So much for the "risk-free investment"

Last week the default risk on U.S. Treasury bonds doubled. This week it has increased still more. This risk is measured by credit default swaps (CDS's), which insure investors against bond defaults. Of course this risk, contrary to a very stupid but very popular myth among U.S. economists, has never has been zero: there is no such thing as a "risk-free" investment. Anybody with a modicum of knowledge of economic history knows (in other words, alas, very few people know) that over historical timeframes government defaults on their debt, both overt and covert (through inflation), are common. Indeed over >20 year timeframes even stocks are less risky than government bonds, but for shorter timeframes bonds are, in nominal terms at least, normally far less volatile than stocks. Reuters observed,

The cost to insure Treasury debt with credit default swaps jumped to 16.5 basis points, or $16,500 per year for five years to insure $10 million in debt, from 8 basis points on Thursday, an analyst said....Debt protection costs on U.S. government debt are now higher than those for Germany, which trades at 9.5 basis points, and are trading at similar levels as Japan and the United Kingdom, which are around 16.5 basis points, the analyst said.

So far this week it has increased to 22 basis points for five years of default insurance. Bloomberg observes the probable cause of this increased risk:

Treasury Secretary Henry Paulson said July 13 the U.S. would seek authority from Congress to buy unlimited equity in so-called government-sponsored enterprises Fannie Mae and Freddie Mac and to extend them as much credit as needed. The move effectively put the weight of the treasury behind the companies, which own or guarantee almost half of the $12 trillion in U.S. home loans outstanding. The Federal Reserve also agreed to lend directly to Fannie Mae and Freddie Mac.

In other words, not only is the Federal Reserve now playing John Law by printing dollars to buy bad real estate investments, but now the federal government has declared its willingness to get in on the act in an even bigger way.

Note that default risks measured by CDS's do not include the risks of what are effectively ongoing de facto mini-defaults on all dollar-denominated debt due to inflation, risks that have been rising substantially over the past ten years, as reflected by the prices of the main insurance against inflation risk, commodities.

In the U.S. there have been a number of de facto inflationary defaults on U.S. federal debt -- the Revolutionary War (Continentals), Civil War (Greenbacks), Great Depression (resetting the gold conversion rate). The largest de facto default occured in the 1970s (float and inflation) and we are in the midst of one currently (float and inflation) that may turn out to be even larger. But the only overt default on "national" governmental debt in our 232-year history was that of the Confederate States of America in the throes of losing its war against the (rest of the) U.S.

Compared to the 1970s, oil is responding faster and more completely to Fed inflation, and oil remains a crucial part of our industries. As a result, the havoc caused by high oil prices may put a stronger limit this time on how quickly the Fed shredder can dispose of the real value of U.S. paper. If the degree covert default is thus limited, but the risk of default increases, the risk of overt default rises. The market last week seemed to be saying that the Fed may be starting to approach some such limit, perhaps a political limit due to hysteria over gas and food prices, on its practical ability to inflate the U.S. currency. In other words, markets may be saying the Fed cannot necessary resort to a Weimar- or Zimbabwe-style hyperinflation -- that if federal financing gets to that extreme U.S. politicians may choose to overtly default instead.

The city of Vacaville, California recently overtly defaulted on its debt, as have a number of other municipalities in the U.S. Worldwide overt defaults on government debt during the second half of the 20th century usually occured in Third and Second World governments (e.g. Russia in the 1990s), but there were a large number of overt government defaults in governments of all sorts early in the Great Depression (indeed these were a leading cause of that economic disaster), and in prior centuries government defaults wherever governments borrowed money, including leading nations in Western Europe, were common. Mature democracies with central banks that can engage in covert defaults (inflation) have had a far lower rate of overt defaults than other forms of government or democracies without central banks.

That the risk of overt default has now substantially increased means that investors are are recognizing that the unprecedented revenue-generating combination created in 1913 -- IRS (which has been able to reliably collect $trillions per year) and the Federal Reserve (which has been reliably able to enage in covert gradual defaults by printing money to buy $trillions worth of Treasury debt per year) -- is not indestructible. U.S. Treasuries, like every other investment, have never been risk-free and they've just gotten quite a bit riskier. Nevertheless compared to historical averages for governments, the risk of overt default by that powerhouse 1913 duo is pretty low. With very high probability they will keep paying interest and principal on their debt while me and my fellow U.S. taxpayers will keep having to shell out substantial sums to the IRS every year, and see our dollars frittered away every year, that this dynamic duo may continue to uphold "the good faith and credit of the United States" while the discreditable activities, often done in rather poor faith, of the federal government in "redistributing" wealth, attacking foreign countries in very expensive ways, promising vast pensions that it cannot pay, promising health care that it cannot fund, and forcing private businesses to do bizarre things (like take on vast amounts of moral hazard by lending into "underserved communities", and to actually fund those government medical mandates) continues.

In related financial news, what I've been predicting for a long time would happen is starting to happen: the U.S. dollar inflation indices PPI and CPI, despite being under-reported compared to prior decades (due to a radical revision of the formulae), are starting to rise to 1970s rates of increase. Sticky prices in manufactured goods and services, as well as wages (the stickiest prices of all), are playing a very long-term game of catch-up to commodity prices, and especially to gold and oil, which are leading indicators of inflation. I continue to predict 5%-15%/year increases in the CPI and PPI, and probable "stagflation" (inflation plus recession, which according to Keynesians is not supposed to happen), until such time as they catch up to the commodity price increases. Commodity prices themselves, despite their stratospheric levels, may continue to increase as the Federal Reserve tries to deal with large government deficits and the fallout from the awful moral hazard in our housing markets, a moral hazard in no small part due to previous inflationary policy by the Fed itself combined with the outrageous pressures from U.S. politicians to relax lending standards in order to get people to buy houses in "under-served communities" and naive "real estate always goes up" bubble behavior on the part of the real estate industry and house buyers. The Fed-and-IRS-backed political franchises Freddie Mac and Fannie Mae have been moral hazard disasters waiting to happen. Inflation is still by far the largest problem these federal activities are causing; the doubling of the overt default risk is just an interesting related blip. My recommendation: keep only spending money, not savings or long-term investments, in dollars or dollar-denominated debt, and keep trying to unstick your own wages by frequently asking your boss for a big raise.

On the increase in Treasury default risk H/T to Alex Tabarrok.