There is increasing chatter of the great “bond bubble” as U.S. Treasury bonds surge ever higher and deflation fears rise. This is just one more myth that has persisted in recent years (decades really) due to mass misconception of the way the bond market actually operates and this propensity to label everything as a “bubble”.

Before we dive into the real meat of the argument it’s important that we define what a market “bubble” is. A “bubble” occurs when market forces combine to generate a highly unstable position. This results in the system entering an extreme disequilibrium and ultimately failure. The causes of this “bubble” (or extreme disequilibrium) can be many – though primarily psychological any number of exogenous factors can contribute to the instability of the system (government policy for example). The psychological aspect of a bubble is well explained by analysts at BNP Paribas:

“When interacting agents are playing in a hierarchical network structure very specific emerging patterns arise. Let us clarify this with an example. After a concert the audience expresses its appreciation with applause. In the beginning, everybody is handclapping according to their own rhythm. The sound is like random noise. There is no imminence of collective behavior. This can be compared to financial markets operating in a steady-state where prices follow a random walk. All of a sudden something curious happens. All randomness disappears; the audience organizes itself in a synchronized regular beat, each pair of hands is clapping in unison. There is no master of ceremony at play. This collective behaviour emanates endogenously. It is a pattern arising from the underlying interactions. This can be compared to a crash. There is a steady build-up of tension in the system (like with an earthquake or a sand pile) and without any exogenous trigger a massive failure of the system occurs. There is no need for big news events for a crash to happen.

Financial markets can be classified as open, non-linear and complex systems. They also exhibit emanating patterns as a result of which the “invisible hand” can be very shaky. More then 40 years ago Benoit Mandelbrot described the fractal structure of cotton prices and the emanating properties of fat tails and volatility clustering and Hyman Minsky proposed a theory for endogenous speculative bubble formation. More recently Robert Shiller and Alan Greenspan made the irrational exuberance paradigm fashionable. These all fit in the framework of Complexity Economics, which describes the properties that emerge from interacting agents. It has become clear that herding behaviour in financial markets results in positive or negative feedback mechanisms causing price accelerations or decelerations and (anti)-bubble formation, where asset prices become detached from the underlying fundamentals.”

So, we can conclude that a bubble (as it pertains to markets) is an irrational psychological market environment resulting in extreme disequilibrium and ultimately some form of systemic collapse. The keys here are extreme disequilibrium and systemic collapse. In order to have a bubble both aspects must occur. I will revisit this later.

There is ever increasing chatter of a bubble in the U.S. bond market. This idea of a bubble has become pervasive due to the myth that the U.S. government bond market can and will collapse under mounting fiscal burdens and the idea that bonds are “expensive” when compared to other assets.

Over the years investors have become increasingly concerned about the risk of sovereign default in the United States. China officially “hates” us. Alan Greenspan is frightened that the bond vigilantes are merely sleeping. Jeff Gundlach is worried that the United States is already insolvent. But are these concerns justified?

This brings us to a key question. Why don’t the bond auctions fail causing a solvency crisis in the USA?  This is best understood by studying the bond auction data in the USA. Despite constant shrieking of a potential lack of buyers in government bonds over the years we continue to see incredibly high demand for US debt. The auctions are always oversubscribed. They never fail. Why is this? Why do the buyers keep coming back for more? The simple answer is because the government puts the buyers there. The auctions are designed not to fail. How is this you ask?

The Federal government has a unique relationship with its central bank and banking system in which it can harness these entities as agents of the government to supply funding. Our monetary system is designed in such a way that there will always be a buyer of government bonds.  That is, the Primary Dealers are required to bid at Treasury auctions and they’re happy to do so because they’re acting primarily as intermediaries who are able to sell the bonds to clients so long as inflation doesn’t rage out of control and reduce the demand for government bonds making it intolerable for bond holders to hold t-bonds versus cash (which would also be losing value, but not principal).  And even in the worst case scenario where the banks couldn’t sell their inventory it’s likely that the Fed would step in to soak up the lack of demand. In other words, the Fed could directly fund the US government in a worst case scenario so worrying about a lack of funding in the USA is silly.  The USA has an inflation constraint, not a solvency constraint.

So, interest rates are primarily a function of perceived future inflation.  Interest rates in the USA won’t rise until spending far outstrips productive capacity as inflation begins to rise.  At this point bond traders will front-run the Fed who will likely begin to raise rates.  This won’t be a function of a solvency collapse though.  It will be a function of economic recovery.  The defaultistas and inflationistas get this point entirely backwards in constantly comparing the USA to Greece or Latin American nations.

