REVIEW & OUTLOOK
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March 12, 2012
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Uncle Sam's Teaser Rate
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Low interest rates disguise the federal debt bomb.




One business story these days is how companies are crashing the debt markets to raise money at today's bargain rates. The same goes for the world's biggest borrower, Uncle Sam, which is also quietly benefitting from historically low interest rates that cannot last. The latter deserves more attention because the next President and Congress are likely to be stuck paying the bill when rates inevitably rise.


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First, a couple facts: the U.S. Treasury currently has $10.7 trillion in outstanding publicly-held debt, and more than $8 trillion of it must be repaid within the next seven years. More than $5 trillion falls due within the next 36 months.




This relatively short-term debt sheet is no accident. Like a subprime borrower opting for a low teaser rate, the government has structured its debt to keep current interest payments low. This is a political temptation for every Administration because it means lower budget deficits on its watch.




The Obama Administration has added close to $5 trillion to the U.S. debt. So it much prefers to finance all of this at a rate, say, of 0.3% in two-year notes than at 2% in 10-year notes. The nearby charts show how federal debt has soared during the Obama years, yet net federal interest payments are lower than they were in 2007 and lower than they were in nominal dollars even in 1997 when public debt was a mere $3.8 trillion. This year the debt is expected to reach $11.58 trillion.




The problem is that this disguises the magnitude of the debt threat and stores up trouble for future Presidents and taxpayers. And maybe not far in the future.




The Congressional Budget Office (CBO), for example, forecasts that in the period 2014-2017 the average rates on three-month Treasury bills will rise to 2% from less than 0.1% today. CBO expects average rates on 10-year Treasury notes to climb to 3.8%, from 2.03% now. CBO adds that every 100 basis-point rise in government borrowing costs over the next decade will trigger almost $1 trillion in new federal debt.
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As of January 2012, taking into account all the various notes and bonds issued by the federal government to the public, Uncle Sam is paying an average interest rate of 2.24%. The government expects to spend in the neighborhood of $225 billion this year making interest payments. That may seem like a large sum, and it is, but consider what happens if rates quickly rise back toward their historical norms. As recently as early 2007 the government was paying 5% on its debt, which is the average of the last two decades, though of course rates could always go higher. During the 1990s, the average was well above 6%.




If the government had to pay the 5% rate that it was offering before the financial crisis on today's debt, the annual interest payments would be $535 billion, twice CBO's projection for total federal spending on Medicaid this year. If Uncle Sam had to pay 6% on its debt, the annual interest payments of $642 billion would surpass total federal spending on Medicare, currently $484 billion. Such a radical change in budget math could trigger a political panic and intense pressure for tax increases, perhaps even for a European-style value-added tax.



Should Treasury be much more aggressive now in seeking to borrow for the long term at today's low rates? This would seem to be a sensible call, especially given that everyone except perhaps the Federal Reserve Board of Governors expects rates to rise.



Treasury says it is aware of the dangers and is acting on it. In a September 2010 letter to the Journal, Mary J. Miller, Treasury's assistant secretary for financial markets, reported that 55% of Treasury debt was maturing within three years and that this figure was declining. She added that Treasury planned to continue lengthening the average maturity of its debt.



Ms. Miller and her Treasury colleagues have been true to her word. Today, 52% of the debt is due within three years.



The problem is that, amid the astounding Obama-era increase in federal debt, Ms. Miller's letter arrived almost $2 trillion ago. So while short-term debt may be declining modestly as a percentage of Treasury paper, it's part of a much bigger debt pie.



Of course, Treasury can't decide entirely on its own to rely on longer-term financing. Investors watching the mounting Obama debt pile probably wouldn't agree to finance most of it for 30 years at a low rate. The risk of future rate increases or inflation are too great.



Not that we can tell how much private market demand exists for 30-year bonds anyway. The Federal Reserve is now among the largest buyers as it implements "Operation Twist" and other monetary adventures.



This is a useful reminder that fiscal authorities aren't the only ones who will have trouble exiting from this era of profligate government. Sooner or later the Fed has to manage the withdrawal from its historically accommodative monetary policy. Even now many investors suspect that the Fed is keeping rates so low for so long in part to finance federal debt on easier terms.



