On Borrowed Dime

Story Highlights:

• We'll see some form of additional stimulus in 2009. It's uncertain how exactly the stimulus will affect the economy, but it'll certainly cost the government a pretty sum.
• The government will likely foot the stimulus bill (and other spending) by increasing the supply of Treasury bonds.
• Low borrowing costs and potential returns on investment make government debt expansion a sensible solution.

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Take a stroll around US media sites and you're bound to bump into stimulus plan news. The stimulus is everywhere—quite a feat for something moving slower than sap. Making up for its sluggish pace is its steep price—currently $819 billion and counting. The American public will see some giant form of additional stimulus in 2009. Thought it's uncertain how exactly the stimulus will affect the economy (its shape, size, and scope are still debated by the Senate), it'll certainly cost the government a pretty sum. How will the government foot the bill? Likely by even greater borrowing.

The US is no stranger to borrowing—selling Treasury paper enables the government to finance trillions in the red. And it's likely the government will issue more Treasuries of all maturities to finance the stimulus (this on top of TARP and existing deficit spending plans). Keep in mind, the government's borrowing costs remain very low—around 2.9% for 10-year Treasuries and 3.7% for 30-year.* At some point, those costs (Treasury yields) will rise as supply increases, though the price elasticity for Treasury bonds is difficult to guess. It would probably take a vast amount of new supply to move yields much, considering yields remained low—even falling a bit recently—despite 2008's $1 trillion-plus incremental issuance of new Treasury bonds. Said another way: We could afford an even more expensive stimulus plan.

How is that possible? It's key to remember the US government doesn't borrow for borrowing's sake—that money somehow, some way, becomes a profitable asset. In a hypothetical scenario, say the government sells 10-year Treasury bonds at a cost of 3% and raises $1 trillion above what covers any current spending plans. The government then does what TARP was initially intended to do and uses those proceeds to purchase riskier assets like corporate bonds, mortgage-backed securities, whole loans, etc. from banks and other troubled entities. Assuming the government holds the assets to maturity, the assets as a package might yield annual returns of 10%. This means annually, the government pays $30 billion to borrow and receives $100 billion in investment income—net annual profit of $70 billion. Meanwhile $1 trillion in risky assets are removed from banks' (and others') balance sheets, allowing them to make new loans, fund acquisitions, bolster capital bases, etc. And for such a pool of assets, the average default rate works out to be, well, average. Plus, the basic hold-to-maturity value of so-called "toxic assets" is higher than what the government can buy them for right now—in some sense, it's a once-in-a-lifetime arbitrage opportunity for those with the wherewithal to do it (and the government has that wherewithal).

The US government may be working on borrowed dime—one that's growing by the minute. But that shouldn't be cause for investor concern. If the government uses its low borrowing costs to stabilize markets and stimulate economic growth, isn't that a sensible solution?

*Source: Bloomberg, as of 2/4/2009