Over the years the classic hyperinflationist or defaultista argument has been that China will stop buying our debt or that Japan will stop buying our debt. But the problem with this argument is that China is not our banker. Japan is not our banker. What do we care if they buy our bonds? They desire to net save with the U.S. and we happily send them pieces of paper with old dead white men on them to satisfy this desire. In recent months Chinese net holdings of U.S. debt declined:

“China’s ownership of US government debt has dropped to the lowest level in at least a year, Treasury data showed Monday, in a sign Beijing is increasingly keen to diversify out of US bonds.

The cash-rich Chinese government reduced its US Treasury bond holdings to 843.7 billion dollars in June, the lowest level since at least the same month last year, the Treasury said in a report on international capital flows.

The June data was lower than the 867.7 billion dollars in Treasury bonds held by the Chinese in May and 900.2 billion dollars in April.”

But U.S. treasury yields continue to plunge. The demand for this paper is enormous even though the largest holder of these bonds appears to be getting scared off. The demand is well beyond what the Fed even requires (as previously explained). While the Chinese fret about U.S. insolvency we’ll gladly keep sending them pieces of paper in exchange for real goods and services. If they desire to save less (which actually benefits their citizenry) then the United States will save more domestically (not all bad if you ask me). But ultimately, what they decide to do with those pieces of paper is their business and is not going to sink the U.S. economy.

Many of the arguments in favor of a bond bubble can be debunked by reviewing the hyperinflationist argument over time. For instance, in January of 2009 The Telegraph had a provocative piece titled “The bond bubble is an accident waiting to happen“. The author, Ambrose Evans-Pritchard, said the bond vigilantes were asleep and that China and Japan would soon stop funding the US need for debt:

“The bond vigilantes slumber. As the greatest sovereign bond bubble of all time rolls into 2009, investors are clinging to an implausible assumption that China and Japan will provide enough capital to keep the happy game going for ever.

It is lazy to think that China, Japan, the petro-powers and the surplus states of emerging Asia will continue to amass foreign reserves, recycling their treasure into the US and European bond markets.”

The only thing that appears lazy in this whole argument (aside from the argument itself) is the bond vigilantes, who, 18 months after this piece was penned, just refuse to wake up! Unfortunately for Mr. Evans-Pritchard China has already begun reducing their holdings of treasuries and the bond yields have continued to tick lower. He went on to describe how Mr. Bernanke was about to be the cause of horrid inflation and how we weren’t at all similar to Japan:

“Investors have drawn a false parallel with Japan’s Lost Decade, when bond yields kept falling, forgetting that Tokyo waited seven years before resorting to the printing press. Mr Bernanke has no such inhibitions. He has hit the nuclear button in advance.”

Unfortunately, that nuclear option did not prove inflationary at all and we are looking more and more Japanese by the day. Although the Fed’s actions changed the composition of bank balance sheets and helped trigger a mean reverting move in some asset prices it has not caused even one iota of inflation. In fact, recent data shows that the private sector appears to be at serious risk of retrenching and could take prices down with it. In a de-leveraging cycle, the Fed has far less control over the money supply than many presume. Bernanke’s great monetarist gaffe was based on this idea that saving the banks would save the economy which would save the private sector. But that has been proven entirely false as Bernanke’s focus on saving the banks has actually translated into very little private sector good. Without a steep acceleration in borrowing I would argue that Mr. Bernanke has failed entirely. Hence, his frustrating battle with disinflation (and risk of deflation).

Some market participants have gone so far as to compare the U.S. bond market to the Nasdaq bubble. This is simply not a fair comparison. The Nasdaq declined 90% from peak to trough. If you buy a 10 year government bond and hold it to maturity you will receive your principle back in full in addition to the coupon payments. If inflation jumps from the currently low levels to 5% you will be sacrificing 2.5% per year in real terms. Certainly not a winning pick, but nowhere near what the apocalyptic results of the Nasdaq bubble were. To reinforce this point I would highly recommend reading this paper from Vanguard which nicely summarizes the risks of the current low rate environment:

“When evaluating the potential risks in the bond market, it is critical to remember exactly why bonds are an integral part of a well-thought-out asset allocation plan—to diversify the risk inherent in the equity markets. Simply put, while the fear of rising interest rates may be legitimate, a potential bear market in bonds is dramatically different from a bear market in stocks (or other risky assets). In fact, unlike stocks, where the common definition of a bear market is a 20% decline in prices, to most investors a bear market in bonds is simply a period of negative returns. And to date, the broad U.S. bond market has never experienced a –20% return. Indeed, it’s the magnitude of returns that is the key differentiator between bad periods for bonds versus stocks. For example, the worst 12-month return for U.S. bonds since 1926 was –9.2%, while the worst 12-month return for U.S. stocks was –67.6% (12 months ended
June 1932).

