THE BLOG
07/12/2009 05:12 am ET Updated May 25, 2011

Fiscal Lessons from Moscow?

You know we have a problem when Moscow begins searching for an alternative to investing in U.S. Treasury notes. On 10 June 2009, the Russian central bank warned it plans to reduce Moscow's $140 billion investment in our national debt. Rather than continue to fund our profligate spending, the former Soviet Union is now looking to place $10 billion in International Monetary Fund (IMF) bonds and otherwise further diversify investment of Russia's $400 billion foreign exchange reserves. Not coincidentally, Brazil has declared an intent to invest a similar amount in the IMF. And China has said she is interested in putting $50 billion in the IMF's hands.

None of this should come as a surprise. Washington's foreign creditors have been expressing concerns about our mounting budget deficit for months. One suspects some of this rhetoric was dismissed as little more than background noise. A quick glance at the monthly Treasury report on foreign holders of our federal debt suggests Moscow and Beijing are busy crying wolf. Between September 2008 and March 2009, Russia's disclosed investment in U.S. Treasury notes grew from $99 to $138 billion. During the same time period China's reported holdings in this area grew from $618 to $767 billion.

At first blush this expanded interest in U.S. Treasury notes appears an expression of faith in Washington's fiscal practices. I contend it was little more than a rush to avoid further losses associated with investments in the world's equity markets. Rather than continue to suffer negative returns, investors of all stripes fled to the safest place they could find -- in this case, Washington's debt. The result was somewhat predictable. The yield on short-term Treasury notes dropped to almost zero, and 10-year notes were only returning 2.035% in December 2008.

Now for the bad news. Investors have begun to realize they can earn greater returns by taking their money elsewhere. The predictable result? Rising interest rates on U.S. Treasury notes. By 10 June 2009, the 10-year Treasury notes were promising a return of 3.99% -- and there are rumors the yield could climb further as we seek a means of continuing to lure foreign investors to our shores. Why? As one hedge fund manager told Bloomberg News, "The bigger picture is people are worried there are too many [Treasury notes], and that no one is even making a pretense of getting the fiscal deficit under control."

I agree with the first part of this statement, but would have to express reservations about the latter half...Washington has at least offered a "pretense" concerning our mounting deficit. On 8 June 2009, President Obama declared he is going to seek the reestablishment of rules requiring lawmakers to pay for new initiatives, or face automatic spending cuts. This revival of the pay-as-you-go system that facilitated the Clinton administration's successes on the budgetary front would forbid Congress from expanding entitlement programs -- Medicare or Social Security -- creating new entitlement programs, or cutting taxes unless the cost is covered via cuts elsewhere or through establishment of new revenue enhancement streams.

Sounds good to me -- and likely to Beijing and Moscow -- until one takes a closer look at the president's proposal. Unlike the pay-as-you-go system employed during the Clinton era, Obama's proposal comes with giant loopholes. The Obama plan only applies to new or expanded entitlement programs -- not existing sinkholes like Medicare and Social Security. Furthermore, the proposed plan does not apply to discretionary spending or any of the Bush tax cuts that Washington might chose to extend past 2010. As the Washington Post notes, the current Obama plan would thus actually allow annual budget deficits to increase by more than $3.5 trillion during the coming 10 years.

That's right, $3.5 trillion...and we wonder why foreign investors are now seriously discussing plans to divest from U.S. Treasury notes. Ah, I see skeptics in the audience shaking their heads in disagreement. Governments, they argue, may discuss moving their cash elsewhere, but there are few viable options. Well if you're seeking easy access to money in a rapid manner -- the skeptics are right. But this argument begs the issue of how much of a foreign exchange reserve is really necessary. The IMF suggests maintenance of an account equivalent to three months of imports, while others have argued these reserves should be large enough to cover all foreign liabilities coming due over the coming year. Suffice it to say Washington is nowhere close, nor is Germany, France, Italy or the United Kingdom.

In fact, it appears the IMF recommendation is overly conservative. A nation's foreign exchange reserves only need be large enough to cover short-term currency stabilization and liquidity management. The rest of the money is available for investment elsewhere -- and as we have seen with sovereign wealth funds or Harvard and Yale's endowment funds, that is not in U.S. Treasury notes...particularly when our current fiscal policies are apt to drive inflation at a rate that renders any earned interest moot.

So where is the money likely to go? To answer that question I suggest we reexamine where the endowment management teams at Harvard and Yale intend to invest in the future. While these endowments have also suffered during the current global recession -- their investment models remain attractive to governments weary of low-yield U.S. Treasury notes. As such, we can expect the flight from T-notes will be accompanied by an unprecedented level of diversification that will bolster commodities, emerging markets, private equities, real estate, and foreign industries.

I do not expect a sudden rush to Wall Street. As the Wall Street Journal reported in March 2008, "Stocks, long touted as the best investment for the long term, have been one of the worst investments over the last 10 years." Why? As one analyst told the Journal, Wall Street was attractive when the U.S. offered a 4% annual economic growth pattern. We are a long way from that in 2009 and probably in 2010. In short, don't expect our foreign creditors to suddenly seek to bailout corporate America.

Moscow is right; Washington must get its fiscal affairs in order. The slow shift in foreign investment patterns suggested by statements coming from Russia and China are a further sign the global financial system is evolving -- and barring real corrective action the United States is about to be removed from the top of the food chain.