Tyler Cowen writes,

When it comes to the mortgage agencies, there is no real choice but to bail out the debt holders. The alternative is a run on the dollar and collapse of faith in U.S. government securities and the end of the world.

Think of the U.S. government as the world’s biggest hedge fund. One thing a hedge fund does is engage in credit arbitrage. When you can borrow risk-free, you can make a profit holding risky assets. That is what Congress is hoping will happen with the Freddie-Fannie bailout.

We have grown accustomed to the assumption that the risk of default of U.S. government liabilities is zero. That in turn allows Congress to act like the biggest hedge fund on the block.

But over a ten- or twenty-year horizon, are Treasuries really default-free? Or could the U.S. government suffer a loss of confidence among investors, as happened to Fannie Mae and Freddie Mac?

Consider the long-term obligations of the U.S. government: Social Security, Medicare, the Pension Benefit Guaranty Corporation, public employee pension plans. Add to those the risks of the securities that the government is effectively choosing to guarantee in the Bear Stearns merger, the Freddie-Fannie prop-up, and other steps that are being taken or will be taken in the mortgage and financial market. It seems to me that in order to achieve short-term stability we are piling on long-term fragility.

A lot of my portfolio is in inflation-indexed Treasury securities. At some point, though, I am going to start thinking that there is some default risk in those securities, and I will be looking for a new risk-free asset. My guess is that the closest thing will be a highly diversified portfolio, one that includes a lot of foreign securities.

There is a reason that Tyler calls this scenario “the end of the world.” If people do not have confidence in the long-term financial stability of the U.S. government, the chances are that they will not have much confidence in the long-term stability of U.S. corporations, and so you would see a collapse of long-term investment altogether.