In another example, the worst calendar year for the broad bond market was 1994, when due to an unexpected upward shift in interest rates, the bond market returned –2.9% (in 1995, the bond market returned 18.5%). Contrast this to the experience of stock investors in 2008, when the Standard & Poor’s 500 Index lost more than –2.9% in 27 individual trading days.”

When it comes to this whole debate the most important factor is the mere reality of our economic plight. As we all know by now, we are currently confronted with the threat of deflation, 9.5% unemployment, 74.8% capacity utilization, falling home prices, durable goods orders that are more than 20% from their peak levels, rising unemployment claims, equity prices that are 30% from their peak and high historical private sector debt levels. When your options are 0% cash, unstable real estate and equity in what appears like a weak economy that 2.6% government bond doesn’t sound so bad. Perhaps not the best bet in the world, but irrational? Certainly not. As Vanguard says, when compared to the long-term growth potential of equities bonds currently look like a fairly good hedge.

So, you can see that it is not accurate to describe the U.S. government bond market as even remotely comparable to the “bubble” occurrences we have seen in other asset classes throughout history. Even at its worst “valuations” the U.S. government bond market has performed relatively well when compared to the well known “bubbles” of history.

In summary let us remember that a bubble (as it pertains to markets) is an irrational psychological market environment resulting in extreme disequilibrium and ultimately some form of systemic collapse. These characteristics are not currently attributable to the U.S government bond market. Given the economic environment (and potential outlook for equities) it is not irrational for investors to seek a very safe interest bearing asset in a time of high uncertainty and 0% interest rates. In addition, as shown in the examples above, it is highly improbable that the US government bond market will collapse as the market itself is designed solely as a monetary tool. Lastly, while bond investors might be susceptible to losses history shows that it is not accurate to imply that they are susceptible to a “collapse”. While a 10 year U.S. treasury at 2.6% might not be the world’s greatest bargain it’s entirely incorrect to argue that there is a “bubble” in government bonds. In fact, I would argue that the term is not even applicable.

Cullen Roche

Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.

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  1. first,

    I would like to answer your question if I may. The Fed is paying on reserves to protect what is left of the money market industry. If the Fed were to drop the rate to zero, money markets would be yielding negative rates after expenses. This is not to say that the Fed will this option off the table going forward. Indeed, it is still one of the tools that they have in their disposal. My I do believe however, that they will opt to instead keep buying more treasury securities and hence increasing the size of their balance sheet further before they take the FF to zero which will cause all sorts of other disruptions.

    Andrew P,

    The Fed knows that the ratio I talked about is going lower and it is the single biggest reason why they fear deflation. They will do everything to avoid this outcome. While many don’t believe this is Japan 2, the similarities are significantly more than people want to believe. It was corporate leverage there. It is household (particularly house mortgage) leverage here. The best investment you can make now is indeed to pay off your mortgage and all other debt. The problem is that if everyone is as smart as you, the money supply will collapse and the bank will have to respond by shedding assets. This is precisely the Fed’s nightmare scenario.

  2. first,

    As to your other comment on the possibility of inflation destroying the value of your 30y bond portfolio, one needs to have an inflation/deflation framework to use in forecasting. Is a major inflationary cycle possible? I think that it will take a major turnaround in consumer demand and borrowing before GDP grows at sufficient enough rates to close the ample slack that exists today. Were that to happen, then sure 30y bonds will suffer a major capital hit. Given the comment on debt ratios that I made earlier, I find a major uptick in consumer spending rather unlikely. The willingness to borrow is not there either (it is not just the banks that don’t want to lend). Between the two scenarios, I therefore see the risk of further disinflation as greater than inflation.

  3. I posted on your Seeking Alpha article, and I will add a question here.

    From what I understand, the US Treasury buys back their own bonds by bidding in the bond auctions that they issue.

    How is this constructive? Aside from driving up the prices of the bonds, but if they are forced to buy too large of a percentage of their own bonds, it seems that this is not helping to provide capital or even soak up reserves.

    I have an additional question from your article on “When Will the Bond Auctions Begin to Fail?”

    You had a reply in a comment there about taxes and Chinese buying bonds:

    “China’s bond purchases fund nothing though. Just like your taxes fund nothing.”

    This comment makes absolutely no sense to me. If they do not fund anything, then why even have them in the first place? Why not just print all the money we need and be happy? It seems to me that there must be some real value (regardless of the amount of currency in circulation) in order to pay off the enormous debts that the government is issuing.

    Maybe you can explain further if I am misunderstanding something or not seeing the full picture.

    • took me awhile, man,back when……i had the same questions…..but his market calls and deft article-picking made me persist…….just consider his words….and more than once….i had to read them way more than once…..bout 6 mos ago.