If the economy gains steam—say, in a new Administration that reforms the tax code, cuts spending and reduces regulation—the Fed may have to raise rates to forestall inflation. But if it raises rates, interest payments on the debt will soar, the deficit may not fall from its Obama trillion-dollar levels, and pressure could build for a tax increase.
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President Obama may not mind this outcome but Mitt Romney and Rick Santorum should, which is why they need to talk about this fiscal nitroglycerin that Mr. Obama and Fed Chairman Ben Bernanke have created. The two Republicans might also take a moment to wonder how much they really want this job. The next Presidential term may be spent trying to defuse the Obama debt bomb.
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Copyright 2012 Dow Jones & Company, Inc. All Rights Reserved


The Greek debt drama has merely paused for an interval
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Mohamed El-Erian
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March 13, 2012


Many investors wish to wave a final goodbye to the disruption the Greek debt crisis has had on market valuations. Meanwhile, European policymakers are already trying to move away from the dramas on the periphery and focus on restoring growth in Europe.


Both impulses are understandable. Unfortunately, they are premature.




The debt reduction agreement put in place last week is the biggest sovereign restructuring ever. Yet it only goes part of the way in helping Greece overcome its core problem of too much debt and too little growth. And it won’t be long before this latest deal also comes under pressure. So here is what to look for, and what to do about it.




With debt reduction only one of three components of the recent €130bn bailout, expect more details this week on the other two. On Tuesday and Thursday we will find out how much money the European Union and the International Monetary Fund are willing to release to Athens upfront. Markets are hoping for heavily front-loaded payments, while official creditors prefer them to be more back-loaded.




This difference relates to Greece’s ability to deliver on its part of the bargain – particularly an additional dose of heavy austerity at a time when youth unemployment is already 51 per cent and the economy is contracting at rate of seven per cent per year. Even if socially and technically feasible, the upcoming elections in Greece will introduce yet another element of complexity.




Going beyond the next few weeks, it is highly likely that the Greek bailout will again be found wanting. Were it to be fully implementedhighly unlikely – the result would still be an unsustainable debt stock of 120 per cent of gross domestic product in 2020. With such a prospect, new private capital will not engage in Greece, robbing the country of the oxygen needed for investment, growth, competitiveness and jobs.




No wonder markets are already pricing in a significant probability that Greece will have to again restructure its debt. And the next round is likely to be a lot messier. Talk about “PSI 2” is already accompanied by growing awareness of “exit risk” (the possibility that Greece will have no choice but to exit the eurozone to restore competitiveness and growth).




Whenever it occurs, PSI 2 will be a very tricky affair because of what Greece has just agreed to. By shifting the legal jurisdiction governing most of its outstanding bonds from Greek to UK law, the country is giving up significant flexibility and narrowing its range of options. It is also exposed to a lot more risk in the event of a future restructuring.


Finally, the overwhelming majority of new loans comes from the official sector. With this large accumulation of liabilities to ’senior creditors’, any disruption in payments could quickly spiral out of control.




Already official holders of Greek bonds, such as the European Central Bank and European Investment Bank, refused to participate in last week’s restructuring deal. If Greece were to default on such creditors, let alone on the IMF, it would undermine the one source of new financing that is still available.




Finally, Greece cannot – and should not rely on its European partners and the IMF to maintain indefinitely an approach that repeatedly fails to deliver. With a referendum in Ireland and presidential elections in France (held against the background of seven governments having lost office in Europe since 2010) we should expect many more calls for a fundamental redesign of the eurozone. Few will favor more exceptional large-scale financing for Greece.




What last week’s debt reduction deal really delivers is a bit more time for others to reposition for the next, more disruptive, act in this unfolding Greek drama. For European policymakers, this means even more urgent building of firewalls to protect countries such as Italy and Spain, continuing to strengthen the core through better fiscal and political integration, and forcing banks to raise capital. For investors, it is about reducing their exposure not only to another default by Greece, but also the risk of the country’s exit from the euro.




If this were to happen, the latest agreement would end up being characterised in history books as more than just a costly failure.


.The writer is the chief executive and co-chief investment officer of Pimco


Europe’s Trust Deficit

Barry Eichengreen

2012-03-12





BERKELEY – There is no shortage of talk nowadays about Europe’s deficits and the need to correct them. Critics point to governments’ gaping budget deficits. They cite the southern European countries’ chronic external deficits. They highlight the eurozone’s institutional deficits – a single currency and a central bank but none of the other elements of a well-functioning monetary union.




Of course, in all of these areas, the critics have a point. But none of these is the deficit that really matters. The deficit that prevents Europe from drawing a line under its crisis is a deficit of trust.




