Mr. Market Fantasy

– “Dear Mister Fantasy play us a tune. Something to make us all happy.” When Stevie Winwood sang these lyrics in 1967, your 7-year old California editor took them at face value. The lyrics felt soothing and magical. Today, those same lyrics feel like a grim ode to U.S. fiscal policy.

Back in 1967, President Johnson was just getting the hang of raising taxes and redistributing the nation’s wealth.  43 years later, President Obama has mastered the art. Obama is not unique among frees-pending politicians, of course. He merely typifies the breed.

Washington’s something-for-nothing ethos has escorted our national finances so far into the extremes of fiscal lunacy that we taxpayers are left with little more than fantasies and happy tunes. The national health care initiative, for example, like so many of the initiatives that preceded it, promises to save us all money, but only by costing hundreds of billions of dollars first.

We doubt this math will work.

Maybe the health bill is great legislation, but it is wacky economics. And therein lies the problem. Noble ambitions cost money and no one wants to pay for them. So we end up with lots of lots of well-intentioned programs that the country cannot possibly afford.

That’s when things get really interesting… and perverse. When we can no longer afford to finance our own social programs, we must rely upon the kindness of strangers.  And we would be foolish to expect any measurable kindness from the strangers who are buying our Treasury bonds.

Our foreign creditors simply want to receive the interest and principal payments we have promised them. They couldn’t care less about whether we Americans can maintain funding for food stamps or free school lunches or unemployment benefits or the National Park Service. And our creditors certainly couldn’t care less about whether we Americans can continue doling out tax credits to homebuyers, subsidies to Amtrak or bailouts to General Motors.

Our creditors simply want to receive full payment at maturity. In recent history, this simple fact has inspired no great consternation here in the States. That’s because our largest creditors would simply take their proceeds from maturing Treasury securities and buy new ones. Lately, however, foreign creditors have modified their investment behavior. They are reducing their purchases of Treasury securities. Maybe that’s why interest rates have been edging higher along the entire Treasury curve.

So far, the falloff in “indirect bids,” the category that includes foreign central banks, has been fairly modest. But remember, America’s borrowing needs are soaring, not falling.

The waning foreign demand for Treasury securities is probably nothing to worry about…yet. And besides, didn’t the Treasury just book an $8 billion profit on its “investment” in Citigroup. That’s a good thing, right?

“Dear Mr. Fantasy, play us a tune. Something to make us all happy…”

Eric Fry
for The Daily Reckoning