U.S. Treasury market a sinking ship

We separate the concepts of Federal Reserve Notes (“U.S. dollars”) and U.S. Treasury bills, notes, and bonds (“Treasury securities”) at our peril. Both are government liabilities (debts) and must be understood as such. “Dollars” are certificated, non-interest-bearing, face-amount notes, whereas U.S. Treasury securities are either book-entry discount notes (“bills”) or book-entry, interest-bearing notes (“notes” and “bonds”).

Technically, the U.S. central bank (the “Fed”) issues dollars, while the U.S. Bureau of Public Debt issues Treasury securities, but this is really a distinction without meaningful difference. Both are backed by the full faith and credit of the U.S. government. Both are issued and redeemed by the Fed. To “redeem” Treasury securities is merely to exchange one form of government liability for another. That is, no one can redeem Treasury securities for anything other than another liability of the U.S. government.

When we say that the dollar is the world’s “reserve currency,” we misspeak. The world’s reserve currency is the *combination* of dollars and Treasury securities. People hold reserves in dollar form only to the extent needed for immediate expenditures or because they find it impractical to hold reserves in the form of Treasury securities. Otherwise they hold reserves in bill, note, or bond form or because they find it impractical to hold reserves in dollar form. Holders of reserves in dollar form receive no interest thereby. Holders of reserves in the form of Treasury securities earn interest, though at the cost of liquidity. Even the interest payments are nothing more than additional liabilities of the U.S. government.

Whether held in the form of dollars or Treasury securities, the sole purpose of holding reserves (including interest received on those reserves) is for the future purchase of other goods or services. A “price” is nothing more than a ratio between the good or service in question and the reserve currency in dollar form. To accept the U.S. as issuer of the world’s reserve currency is to accept implicitly that the U.S. government will manage responsibly the dollar price of goods and services, both now and into the foreseeable future.

It should thus be obvious that arguments to the effect that Treasury securities are free of default risk because the Fed can print unlimited quantities of dollars with which to redeem them are spurious. No one relies on a reserve currency because it can be created in unlimited supply or debased at will. Quite the contrary: the implicit bargain between the holder and issuer of the reserve currency is that the issuer will behave responsibly and thereby protect the interests of the holder with respect to the purchase of future goods and services. Once holders begin to doubt the intentions of the reserve-currency issuer, they will begin to seek substitute currencies they calculate will better protect their future interests, or liquidate their reserves in favor of other assets, causing the dollar prices of those assets to rise.

The dollar prices of Treasury securities reflect in part the demand for U.S.-issued reserves and in part differences between supply of and demand for reserves in dollar form and reserves in security form. Thus, dollar prices for Treasury securities can easily transmit a false signal to reserve holders – disastrously so. To the extent they focus on the dollar prices of Treasury securities to the exclusion of the dollar prices of other goods and services, they may miss what is in fact a massive redemption of the reserve currency in favor of other assets.

When a large ship is sinking, fleeing from lower to upper decks is generally a good strategy and may forestall death, but cannot save the ship. Ultimately, if passengers recognize the danger and can do so, they have to abandon ship in order to save themselves, because when all is said and done, upper and lower decks alike will be under water. Those seeking a safe haven in Treasury securities will not escape the failure of the U.S. as issuer of the world’s reserve currency. Sooner or later, most will realize that holding Treasury securities is a disastrous strategy and that reliance on any fiat currency is folly. When that happens, prices of U.S. Treasury securities will fall far below their par values and issuance of new securities will become impossible. Only vultures, seeking to buy U.S. debt for pennies on the dollar in the hope of an eventual windfall, will remain.

For the time being, the U.S. Treasury market is best conceived as a battleground. The Fed is fighting to preserve the reserve status of Federal Reserve Notes and U.S. Treasury securities in the face of incontrovertible evidence that people the world over are seeking substitutes. The Fed knows that if Treasury prices break lower, the battle is lost. So it is intervening directly in the market in an effort to maintain an appearance of normalcy. How long the Fed will fight this battle I do not know, but I would guess that within two to five years, the Treasury market will see substantially higher yields.

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