First, there is deficient trust between national leaders and their publics. We saw this most visibly in the person of former Italian Prime Minister Silvio Berlusconi, who fortunately has been kicked to the sidelines of the political scene. But even the most stalwart European leaders have lost their followers’ trust by baldly saying one thing today and the opposite tomorrow.




At the end of February, for example, German Chancellor Angela Merkel made a spectacle insisting that no bigger financial firewall was needed to protect other eurozone countries from a disorderly Greek default. Not one more euro of German taxpayer money, she vowed, would be contributed for this purpose. Yet everyone knew that once the Bundestag voted for the latest Greek rescue and enough time passed to acknowledge reality gracefully, Merkel would reverse course and argue that the eurozone needed a bigger firewall after all.




In fact, there is nothing at all graceful about this. For politicians to say one thing now when everyone knows they will soon say the opposite is guaranteed to erode trust in Europe’s leaders.




Second, there is a lack of trust among European Union member states. The real reason why the northern Europeans have been unwilling to provide a “big bazooka” – that is, extend more financial assistance to Southern Europe – is that they don’t trust the beneficiaries to use it wisely. They fear, for example, that additional securities purchases by the European Central Bank, aimed at bringing down Spain’s borrowing costs, would only lead the Spanish government to relax its reform effort. As a result, Germany and its allies are prepared to provide just enough assistance to keep the ship from capsizing, but not enough to set it on an even keel.




Third, there is lack of trust among the social groups called on to make sacrifices. Italian taxi drivers would be prepared to allow more competition if they were sure that Italian pharmacy owners were willing to do likewise. But if issuing more taxi medallions reduces cab drivers’ earnings, while pharmacists succeed in vetoing pro-competition measures to lower the cost of their services, the taxi drivers will end up worse off and the pharmacists will be enriched, which hardly seems fair.




In other words, lack of social trust blocks structural reform. The Greek version of this dilemma, in which no one pays taxes because no one else pays taxes, is particularly stark.




Survey research has revealed that societies vary greatly in their levels of trust. Economists, for their part, have shown that these different attitudes have deep historical roots.


.In European regions where minority groups were persecuted 500 years ago, ethnic and religious conflicts have been more pervasive in recent times. In parts of the Balkans long ruled by the Ottoman Empire, trust in government is lower than in nearby regions that just happened to have been ruled by the more efficient Habsburgs. In regions where earlier inhabitants engaged in farming rather than herding, forcing them to cooperate more extensively, their descendants are more likely to form bonds of trust today.




Evidently, attitudes are passed down through the generations. They are embedded in societies in the form of culture. Simply put, when it comes to trust, history casts a long shadow.




Historians have long emphasized the importance of suchpath dependence” – that events in the distant past continue to shape outcomes in the present. Yet they also point to exceptional windows in time when it is possible for societies to shift away from their established paths. A crisis, when the viability of established arrangements is called into question, is just such a window.




The euro crisis thus offers Europe an opportunity to reestablish trust. Its national leaders need to reestablish the trust of their constituents by offering them straight talk. EU member states need to rebuild their trust in one another. And European countries facing the need for wrenching structural reforms need to restore social trust at home.




If this opportunity to rebuild trust is squandered, it will be difficult, if not impossible, for Europe to address its fiscal, economic, and institutional deficits.



Barry Eichengreen is Professor of Economics and Political Science at the University of California, Berkeley.

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Copyright: Project Syndicate, 2012.


The west must strike a deal with the Taliban to end the Afghan war
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Ahmed Rashid

March 12, 2012




In an army of 150,000 US and Nato soldiers in Afghanistan one rogue solider who massacres 16 civilians, including nine children, does not necessarily mean that discipline and morale of the whole force is breaking down. However, when the spate of recent incidents are put togetherUS soldiers burning copies of the Koran, footage apparently showing US Marines urinating on bodies of dead Taliban fighters and a spate of accidental killings of civilians during US attacks on the Taliban – the situation looks far more grim. There can be no doubt that the western presence in Afghanistan faces a grave crisis of confidence across the Muslim world and in their home countries.




The Afghan people are exhausted by a war that has gone on in one form or other since 1979, when most American soldiers now in Afghanistan were not even born. Increasing numbers of Afghans would agree with what the Taliban have been arguing for almost a decade: that the western presence in Afghanistan is prolonging the war, causing misery and bloodshed. The hundreds of civilians killed already this year across the country are almost forgotten now in the aftermath of the children killed by a “farengi” or foreigner.




