08/29/2009 05:12 am ET Updated May 25, 2011

U.S. Treasury Sweating Bullets over Financing Swelling Deficits

A Treasury auction earlier in the week for two-year debt drew a lacklustre response, setting the stage for what followed a couple of days later, when an auction for five-year debt was conducted. To say that the results were below expectation would be a severe understatement. To convey the importance of what occurred , take the words of William O'Donnell, who heads U.S. Treasury strategy at RBS Securities in Greenwich Connecticut:

"It was just a horrendous result, it was the weakest bid-to-cover since September 2008, and by my numbers it was the biggest tail since February 1993. It was just a very, very weak result."

The auction sold $39 billion in 5-year debt at yields far above what had been anticipated, in the process sinking the value of Treasury bonds. This occurrence is a harbinger of the growing fiscal dangers that are now a full component of the ongoing Global Economic Crisis.

The warning is crystal clear. Before the onset of the current financial and economic crisis, the U.S. had structural deficits measured in the hundreds of billions of dollars. Now, however, the fiscally toxic combination of Wall Street bailouts and economic stimulus programs requiring massive public borrowing have created the unprecedented phenomenon of multi-trillion dollar deficits, equal to 15% or more of the entire United States GDP. If would be bad enough if only the U.S. was engaged in such staggeringly high levels of public borrowing. However, virtually every major economy on the globe, including China and Japan, America's two largest creditors, are also engaging in large deficit-financed stimulus programs. At a time when the U.S. requirement for credit is ballooning, its traditional sources of such largesse are under fiscal pressures of their own. Only by elevating yields on its Treasury bills will the United States be able to attract interest in its ever-expanding menu of Treasury auctions.

Raising yields on Treasuries will greatly increase the cost of public borrowing, thus adding to the fiscal imbalance confronting Washington. The growing unease regarding the size of the U.S. deficit by both sovereign wealth funds and private investors, and the real possibility that Washington will lose its coveted AAA status, has implications beyond Treasury yields. Policy decisions that address the nation's fiscal imbalance may become essential in order to maintain interest in purchasing U.S. public debt instruments. This would mean budget cuts and tax increases, which would greatly increase the likelihood of a double-dip recession.

Given the track record of the U.S. political establishment, I suspect that they will delay a serious deliberation on the fast-developing fiscal crisis confronting the public finances of the federal budget until it is too late to avoid the most critical consequences. What the recent Treasury auction demonstrated is that Washington may be fast approaching a situation where insufficient demand exists to satisfy the government's appetite for borrowed money. What happens then? The most likely result would be monetization of the debt by the Federal Reserve. In effect, the Fed would conjure money out of thin air, and use this newly printed stack of greenbacks to purchase Treasuries that are left behind by global investors and sovereign wealth funds. Should that unhappy day arrive, you can lay the U.S. dollar to rest, for it will not be worth the paper it is printed on.