This week’s news that the Clinton Administration’s budget surplus projection for the next decade has been upped by another $1 trillion is seen as presenting a best-of-all-possible-worlds scenario. Not only is there enough spare cash to retire the publicly held debt by 2012, a year earlier than previously estimated. But President Clinton now can finally propose funding some of the taxpayer-financed goodies that have long been on his wish list while also giving the Republicans some of theirs. The Wall Street Journal’s front-page Outlook column Monday posited that the size of the surplus could ultimately overwhelm even the politicians’ ability to spend it.  With no more debt to pay off or new spending programs to finance, Treasury might have no choice but to funnel surplus funds into purchases of private assets, according to the Journal. The lone suggestion that there could be another, better way to deal with the excess taxpayer funds – i.e., using them to support substantial tax-rate cuts – rated mention only as a sort of gauche political ploy of the Bush presidential campaign. That kind of thing clearly is not what passes for elevated thought in Washington these days.

Obviously, the most straightforward and acceptable argument for using at least part of the surplus to finance tax rate cuts is the superior economic returns that would be realized compared to either debt retirement or increased spending. In the current zeitgeist, it would be politically incorrect in the extreme to suggest that deep tax cuts can be justified as being necessary to preserve an ample federal debt. There is, though, a critical, indispensable role played by Treasury issues in the financial markets which is being totally ignored in the current passion for debt-retirement. The fact that there will be a cost to the private economy from eliminating Treasury debt may not be fully recognized for some time. Already, though, there are indications of negative consequences that likely would surprise those convinced that fiscal policy can serve no higher purpose than to secure a “debt-free America.” 

The special place accorded U.S. national debt instruments in the financial system derives from their “full faith and credit” backing of the U.S. Treasury. While it would be inaccurate to suggest that this gives Treasuries “risk-free” status -- nominal Treasury debt is still subject to inflation risk -- it does eliminate default risk. The absence of default risk makes Treasury debt the least-risky, most liquid asset class available in the global market. It thereby occupies the safest, most secure position on the risk/reward spectrum. This margin of safety, in turn, allows the market to absorb a higher degree of risk than would otherwise be possible. There have been suggestions that AAA-rated corporate debt could fill the benchmark role of Treasuries with no ill effects.  Even the most highly rated corporate debt, however, incorporates a premium to account for a measure of default risk. This would make it impossible for any corporate issue to fully replicate the creditworthiness of a Treasury bond.  The risk tolerance of portfolio investors varies widely depending on any number of factors. But if the least risky of portfolio options must necessarily encompass higher risk, the market’s overall risk propensity would also be correspondingly reduced.

The potential retirement of a major portion of the publicly held debt already can be seen playing some role in the private credit markets. In the past several weeks, as the market’s expectations for additional Fed rate hikes have receded, yields on investment-grade corporates have fallen by more than 50 basis points. Ten-year junk yields, however, have remained at levels above 12.75%, and their spreads to Treasuries some 225 basis points above January levels. Both of these risk indicators are near historic highs and well out of line with any detectable increase in default risk. Indeed, the high-yield debt market this year has gotten whacked harder than any combination of a more aggressive Fed, the possibility of a slowing economy or rising real yields can sufficiently explain.  The culprit, at least in part, appears to be reduced risk propensity owing to the current and expected future contraction of the Treasury debt market.

It should be noted that current surplus/debt-retirement projections remain subject to considerable uncertainty. If recent GDP growth rates of about 4% are sustained, the publicly held debt under current tax and spending policy would disappear within about seven years. A recession or period of below-trend growth, though, would delay the extinction of Treasury debt for several years. In the wide sweep of history, moreover, the early 21^st century appearance of a debt-free America is likely to be marked as a brief interlude. The pay-down of $3.6 trillion in publicly held debt is being matched by growth in the Social Security trust fund, which is expected to reach more than $4 trillion by early next decade. At some point, when the current payroll tax surplus turns to deficit, most likely sometime before 2020, the Social Security system will begin redeeming the trust fund assets to meet benefit obligations. That redemption likely will be financed at least in part by issuance of new debt.

FOMC: Yesterday’s post-meeting statement had a something-for-everyone, production- by-committee tone, which probably indicates that the end is near, but we’re not there yet. The relentlessly hawkish tenor of recent statements was notably absent, replaced by the suggestion that “demand may be moderating toward a pace closer to the rate of growth of the economy’s potential to produce.” Alan Greenspan’s recent re-awakening to the implications of the technology revolution was evident in the assertion that productivity gains “have been containing costs and holding down underlying price pressures.” Still, there are too many members of this committee that have put too much on the line warning of the looming inflation to slink away quietly now. Thus, signs of slowing growth are “still tentative and preliminary, and the utilization of the pool of available workers remains at an unusually high level.” The best bet at this point is for one last 25 basis point move at the August meeting, unless recent signs of a cooling pace of expansion intensify significantly in the interim, which is unlikely.