Moreover, faced with an increasingly corrupt and incompetent government, Afghans are seeing fewer improvements on the ground. So-callednation building” has ground to a halt, simple justice and rule of law is unobtainable and one third of the population is suffering from malnutrition. The people blame not just the Americans but equally Hamid Karzai and his inner circle that gives him conflicting and contradictory advice, leading him to flip and flop on policy issues.




Mr Karzai’s desire to seek a strategic partnership agreement with the Americans is becoming more and more unacceptable to the Afghan people. At the same time he also wants to make peace with the Taliban, but they have no desire for a pact with Washington. His dilemma, which he still refuses to understand, is that he can either ask for a long-term US presence or peace with the Taliban, but not both.




America is clearly also exhausted by the two wars it has waged in Iraq and Afghanistan – the latter becoming the longest war in US history. Officers and soldiers have done several tours of duty in both countries, while the wars themselves have been virtually ignored at home. Neither war has yielded the dividends that Washington once hoped for. Osama bin Laden may be dead, but al-Qaeda’s beliefs have spread their net into many more countries since 2001, while the Taliban have proved to be far more resilient than western forces could conceive of a few years ago.




Yet the US military high command has been lobbying in Washington, insisting that some kind of victory in Afghanistan is still possible if only Barack Obama would not withdraw so many troops so soon and if only Congress would keep the funding flowing. US generals have done their best to delay and undermine the still-weak hand played by the State Department in its efforts to get talks with the Taliban going. But now even the Republicans, many of whom have supported the military and condemned Mr Obama for daring to open talks with the Taliban, appear to be at a loss as to how to move forward in Afghanistan.




After the spate of incidents this year, there should be no doubt in Washington that seeking a negotiated settlement to end the war with the Taliban as quickly as possible is the only way out. Mr Obama has to put his weight behind this strategy to ensure an orderly withdrawal and to give the Afghan people the chance of an end to this war. A power-sharing formula with the Taliban, which now appears increasingly unavoidable, and an accord with neighbouring states, to limit their interference, will be key.




In 1989, it was America and Pakistan who refused to allow for a political solution to end the fighting because they wanted not only the Soviets gone but also Moscow’s Afghan protégées led by Mohammad Najibullah. Instead he hung on for three years, resulting in a civil war. America cannot again leave Afghanistan with a civil war as its bequest to the Afghans. Washington, and Nato, must seek an end to the war before withdrawing their forces. Despite the tragic death of so many innocent children, this is still possible if there is a concerted diplomatic and political push.


.The writer is author of several books about Afghanistan, Pakistan and Central Asia, most recently “Descent into Chaos”


HEARD ON THE STREET

March 12, 2012, 1:03 p.m. ET

Explaining the Bond Yield Conundrum


By RICHARD BARLEY



Are safe-haven bond markets on another planet? Risk appetite has come roaring back in 2012 as central banks have provided huge amounts of liquidity, economic data have been better than expected and the euro-zone crisis has receded—with Greece avoiding a disorderly default. But there has been no corresponding selloff in German bunds, U.S. Treasurys and U.K. gilts.




That is surprising given the huge rally in risky assets. The MSCI World equity index is up 9.2%. Global investment-grade corporate-bond spreads have tightened 0.6 percentage point, Barclays Capital indexes show. Italian government bonds have returned 12.8%. Yet 10-year German bund yields fell to 1.76% Monday, a fresh low for the year.




By some measures, core bonds look overvalued. One guide is that long-term risk-free bond yields should be roughly equal to nominal economic growth. But with U.S. nominal growth at 3.9%, 10-year Treasurys at 2% are almost two percentage points overvalued, UBS notes.




On the other hand, with central-bank policy rates at zero and the U.S. and the U.K. having undertaken quantitative easing, long-dated yields look more rational. Interest-rate curves are very steep, meaning there is actually a big risk premium in long-dated yields. The 1.7-percentage-point gap between two-year and 10-year Treasury yields is more than twice the long-run average. And there is good technical support for bunds, Treasurys and gilts, as there are few substitutes for them after other "risk-free" assets turned out to be anything but.




Low bond yields mean one of two things, therefore. One is that investors fear central-bank liquidity is only plastering over the cracks, and they expect a resurgence of the global financial crisis, hurting stocks, corporate bonds and peripheral euro-zone debt. The other is that long-term yields are rational, in which case yields on other risky assets should converge further with them: The risk-on rally can continue without safe havens selling off.




The key to the conundrum is that central-bank rates are at zero and expected to stay there. As long as that is the case, don't bet on a big rise in bond yields.


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Copyright 2012 Dow Jones & Company, Inc. All Rights Reserved