The Secretary makes reports Whene'er the House commands him But for their lives, some members say They cannot understand him. In such a puzzling case as this What can a mortal do? ~Tis hard for one to find reports And understanding too.
-- John Fenno offers a poetic comment on Secretary of the Treasury Alexander Hamilton's complex reports on the public debt, as cited in the "Gazette of the U.S." on February 23, 1793.
Against the advice of its private advisory panel, the U.S. Treasury has announced plans to scale back the maturity schedule of federal debt. The Treasury will cut the size and frequency of the 30-year bond auction in half, discontinue the seven-year note, and shift new borrowing to instruments with maturities of three years or less.
The new policy originates in a Democratic Party study group and with the advisers to President Clinton. They argue that issuing debt at present short-term interest rates of approximately 3% to 4% will result in an interest savings to the U.S. government. Critics say that the policy increases the interest rate risk assumed by the federal government and that any interest savings may only be temporary.
These changes in the Treasury debt structure are significant for financial markets. Indices that measure the composition of Treasury debt will have to be adjusted to reflect the Treasury's decision. Financial markets will focus on instruments other than the 30-year bond as a benchmark. In all likelihood, the 10-year Treasury bond will emerge as the reference point for longer debt.
Other long-term obligations should quickly fill any gaps opened through the adoption of this policy. Federal agencies will probably initiate additional financing in the long end; so will the private sector.
The President's original budget projections estimated that the interest savings from switching the government's emphasis to shorter-term debt would be $16 billion; last Friday a Treasury official acknowledged they would be less. The Congressional Budget Office will shortly release its estimate, which is expected to be much lower. Private estimates of the savings range to a low of zero.
Some argue that the Treasury's shift to shorter maturities will ease the "crowding out" effect on the long-term corporate bond market. That is not necessarily so.
The risky and riskless debt markets are segmented; that is why credit quality spreads expand and contract during the business cycle. Investor perceptions about the substitutability between risky and riskless debt change continually over time.
The obvious solution to "crowding out" is to reduce Federal borrowing at all maturities by lowering the federal budget deficit. Merely restructuring debt maturities will not alleviate a "crowding out" problem caused by fiscal irresponsibility.
Municipal markets use Treasury securities as reference points for pricing various instruments. State and local governments also need riskless longer-term instruments to fund specific obligations such as escrows for advanced refundings or payment streams for long-term payment liabilities like landfill closure costs.
Diminished availability of long treasuries poses a problem for state and local governments. They will have to consider alternatives to U.S. treasuries both as an investment medium and as a pricing reference. Are state and local governments equipped for this task and its inherent risk? Do statutory investment restrictions have to be amended?
Some contend that the shift to shorter-term maturities will give the U.S. government a greater incentive to promote price stability. Here we enter the domain of the Federal Reserve, America's front-line inflation-fighting institution.
In order for the Fed to pursue price stability it must be granted independence from political risk. It should not be bludgeoned by the Congress or the President.
All bond market participants know that inflation is attractive to debtors because it cheapens the cost of paying future monetary liabilities. The sheer size of the federal financing requirement makes the U.S. government the largest debtor of all. Politicians are notorious for succumbing to the attraction of inflation. The Fed's independence is now at risk from legislation sponsored by Sen. Paul S. Sarbanes, D-Md., and Rep. Henry B. Gonzalez, D-Tex.
All eyes will be on the Fed as the markets adjust to a new Treasury debt structure. The Fed faces excruciating political pressure to preserve the short-term interest rate at 3%.
While the Treasury issues greater amounts of short-term notes and bills, the markets will closely observe the degree to which the Fed monetizes federal debt in order to maintain the 3% fed funds rate. If the markets consider the rate of monetization excessive, then all other interest rates will rise, even though the Fed anchors the yield curve with a 3% fed funds rate.
Financial market players are not dumb. They know that the monetization of federal debt by the Federal Reserve eventually results in inflation and higher interest rates.
One measure of the market's expectation for future interest rates is the forward rate derived from the current yield curve. Forward rates are geometric averages of current rates on the yield curve. They indicate that much higher interest rates could develop in the near future. (See chart).
The Federal Reserve can allow the short-term interest rate to rise. But how will the Clinton administration's policy look if a rise in interest rates ensues shortly after the Treasury's debt structure announcement? What will happen in the financial markets and with government policy when the 3% rate suddenly becomes 3.25% or 3.50%? At what interest rate will the Clinton administration and the Treasury admit a policy error? Would they change the composition of a refunding? At that time, would interest rates be even higher than they otherwise might have been?
This Treasury policy must be examined for two other reasons. The first concerns how the decision was made. In her announcement, assistant Treasury secretary Deborah Danker stated that the Treasury ignored its advisory panel, the Treasury Borrowing Committee of the Public Securities Association. Congressional investigators should ask the Treasury secretary and his staff why they ignored the advice of their advisers and. furthermore, what the advisers recommended. That information clearly ought to undergo public scrutiny.
Second, the Treasury announced that it had based the policy shift on an internal study. Danker said that the Treasury would not release the study to the public. How can the government of the United States alter the debt structure based on a study that is kept secret from those taxpayers who ultimately bear the burden of the public debt?
Federal financial matters have been discussed in the open throughout the history of our republic. The Clinton administration has failed in its obligation to permit our citizens to know how and why they are making decisions about the public debt. Alexander Hamilton must be rolling over in his grave.
David R. Kotok is chief investment officer of Cumberland Advisors, a Vineland, N.J., money management firm; Matthew L. Forester is a research associate with the firm.