Yield Myths
Paul Krugman has a good post up about interest rates which I think requires a bit of elaboration. He says:
“Low interest rates on the bonds of just about every country that still has its own currency have created a small industry of would-be explainers. It’s a bubble; no, it’s the global shortage of safe assets; no, it’s “disaster economics“.
Maybe there’s some truth to some of these stories. But surely the dominant story is very simple: it reflects market perceptions that the economy is going to be depressed for a long time. As I’ve argued before, you really want to look at Japan, which exhibited this syndrome at a time when there was clearly no shortage of safe assets and few were talking about disaster”
I think that’s largely correct. But there’s an important element that I think Dr. Krugman is missing here. If one understands the Contingent Institutional Approach laid out by MR then you understand the complex relationship between the Fed, Treasury and the Primary Dealers. You understand how the Treasury, a currency user, can always fund its account by using the Primary Dealers as funding agents. You also understand how the Fed works in a symbiotic relationship there to essentially guarantee the funding backstop. In other words, the US Treasury can never “run out of money” because the Dealers are required to bid at auctions and the Fed can always theoretically step in to buy the bonds if necessary.
But this is a hugely important point when understanding why controlling your own currency is so important. Why? Because there are no bond vigilantes in the USA to send yields shooting higher. That’s because the risk of a solvency crisis has been eliminated by institutional design. Bondholders in the USA understand this and continue to feed at the trough of US bond auctions because the Fed and Treasury are constantly in their ear saying “here, take these free profits, we guarantee we’ll always be good at maturity!”. And so they buy and buy. And in a period of low growth, low inflation and uncertainty the buyers are fighting tooth and nail to get a good position at the trough.
* Update – I should add that this institutional design feature is precisely the flaw in Europe today. There is no explicit funding guarantee so you have real bond vigilantes rejecting sovereign debt and sending yields higher.
** Chart comes courtesy of Not Jim Cramer at Twitter.
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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86 Comments
How is this not more widely understood?
Probably because JKH just created the contingent institutional approach about 2 months ago.
But yes, it’s surprising that no one went into that kind of detail before he did…. Big time kudos to him.
The global fixed income folks understand it perfectly well. It’s Krugman etal who is just now catching on.
But if a guy like Krugman doesn’t get it then who does get it? Just a select group of bond traders and central bankers?
Nobody gets it except those that read this web-site!
The “flaw” is in the US system not the Euro. Bond vigilantes are doing what they are supposed to do. Pols are not doing what is needed.
Unless pillaging the public is what is supposed to happen…then yeah.
Mark, can you elaborate? How is are we being pillaged by the govt? I say they’re keeping our taxes too high. Do you disagree?
How does it make sense that even with all the authority and all the power that govt has that it needs to eliminate its own solvency risk via design?
It was already solvent – it can forcibly take money from its people via taxes. So why not do that if needed? Why create an artificial and difficult to understand system when a simple one would work? Generally complexity is not favored over simplicity without reason.
If rates are low because the Fed is keeping them low, then the market has no impact on rates, so Krugman is wrong here.
Bondholders are not ‘feeding at the trough.’ Debt is being issued that somebody must hold and the primary dealers, as you say, are taking on that debt.
We have no idea what the true market value for U.S debt is, which is potentially dangerous.
It’s important to note that the bond traders do have SOME control here. Remember, the govt is a currency user in some capacity. For instance, in a hyperinflation the bond traders would certainly boycott govt bond auctions because it would be unprofitable for them to take on these assets. So the Fed would step in and monetize in true form. So let’s not go thinking that the govt is wielding the stick here without any private sector control or any negative ramifications at all – there are scenarios where this can be disastrous. I’d just say that in a monetary system with high levels of overall output and general stability that the currency ultimately is very stable because the quantity value (purchasing power) of the currency remains high. So we have to keep things in some perspective.
Let’s say the primary dealers decide to stop buying the bonds. Conditions would have to be pretty bad for that, right?
Anyway, then the Fed steps in and prints the money. Can you imagine a situation in which the Fed tells the Treasury, ‘Yeah, you guys need $2 trillion to fund the government but sorry, we don’t hae it.’
Even in your example, the primary dealers can’t be trusted to raise any alarms.
I just don’t see how this ends well at any level.
At least in Europe the markets are forcing the governments to address their spending, implement structural reforms, etc., etc. As j236 suggests below, because we can print, we won’t address our mis-allocation of resources until it’s too late.
My understanding is that primary dealers are required to create a market and the Federal Reserve ensures they have all the reserves they need to accomplish this. I interpret this as meaning they must acquire the bonds regardless.
The NY Fed says “Primary dealers are also required to participate in all auctions of U.S. government debt and to make reasonable markets for the New York Fed when it transacts on behalf of its foreign official account-holders.”