      2020,huh….rather than good vision, i’d say that’s about when we start really getting out of this mess……but hey, its an oppurtunity to short….good thing i’m done w/my former occupation tho.

    • There is a great book entitled “Understanding Modern Money” by L. Randall Wray. It’s a very readable book on MMT.

  4. TPC,

    I love all the policy mumbo jumbo and I know you think you’re helping people and helping sway public opinion, but man I really loved it when you used to focus more time on the markets. You’ve made some incredible calls. Will you start focusing more on the markets again? Thanks for all your work.

    • I’m just getting back into the swing of things Gekko. My summer knocked me off my trading seat for a few weeks. I’ll get her back up and running shortly.

  5. Yeap. Bonds definitely not a bubble. Come on you suckers. Buy now that it’s cheap. It has Uncle Ben guarantee on it. Jump aboard! Bernockio & Co. won’t stop until the last short has been wiped out. Who cares about yields! Ha! It’s all a scam! Banks will earn more by selling the garbage back to the Feb than what they lose by the absurdly low yields on the long end.
    The only have one motive: to part you from your money.
    Don’t expect a dialogue…

  6. we are at a precipice here TPC…..appreciate all the education,along with alternative medicine, it is one of the epiphanies of my adult life…. but for the moment, got to agree w/Gordon some.

    moseler, if you are listening…..i see…..tho i only agree how gold SHOULD act in the future, not how it WILL…..with humans, old habits die hard….perception is reality….

    hell, even those in the whitehouse don’t understand the US is not revenue constrained…..given that,how long do you think it’ll take joe the plumber to get the picture?……i’m betting maybe only at the end of the 30 years i got left around here.

  7. Hi,
    A couple of thoughts here. I agree with what you say and it is astonishing that many people still live in the Gold area when in fact we are in a pure faith system. However, I think that your post is missing one key bit which is the “external constraints” that many country face, but not the US.
    I agree with you that in Europe (or more accurately in the Euro countries), the monetary system is quite different and bond auction are truly used as a financing tool. However, for European countries, which are, individually, much smaller than the US, before the Euro, the external constraints was quite strong and the monetary tool not as effective as in the US because of this constraints. So exchanging an illusory monetary freedom against a potential reserve currency wasn’t such a bad idea after all.
    Most European countries musts buy goods (such as Oil) that are not easily replaceable. In order to do so, those European countries have/had to purchase foreign currencies (mainly dollars). Keeping the currency value in the pre-Euro system was most of the time a tough job and any monetary disorder (inflation, even modest, trade imbalances) would lead to a currency loss of purchase power, more inflation, and thus austerity.
    By the way, this is the traditional path for hyperinflation to kick in. I can’t think of a case where hyperinflation did not involve a currency debasement (printing more and more money in order to get less and less of a foreign currency).
    In the case of the US, regarding bonds, I’m completely with you. However, The US has very little (if not at all) external constraints because it has the privilege of paying its imports with dollars. So the Fed and the Treasury can do their operations (almost) without taking into accounts any imbalances with the outside world.
    Is everything ok then? Does trade imbalances matters? No and yes… It represents a leak in the system. As the US $ is a reserve currency, it is not a short/medium term threat. However as the leak grows larger, so becomes larger the need of the US government to have a larger deficits, for one thing because it’s monetary policy has less and less effects on the system: the dollars leaked are not taxable and local producers goes out of business by lack of competitiveness.
    The question is does a disorderly collapse of the dollar possible? We must note that the recent China dollar allocation shifts are perfectly neutral to the dollar. They purchase fewer bonds, but these have not impact, and diversify into other currencies. But in doing so, the counterparty is simply taking the dollar with no net effect on the global system.
    I have long been in the camp that believed that a disorderly collapse was about to happen, but that was a mistake and this is why nobody outside of the US as well was really concerned with the subprime: we were all waiting for the wrong event.
    Dollars are the life and blood of international trade. If a shift is to occur, it would occur slowly, thus looking like relatively orderly which is ok for the US. My take is that today, it is internal issues that are the real threat: debt pilling, banking, asset valuation…

  8. TPC,

    A question I’ve been wondering about for a while. Since the govt is not revenue-constrained and the Fed can just conjure up money as they please, why doesn’t the Fed just give the govt. $5trillion (or $13tril or whatever) to cut the national debt? That would stop all the defaultistas in their tracks and end the U.S.-is-going-to-default argument.

    What effect do you think such an action would have?

    • The bond market is a monetary tool. You’re still thinking that it finances something. That’s not true.

      • Okay.

        No, I don’t think it finances anything.

