Milken Institute Review 2Q10 Page 22

The Milken Institute Review

and John McCain failed to offer plausible
plans for stanching the cash hemorrhage.
Obama promised to extend most of the Bush
tax cuts and to enact a host of other populist
tax breaks and spending programs. McCain,
for his part, was more restrained on spending,
but the enormous tax cuts he proposed would
have blown an even bigger hole in the budget.

The candidates were plainly convinced that

there was no gain to be had in specifying how
they would manage ongoing deficits.

President Obama has since said the right

things (though in general terms) about the
long-run fiscal problem, and he did make the
gesture of supporting a freeze on some forms
of spending in his 2010 budget. But there are
good economic reasons for staying deep in
the red in the near term big deficits are
needed to recover from the recession and
even more potent political reasons to tread
cautiously in this arena.

I haven't been in the relevant room since I

worked in Clinton's Treasury, but I can imag-
ine a discussion among Obama's advisers

going something like this:

Mr. President, if you raise taxes or cut

popular programs, you and your party will
be defeated in the polls and the bad guys will
take over. The bad guys do not share your pri-
orities and they do not care about the deficit.

Therefore, you cannot effectively deal with

the deficit; all you can do is undermine your
agenda.

Conclusion: it is impossible to deal with

the deficit, so don't even try.

I suspect that Republicans willing to enter-

tain a compromise on taxes to reduce the def-
icit are hearing a similar message. Certainly
McCain, whose program was fiscally respon-
sible when he ran in the Republican presiden-
tial primaries in 2000, became convinced that
prudence had no political traction in 2008.

So if the pretzel logic of pandering politi-

cians prevents leadership on the issue, what
about the financial markets? Shouldn't they
start pricing the risk of fiscally driven infla-
tion into interest rates in their bids for freshly
minted Treasury bonds? Probably, but I'm
not certain they will. Remember, the markets
are led by the same geniuses who staked the
future of their firms on the premise that
housing prices could only go up.

There's an analogy between the market for

government bonds and the market for mort-
gage-backed securities. Specifically, it is tempt-
ing to assume that the U.S. government will
always be able to roll over its debt when the
debt comes due. And while endless deficits
imply growth in the amount of interest that
must be paid out as a portion of tax revenues
and GDP, the payments will remain manage-
able for decades at a real interest rate of 3 or

4 percent. So bond buyers can be lulled into

believing that, while the gravy train may
someday stop, there's still time to profit from
the ride.

This creates the potential for a classic bub-

ble in the market for government bonds. As
long as interest rates remain low, the bonds
are safe which seemingly justifies the low
rates. The bubble bursts when something
causes investors to worry about the risk of de-
fault, and the prospect becomes self-fulfilling.

A small perceived risk that Washington

won't make timely payments on the debt
would cause investors to demand higher inter-
est rates on new bond issues. But higher inter-
est payments mean higher deficits and a

greater risk that the Treasury would be forced
to default on its obligations which in turn

would increase interest rates further, creating

a vicious cycle. In the extreme, investors might
decide overnight that the government couldn't
possibly repay its debts and lending would
skid to a halt. (The subprime mortgage mar-
ket in 2008, flourishing one day and dead the

c ata s t r o p h e