign Policy. Morici has lectured and offered executive programs at more than 100 institutions, including Columbia University, the Harvard Business School and Oxford University. His views are frequently featured on CNN, CBS, BBC, FOX, ABC, CNBC, NPR, NPB and national broadcast networks around the world.

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