The U.S. Government Bond Bubble

May 28, 2010 1:02 pm 2 comments

What follows will read like an indictment on our entire economic system. But underlying my (relatively mild) harangue is an observation that people are ignoring the most obvious bubble out there; that is, the bubble in U.S. government bonds. The following is my attempt to figure out why.

Efficient Market Theory

Let’s face it, markets are inefficient. The efficient market theory, manufactured from the ivory towers of academia, poses perhaps the greatest threat to the stability of our system. Here’s why.

False assumptions produce false conclusions. The efficient market theory posits that bubbles aren’t recognizable before they pop. The natural consequence of this misguided belief is that government officials will never act to preempt bubbles since they are, by definition, impossible to identify. This is one of the reasons why supposedly “efficient” markets are consistently marked by fat tails, outright panics, and “once in a lifetime” events.

The efficient market theory currently extends to U.S. government debt. In a circular manner, the strength of U.S. bonds is justified by low yields, which is evidence of the strength of U.S. bonds. But take a step back and remember that current yields are a product of government intervention. Stability, especially artificial stability, breeds instability. U.S. bonds are a bubble, and it’s pretty damn recognizable at the present time.

Psychology and Cognitive Dissonance

I love incorporating psychology to economics because this dual framework explains the world a whole lot better than pseudo-scientific economic models that are consistently wrong. I’m convinced that one of the biggest barriers to investment success is cognitive dissonance.

To briefly explain, cognitive dissonance is a phenomenon by which people attempt to reconcile two opposing views. When faced with seemingly contradictory facts or opinions, most people will defend their existing framework by explaining away anything that refutes it. To understand why this human tendency is important in the context of a U.S. debt default, we must understand the framework most Americans currently carry.

Most Americans cling to a framework that goes something like this: The U.S. is the biggest economic power the world has ever seen. We are the engine of global growth. We are immune to panics that characterize “less developed” countries. Our debt is rated Triple-A. Therefore, we can never default on our debt.

Any evidence contrary to pre-existing frameworks will be explained away- this is human nature. So when gold goes to record highs, instead of recognizing that it is the free market’s indictment of the monetary system, people will say “gold is a bubble.” When Greece experiences a debt crises engendered by factors indistinguishable from ours, people say “we’re not Greece- we can print our own money.” Utter nonsense.

By going short U.S. government bonds, I am basically going short the human tendency to cling to a worldview that provides them the most comfort. Always let historical precedent and facts determine your conclusions, not irrational human tendencies.

Crony Capitalism and Collapse of the Rule of Law

The rule of law is perhaps the most underappreciated aspect of functioning markets. Once the system degenerates into a form of crony capitalism (think: Chrysler bond debacle), you know serious economic shocks lie ahead.

When people realize they can “game” the system, believe me, they will. Economics is all about incentives.

Think about the tragicomedy that is Wall Street. Banks on life support get bailed out from the government to “save” the financial system. But to appease the public, politicians throw in a provision that banks can’t hand out bonuses unless they repay TARP. No problem! Banks issue stock and dilute existing shareholders to repay TARP. Then they hand out record bonuses. Follow the path of money and realize your tax dollars are going directly to the pockets of morons who brought down our system. The system is being gamed big-time.

What’s the net effect? Investors lose confidence in the entire system and withhold their capital. This especially holds true for government bonds. The system can take only so much corruption before imploding at the seams.

Blindly Trusting Financial “Experts”

To rid you of any delusions that experts know what they are talking about, allow me to briefly walk you through the debacle known as subprime.

Most professionals couldn’t see the bubble in housing inflating even though it was staring them in the face. And this was a mere 7 years after the collapse of the Nasdaq! Leading up to the crash of housing, the consensus could not envision a national decline in home prices since their “infallible” economic models used data of home prices over a 60 year period. All quants needed to do was adjust their models back about 15 years to the Great Depression and they would have understood that home prices do indeed fall. Garbage in, garbage out. Models are useless without a proper historical backdrop.

The experts, led by Paul Krugman, are now claiming that the U.S. is not Greece. Some people think this argument is sensible; to me, this is simply evidence of a world gone mad.

The key thing to understand here is correlation. CDO’s were priced so richly because it was assumed that different tranches, which respresented a diverse range of mortgages throughout the U.S, were not correlated. This assumption proved to be false because all homes were inflated equally by the same credit bubble and the same fraudulent system.

False assumptions in correlation are prevalent as it pertains to sovereign debt. Somehow we believe the problems in Europe will not find their way to us. Unfortunately, we are experiencing a global sovereign debt crisis. Every single Western government is in debt up to their eyeballs. All bankrupt nations have lent money to each other in a complicated web that can be addressed only through default. Therefore, in the long run, all sovereign debts are correlated.

Failure to Predict Second and Third Order Effects

Perhaps the tendency that underlies policy mistake after policy mistake is the failure to think beyond first order effects. Politicians are especially adept at thinking at a linear level. Let me give you an example.

Imagine you are the governor of California and your state is bankrupt (doesn’t take much imagination). Say you want to raise your revenue by $100 million dollars. The easy solution is to tax the arbitrarily defined “rich.” Suppose your definition of “rich” is anyone with an income of over $1 million. Assume that the revenue derived from this demographic at current tax rates is $50 million. Simple arithmetic will dictate that you double your tax rate and your problems are solved.

Perhaps people don’t believe this could possibly be the fantasy world our politicians live in. But this is essentially what the state of Maryland did. Millionaires promptly went “missing.”

Our leaders fail to see potential second and third order effects of debt monetization; the subsidizing of the auto, housing, and financial industry; and the ad hoc disregard of the rule of law. If these trends continue, I am 100% sure capital will flee America. We need to start thinking beyond propping up failed corporations and running up our national debt; this course is unsustainable.

Linear World, Dynamic World

Let’s go back to the subprime debacle for a second. Credit default swaps, which were an effective short against housing, only started to crater in mid 2007- even after it was obvious that the models pricing CDO’s were seriously flawed.  Market makers (Government Sachs) briefly manipulated bond prices to buy time as they faded their clients and ran for the exits. Once people understood the toxicity of CDO’s, we saw an all-out stampede as bond prices crashed dynamically,

Does this sound familiar? Is our government not manipulating markets and delaying the inevitable by monetizing debt? Short of saying it outright, our government can’t make it any clearer that trouble lies ahead. Seriously, what do you expect? Imagine Bernanke going on national TV and saying the following:

“I would like to inform the American people that we are bankrupt. We have been hoping to maintain confidence in our system by artificially suppressing rates by buying up bonds with money we printed from nothing. We hope that by keeping rates low, we can create another illusory speculative boom and kick the debt can down the road for another administration to take the blame for. I have no clue what I’m doing- after all, I’m the one who thought subprime was “contained.”"

Yea right. Our leaders are going to spend like drunken sailors until the entire house of cards comes crumbling down. I’m telling you, the evidence is staring you in the face. Gold is your only insurance.

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