        What I’m suggesting is the bond market continue operations as normal, but the Fed merely buys the outstanding debt from the govt (i.e., just transfer it over onto the Fed’s infinite balance sheet). Hence, the govt now has zero outstanding “debt”. Would that not assuage the fears of the defaultistas, to use your term?

        Why should, or should not, this be done?

        • Well, you’re basically saying we should run a surplus. The govt could do that tomorrow if they wanted to. They could tax us all to high heaven. Or they could cut spending in such a manner that the govt effectively own none of the US labor force or productivity.

          That would be the same as austerity. What would happen to this economy if the govt raised the income tax rate to, oh, 75%? It would utterly crush the country. Buy hey, we’d be running a surplus, right!

          Do you get what I’m saying?

  9. If for some reason you need cash in 2 years and you bought those ten years and they bumped up to 4%, then we are in a bond bubble because you will get hammered. Only if you are willing to hold until maturity would I not call it a bubble.

    • Why in God’s name would you buy a 10 year bond if you only planned on holding it for 2 years? Just buy a 2 year bond. That’s like saying that you want to take out a 5 year mortgage on your house even though you intend to pay it back over 30 years. It makes no sense. People are so near sighted these days and pessimistic that they just want to label everything as some dramatic and horrifying event. The truth is, you will never lose 90% on your bonds. I could care less if bonds tank 20% in the next year. If that’s the case and you have a 12 month time horizon then you should have bought a shorter duration bond…..

      • That is not what I said. No one really wants the 2 year at 0.5% anyway. My point is that should one get the ten, but FOR SOME REASON an emergency comes up and you need the money before maturity, you will lose a small fortune. So why risk that for a measly 2.5%? Better stay in cash, or better yet, but JNJ at 3.7%.

        • I have never disputed the fact that the long bond could tank from here. If you’ve got your life’s savings in the long bond then that’s a risk you need to understand. Especially if it’s just for a trade. Let’s assume you’re in that position though and the long bond jumps to 4%. You’ll lose maybe 15-20% in capital over that time. Not a great trade, but should we really be implying that this is a “bubble”?

          This argument is about duration really and the insane idea that so many people have about trading bonds. The whole point of my article was to show that bonds are to be invested in based on their duration. You don’t buy a 10 year bond and day trade it if you can’t accept some losses. Regardless, the potential of you ever experiencing a Nasdaq or Nikkei like loss in this asset is VERY low if you’re trading it and impossible if you’re actually using the asset the way it was intended to be used.

          • And this is important – I am a fixed income trader. I am not a born and bred global macro guy like you might think from this site. I do a lot of distressed debt and govt bond trading. I shorted the hell out of the long bond at the end of 2008 and I went long in mid 2009. I understand the trading implications of this market very well. You just can’t use the term “bond bubble” in govt bonds in my opinion. It’s an oxymoron. If you want to say that bonds look mispriced then that’s one thing, but bond bubble is a no no and very misleading in my opinion.

            • And just one more thing. I am sensitive about this because I used to work at a big brokerage shop and I used to see the fear mongering and misconception firsthand. It disgusted me. The term “bond bubble” conjures images of a highly unsafe market that is susceptible to incredible declines. I just don’t think it’s an applicable or appropriate term for anyone to use. Sorry for the rant. Hope I didn’t ruin your weekend before it even started!

          • I’m not sure about the not trade aspect. Many trading ZN, the leverage is unbelievable and it behaves very well technically. $800 margin per car, $15 a tick (64 ticks to a full point, which is $1000 per), quite a vehicle and I assure you many high flyers trade it, especially big firms, since the volume is huge and you always find liquidity, no matter what time. Which is another reason I suspect this latest move is loaded with speculators.

            • Edward,

              If you’re saying that there are risks to TRADING long bonds at these levels then we’re on the same page. We’re seeing a totally parabolic move. It might not be normal, but it’s not a “bubble”. You’re not at risk of losing 90% here.

              If this sustains itself for much longer I’ll probably short these same bonds for a trade. That doesn’t mean I think there’s a bubble….

              • By the way, nothing beats using the futures vs all those silly etf’s, or even options on futures. Fast and liquid with ultimate leverage. Overnight maintenance is only $1400 per.

      • TPC, just a friendly reminder, it’s “couldn’t care less” not “could care less”…because if you COULD care less, well….lol.

        • Thanks. Apparently, understanding the language is vital for communication. Call me a work in progress!!!!

  10. This post is the 2010 analogue to Time magazine’s 2005 cover story, ‘HOME SWEET HOME: Why we’re going gaga over real estate.’ Only this time the object of deluded affection is bonds.

