We won't be able to say we weren't warned. Continued huge federal budget deficits will eventually mean huge increases in government borrowing costs, Erskine Bowles, co-chairman of Barack Obama's deficit reduction commission, predicted this month. "The markets will come. They will be swift, and they will be severe, and this country will never be the same."
Bowles is talking about what the business press calls bond market vigilantes. People with capital are currently willing to loan money to the federal government, by buying U.S. bonds at low interest rates. That's because interest rates are generally low and because Treasury bonds are regarded as the safest investment in the world.
But what if they aren't? What if investors suddenly perceive a higher risk and demand a higher return? That's what Bowles is talking about, and there are signs it may be starting to happen. The Federal Reserve's second round of quantitative easing -- QE2 -- was intended to lower the interest rate on long-term bonds. Instead, the rate has been going up.
The federal government still seems a long way from the disaster Bowles envisions. But some state governments aren't.
California Gov. Arnold Schwarzenegger came to Washington earlier this year to get $7 billion for his state government, which resorted to paying off vendors with scrip and delaying state income tax refunds. Illinois seems to be in even worse shape. A recent credit rating showed it weaker than Iceland and only slightly stronger than Iraq.
It's no mystery why these state governments -- and those of New York and New Jersey, as well -- are in such bad fiscal shape. These are the parts of America where the public employee unions have been calling the shots, insisting on expanded payrolls, ever higher pay, hugely generous fringe benefits and utterly unsustainable pension promises.
The prospect is that the bond market will quit financing California and Illinois long before the federal government. It may already be happening. Earlier this month, California could sell only $6 billion of $10 billion revenue anticipation notes it put on the market.
Individual investors have been selling off state and local municipal bonds this month. Meredith Whitney, the financial expert who first spotted Citigroup's overexposure to mortgage-backed securities, is now predicting a sell-off in the municipal bond market.