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BBA: Our Best Bond Bubble Insurance

There has been a ton of recent reports about Greenspan's prediction of a bond bubble bursting. It is far from uncontroversial. Experts are on both sides of the issue. But the real question is what does it mean?

A bond bubble is a situation where the prices of bonds are unsustainably high. That's just another way of saying that the interest paid on the bond is unsustainably low.

What do the interest rates on U.S. Treasuries look like?

It sure seems like current Treasury rates (3 month, 10 year and 30 year) are unusually low based on historical standards. Are they unsustainably low? It will likely depend on what happens with inflation (the effects of economic growth or the lack of economic growth are more unpredictable). Inflation currently has nowhere to go but up. And if it does, as a general rule, interest rates must rise too.

If interest rates double to approach the historical average, what will happen to the budget? The below chart imagines the rough effects of doubling the interest rate paid on U.S. Treasuries to something closer to the historical average. It is not exact because the effects of a doubled interest rate would not register on longer term obligations immediately, unless they are refinanced (which is unlikely if interest rates rise).

It is hard to imagine where the extra couple of hundred billion dollars will come from unless we borrow even more to pay the interest on borrowing or raise taxes. But many economists believe that those tactics would cause bond markets to predict even higher interest rates, causing interest rates to rise yet again, and making the problem even worse for the next round of bond issuances. It is a cycle that leads to fiscal calamity. Just ask Greece.

But what if the federal government made a credible commitment to get its fiscal house in order? What if bond markets had reason to believe that the risk of an endless cycle of ever increasing amounts of borrowing at higher and higher interest rates would end?

The natural conclusion is that bond markets would have reason to moderate their demand for higher interest rates for U.S. Treasuries. The ability of the nation to repay its debt will become easier. The spending reductions or tax hikes that might otherwise become necessary would be minimized.

In other words, a Balanced Budget Amendment is our best insurance against the current trends that foretell a bond bubble bursting.

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