    Deficits don’t matter. Foreign buyers don’t matter. Prices are justified. All the classic, idle, goofball rationalizations for a Bubble are present, cloaked in pseudo-technical explanations which fail to conceal a profound misunderstanding of the most elementary aspects of accounting and finance.

    Save this page, folks. Cuz next year, I’m gonna cite it my honor roll of ‘Busted Bubble Believers,’ ‘Deluded Doofuses,’ and ‘Crackpot Cretins.’

    Jim Jones had nothin’ on brother TPC. Damn, this is tasty Kool-Aid! Y’all didn’t notice I tossed my into the bushes, did you? After you all keel over, I’m harvesting your wallets. HA HA HA HA!

    • As someone who foresaw (and shorted) the housing bubble and the Hang Seng bubble I am fairly certain I know a thing or two about bubbles….

  11. Late to the conversation, Great post TPC and looks like comments are mostly serious and thoughtful, which is increasingly rare these days on econ blogs. Can’t really respond in depth right now (8mo old and baby mama is trippin) but among other things that make me think we are going to transition into hyperinflation from the current deflation environment is the need, perceived or real, by central banks to diversify out of the dollar, And when they look at their options, the one standout is commodities, be it precious metals, energy inputs, or food inputs. In the near term as equities accelerate into their re-test of the lows, certainly we should see these assets follow, Or will we? The action in the commodity complex bears very close attention. Gold, goes without mention, and silver has oddly been in a fairly tight flat trend. Grains are up and maybe its just cause of the russia thing. But maybe thats my point, it’s not going to take much to drive oil into a hoarding frenzy, let alone if there is actually another military engagement in the middle east. In an environment where people are already sketchy, it’s not hard to understand the plausibility of that scenario. Now, I do not necessarily think that this scenario is right around the corner. De-leveraging is a long and painful process and I’m long treasuries for sure. But i’ve got my finger on the trigger to buy gold on dips, and looking to get long oil when equities re-test lows.

  12. Mr. Haygood: I have printed out your comment and in one year from now, August of 2011, I will let you know how good of a prognosticator you are.

  13. TPC,

    Based on your example, you must force (with 500 men in body armor with assault rifles) the citizens of your country to use TPC notes, because they are inherently worthless. This sounds more like communism than any capitalist system I am familiar with. You would think that if the TPC notes had any value (based on faith in the issuer) that the citizens would use the currency of their own free will. We may not be under the gold standard anymore, but we are still constrained by real value. The government issues the a worthless currency, and it is then assigned a value when the citizens (or foreign countries) decide to trade real value goods and services for that currency. How can it have a value assigned or even controlled by the government?

    You say, “China gets pieces of paper with old dead white men on them in exchange for real goods and services”, but what happens when they decide that those pieces of paper are not worth their goods and services anymore? Is that why they are reducing their US Treasury holdings at as quick a rate as they believe is safe to do? You say that China cannot sink the US economy, but the very fact that they are holding US currency means that they are a part of this “faith-based” system. When they lose faith in our currency, who is next? It seems like it would be a domino effect inevitably leading to hyperinflation. They are the ones holding the real goods and services, not the US government. It just feels like the government is trying to keep this ruse going as long as they can. Like the emperor with no clothes on, how long can they go before someone calls their bluff and refuses to trade real goods and services for a worthless currency?

    • That currency is ultimately backed by some level of productivity. The govt merely buys it up. In my case, someone wanted a job so I put them to work. I will be the first person to admit that the govt sector cannot generate sustainable and healthy economic growth forever. I am a firm believer in the fact that the growth engine of America is innovation, entrepreneurship and creativity and the truth is that the govt is generally poor at all three. But this should not be misconstrued with the idea that govt cannot do good.

      But your point is true to a large extent. The currency cannot be forced on people. There must be a level of productivity that backs it and the private sector must prefer to transact in the currency. Taxes ultimately generate demand, but that’s a two sided coin and can break down if the govt appears to be a poor steward of the currency.

      Economies are faith based systems backed by some level of productivity. If you lose either you’re up $%*& creek without a paddle.

      • TPC,

        Thanks for the reply. I will keep reading through your various articles to see if I can gain a more full understanding the situation.

  14. The government bond market is merely a monetary tool that the central bank utilizes to control the cost (or supply) of money by controlling the level of reserves in the system..”

    Not exactly. Government securities issuance is a monetary operation that drains excess reserves generated by deficit expenditure, permitting the Fed to hit its target rate (FFR) in the overnight market for reserves. The Fed controls the price of money, not the supply of money into the economy. True, the Fed can increase the amount of base money through monetary operations, but these operations neither increase nor decrease nongovernment net financial assets, which only the Treasury can do, and they do not result in banks increasing money in circulation by lending, since banks don’t lend reserves and they don’t lend against reserves either. The “money multiplier” is ex post facto accounting phenomenon, not an ex ante cause of money creation through bank lending.

