Why are T-Bills so popular

One of the puzzling aspects of the current economy is the soaring demand for US treasury bonds. On the face of it, T-Bills seem like a pretty terrible investment. The yields are low and given the massive government and current account deficits being run by the United States, it is highly likely that the dollar will lose value relative to other currencies.

But these loans aren't investments, they are insurance. With the global economy in free fall nobody knows how bad things could get. There is a non-zero probability that we could be witnessing a true economic collapse. The sort of era defining event that will signal the end of the 500 year march of human progress and plunge us into a new dark ages. How will we know when it's time to bust out the old amour suit. A good guess will be when treasuries fail. In other words if the US government defaults, we are all fucked. The only assets that will be worth anything will be shotguns and canned beans.

Lets say things don't get that bad, there is still a long way to fall. If the economy continues contracting at its current rate, by the end of 2010 things will be as bad as the 1930's. An economic collapse of that magnitude will have profound political consequences. Which brings us back to the original topic of the post.

In a climate of extreme uncertainty, the long history of stability is a unique asset of the American economy. The Euro is the most obvious rival currency to the dollar, but with less than a decade of experience the Euro has never survived a severe crises. If this recession hits the depths of the 1930,s politicians in hard hit countries like Spain and Ireland will be under intense pressure to break free of the Euro. During the great depression, countries that abandoned the gold standard benefited immensely from their devalued currencies.

Developing, countries don't offer better security prospects. It is hard to think of a developing country whose economic and political stability wouldn't be threatened by a severe depression. The communist party is the third largest party in India's parliament and the nationalist BJP is the second largest. It is easy to imagine a severe downturn tipping the balance of power towards these parties at the expense of international investors.

Latin America has a long history of socialist governments taking power and appropriating private property. It is not hard to imagine these elements gaining strength in countries such as Brazil, Mexico and Argentina. Africa and the Middle East are considered risky places to invest for too many reasons to list here. It is uncertain if the Chinese government can maintain stability through a severe downturn.

That leaves the US and the other wealthy English speaking countries as the most likely economies to survive a severe downturn. The catastrophe in Iceland demonstrates the danger of lending too much to a small economy. Given the quantity of money looking for a harbor it is possible to imagine international capital overwhelming a country such as Canada or Australia. Simply put it is possible to imagine the US economy surviving a complete meltdown in Canada, but there is no way Canada survives a collapse in America.

So what does this all mean for the future. As long as complete systemic collapse remains a real possibility, investors will be rushing to loan money to the US government. But as investors gain confidence that recovery is in sight demand for American debt will dry up. One sign that a recovery is on the horizon will be a decline in the dollar relative to other currencies. As the economy rises from the grave the dollar will steadily weaken.

This should be encouraged. One of the driving forces behind global instability has been the huge amounts of foreign capital entering the US economy and the countervailing large trade deficit that Americans have run. If we emerge from this crises with a more balanced global economy that would be a good thing.