    This is a good article overall, but the relationship of Treasury currency and bond issuance needs to be cleaned up. I would stay away from the generic term “money” and state what form of money you are talking about in order to obviate confusion. I would recommend sticking to the following paradigm, which focuses on operational reality by delineating the operations of the Treasury, Fed, and nongovernment banking system. I am sure that you know this, so forgive me for nitpicking, but your readers may not understand this, judging from most of the comments.

    The US government uses Treasury to issue currency by crediting back accounts through its expenditures, and this increases the financial assets of nongovernment. The government withdraws currency from nongovernment through taxation, decreasing nongovernment financial assets. The government balance shows an increase of nongovernment NFA through a deficit and a decrease in nongovernment NFA through a budgetary surplus. Tsy issuance in offset is not a fiscal operation to finance the government, which funds itself through currency issuance. Tsy issuance just changes the composition of government IOU’s from non-interest bearing to interest-bearing, like shifting funds from a deposit account to a time account.

    The Fed operates only in the interbank settlement market through reserves, except to buy and sell securities in order to influence reserves. This is a monetary operation for influencing interest rates, especially the FFR, although the Fed can control the yield curve if it wishes. The important point here is that reserves are for interbank settlement. Reserves never enter nongovernment directly, but always in another form, e.g., cash or bank customer deposits. Banks get cash to meet demand at their windows by exchanging reserves for them. Checks are settled through the interbank system by bank’s settling up in reserves in the FRS. The FRS is chiefly a settlement operation, although the Fed uses the system to set interests rates, too.

    Commercial banks lend against capital to creditworthy customers at a mutually agreed rate of intrest. Bank credit extension creates deposits, adding to M1. After making loans, banks obtain reserves as necessary for settlement and to meet reserve requirements. Reserves do not materially affect bank lending, other than through the FFR that influences spreads.

    Money multiplier and other myths

    • This is a bit semantic, but the price and supply of money are very closely tied in this case. We’ll agree that all bank money (leveraged money) nets to zero, but it’s not accurate to imply that interest rates have no influence on the supply of money. Yes, we both know the Fed doesn’t change the level of high powered money, but the Fed can very much influence the level of leveraged bank money. Of course, when the private sector is more focused on paying down debts monetary policy is a blunt instrument so your point appears particularly true at a time like this, but in a “normal” recession the Fed most certainly can and does have the ability to influence leveraged money to a large extent.

      Correct me if I am wrong….

  15. Correct me if I am wrong….

    Well, I’ll just state my understanding from reading about MMT.

    According to MMT’ers that study this, the price of money as the interest rates set by the Fed that set benchmarks that influence other rates is only tangential related to the amount of reserves, and the amount or reserves does not control the amount of lending as the money multiplier theory holds. That is to say, if excess reserves are not drained by Tsy issuance, then overnight rate will go to zero, unless the Fed pays the target rate as interest on excess reserves. Fed operations in addition to settlement are essentially control mechanism for setting the interest rates that the Fed wants to establish as benchmark rates.

    According to MMT’ers and knowledgeable people in the industry, banks loan against capital without concern for reserves, other than the going rate they will have to pay to acquire reserves for settlement and requirements. That is figured into the price of the loan and it is rather tangential to credit extension. Banks leverage their capital and they make loans to creditworthy customers that they determine are prudent and profitable. Since the Fed always stands by to provide liquidity at a price (discount rate), banks are not concerned with liquidity. Nor are they overly concerned with capital, because if they have the need in terms of creditworthy borrowers seeking loans profitable to them, they will just expand their capital to accommodated this. Bank credit is demand-driven. What the Fed does or doesn’t do has little direct effect on this. Demand for loans is closely related to aggregate demand in the economy, since incomes drive credit capacity and also underlie investment. Business do not expand when aggregate demand does not support expansion, no matter now low rates are. Similarly, if demand is strong and business booming, high interest rates are not that effective in restraining it.

    The prevailing theory is that price is the controlling factor in the economy, and that the price of money is therefore fundamental in controlling other prices. That theory is a failed theory because it is based on an attempt to scale micro up to macro, and this falls guilty of the fallacy of composition. According to MMT, for example, the correct macro approach is the sectoral balance and stock-flow consistent macro model approach developed by Wynne Godley and functional finance stemming from Abba Lerner. This approach places little emphasis on monetary operations and principal emphasis on fiscal operations that affect effective demand. Price stability is also managed through fiscal policy, according to this view, in that monetary policy is relatively ineffective and also a blunt instrument. Bill Mitchell and Joan Muysken have written a book on this, as I am sure you are aware.

    Conversely, the Fed relies on price (interest rates setting) to control price stability. In doing so it uses an a buffer of unemployment as a tool in interest rate targeting, in violation of its mandate to maximize both price stability and employment, using the questionable theory of NAIRU to justify this, and seems ready to shift the goal post of natural unemployment upwards if needed, by declaring a new normal.

    I am not suggesting that the Fed has absolutely no effect on the supply of money since price influences demand. Even so, the Fed benchmark price is only used in setting spreads, and so it is hardly determinative of the price of individual loans, which depend on more important factors involving risk in individual cases.

    The effects that the Fed has control over are relatively small. I am reiterating what I understand the MMT economists who have studied this and say it is not the case that “”the Fed can very much influence the level of leveraged bank money.” For a simple ppt overview of main points, see Scott Fulwiller, Monetary Operations 101.

    • I think we largely agree then. I’ve often written here about the impotency of the Fed’s various actions. I think the Fed’s abilities are particularly muted during this particular type of recession where the private sector is so deeply indebted. I would argue that the Fed has more power over the economy when the private sector balance sheet is healthy.

      • #I’m not accustomed to this system that much i hope this doesn’t double post as i wrote a
        reply to T.C.P. with a question.
        08/23/2010 at 1:57 AM
        Retired One

        T.C.P. in your reply to Gumshoe you said,
        I am a firm believer in the fact that the growth engine of America is innovation, entrepreneurship and creativity and the truth is that the govt is generally poor at all three. But this should not be misconstrued with the idea that govt cannot do good.
        But your point is true to a large extent. The currency cannot be forced on people. There must be a level of productivity that backs it and the private sector must prefer to transact in the currency. Taxes ultimately generate demand, but that’s a two sided coin and can break down if the govt appears to be a poor steward of the currency.

        Economies are faith based systems backed by some level of productivity. If you lose either you’re up $%*& creek without a paddle.
        My question is with the debt level in the average American home so high.
        I can’t see these people being able to pay down this debt. Therefore i see your theory and tend to agree but can’t see the tree producing enough to come out of this forest of debt abyss. How do you rationalize this?
        VA:F [1.9.3_1094]
        Rating: 0.0/5 (0 votes cast)

  16. Every one percent move up in the 30y bond, causes a capital loss of 18% according to today’s WSJ. One loses 90% on a 30y bond yield if the 30y bond yield closes at 8.66% versus its 3.66% close on friday.

  17. I have to change my mind. I do think we’re entering the final blow off phase of the bond market in the US.

  18. For the life of me, I don’t know why some of the posters here equate losing money on a long position as prima facie evidence of a bubble. Bonds simply cannot be classed as being in a bubble when their fundamental drivers are suggesting current levels are entirely appropriate. If GDP and inflation were a lot higher, then yields at current levels would not make sense (and they would rise). The facts remain that both are low and declining (and don’t bet on Q3 GDP being positive either), and funnily enough (not), so are bond yields. When the US govt. gets serious about addressing the huge hole in aggregate demand, then maybe I’ll change my view on GDP, inflation, and therefore, rates. Until then, happy shorting to you.

  19. apj,

    You are correct. Ask people who have tried to short Japanese bonds over the past decades. That trade has not worked out too well thanks to disinflation/deflation in the face of massive government deficit/gdp ratio. Why? Bank lending never picked up both because of unwillingness to lend and/or borrow.

  20. We ARE in the blow out phase/the last throes of the bond bubble. Because I saw something worrying in may and june of this year. Short term maturities went up in price and longer term maturities went down (somewhat) in price. And that was new. That didn’t happen in the 2nd half of 2008 or in late november 2009 (Keyword: Dubai debt crisis)

  21. T.C.P. in your reply to Gumshoe you said,
    I am a firm believer in the fact that the growth engine of America is innovation, entrepreneurship and creativity and the truth is that the govt is generally poor at all three. But this should not be misconstrued with the idea that govt cannot do good.
    But your point is true to a large extent. The currency cannot be forced on people. There must be a level of productivity that backs it and the private sector must prefer to transact in the currency. Taxes ultimately generate demand, but that’s a two sided coin and can break down if the govt appears to be a poor steward of the currency.

    Economies are faith based systems backed by some level of productivity. If you lose either you’re up $%*& creek without a paddle.
    My question is with the debt level in the average American home so high.
    I can’t see these people being able to pay down this debt. Therefore i see your theory and tend to agree but can’t see the tree producing enough to come out of this forest of debt abyss. How do you rationalize this?

    • The reality is that the road ahead will be very difficult until the private sector debt burden is alleviated.