But if it became unprofitable for them (let’s say in a hyperinflation when prices are dropping like a rock) then the PD’s would most certainly boycott and you’d have to have the Fed step in. People call today’s Fed buying monetizing, but I think that’s wrong as it implies a lack of demand from the PDs.
it makes sense in terms of hyperinflation because there would be no way (that I can think of) for the Fed to sweeten the deal enough for PD’s to continue the arrangement. Short of that scenario would not the Fed be able to effectively guarantee profitability?
Mr. Roche,
Couple of questions just for my understanding.
1) I get that the dealers are required to bid by design. But cant they not bid which will amount to a higher interest rate? Can they only bid at the short term rate set by the Fed?
2) If it is a question of design, why do we have Sovereign defaults? It seems basic that any country which controls its own currency should have a similar set up?
Thanks
Hi Karthik,
1) The bidding process is detailed here. http://www.newyorkfed.org/aboutthefed/fedpoint/fed41.html In short, it’s a matter of supply/demand and the govt allocates accordingly. Clearly, demand is enormous currently. It’s a bit more complex than that so see the link.
2) Not all countries have this design feature. Europe certainly doesn’t. And there’s a certain element of exorbitant privilege in being able to devise such an institutional design. The USA is a very diverse, dynamic and deep economy. Its markets are similar. So this sort of design is easier to implement and maintain in such an economy. That doesn’t mean that it’s impossible for other nations to copy or that the USA is the only one (it’s not), but it can be harder, say, for an emerging economy to implement a similar design because their real constraints are different. And this never eliminates the potential for hyperinflation like we saw in Russia in the 90′s which led to an eventual sovereign default. Controlling your own currency is a big advantage in implementing policy, but it’s no replacement for having a sustainable and viable economy underneath that institutional design.
Hope that helps.
There are other countries which are sovereign and with a much better debt position. Norway for example. Of course is a small country and you can park there 100 billions but I don’t have all that money. But I bought norway bonds both hands after the first greek crisis and it was a great idea. Now it’s the bigger position in my portfolio and I sleep confortably at night. Better the treasuries because the country has negative debt if you consider the huge sovereign fund and small in any case if you don’t consider it (but it’s public money albeit segregated in a fund)
Cullen,
This link is great but gives high level explanation of bidding process. It does not tell where and at what step the NEW money is created.
Say treasury needs 10 Billion in NEW money which is not existing in the private sector. How does that come into existence. I understand that primary dealers have to participate in the auction but where are they getting this NEW money to buy NEW bonds?
If the money already existing in the banking system/private sector is being used to buy bonds at the auction, then how is govt spending leading to deficits? Moreover in this case when all the money with the private sector/private dealers is exhausted, no new bonds can be bought by them. Hence there has to be a step where new money is brought into existence. Where does that happen?
I have already read your understanding-modern-monetary-system writeup.
regards
AarBee
As I understand it, government spending creates new money. They usually sterilize it (offset the money creation) immediately by issuing bonds. Tax collection also works as a sterilization mechanism. Bond monetization reverses the sterilization forces. Thus there are some questions of timing, but essentially government spending creates the new money. Cullen, do you agree?
I think govt must, by law, have a bond auction before they can spend. Treasury department gets money in it’s account via auction which is facilitated by Fed and Primary dealers(Somehow new money comes into existence within this process) I want to know HOW and AT WHAT STEP is the new money created into existence.
This is correct Aar. Sorry I missed the above comment by Tbill. New govt spending can only occur after the Tsy has procured funds via taxes or bond sales. In this regard, all govt spending is a recycling of pre-existing money (except the issuance of outside money like notes and coins). Importantly, what occurs when the govt sells bonds is the issuance of net financial assets. That is, the govt debits private bank accounts, credits someone else’s account with cash AND credits the bond buyer with a bond.
Huh? Deficit spending is government spending more than the tax rate. That is a net add to the money supply. The new money in that case comes from the FED. The print it up on their digital keyboard. Their new money finds a counter in a T-Bill that was issued by the Treasury in the primary markets. The Treasury is now free to deficit spend. Essentially the money was created when the TBill was created, and that was allowed by law. (Is a TBill created in this fashion Credit, as so many economists like to spout. Or is it law based on the ability to collect taxes? Is it credit based on an asset when the FED rebates at 90%. Sorry, just poking in the eye because this is an important point.)
In effect the new TBill and the new Fed money find each other. Both double entry ledgers are satisifed at the FED and at the Treasury.
The TBill and Fed money are sanitized when they go through the market as a holdover from the gold days. Wright Pattman had plenty to say about this subject.
This is not correct. The Fed is not allowed to buy t-bonds on the primary market. They can only buy on the open market. So the funding source is always private banks who supply reserves in exchange for t-bonds. That results in Tsy’s account at the Fed being funded and then govt spending which credits a pvt account. The important result is an increase in net financial assets as the private sector how has a new t-bond AND the deposit which was essentially recycled.
I explained it in a long ago post. The FED buys on the secondary market. That money sweeps away old bonds and the new “digital dollars created at the FED” find their way into the market. The “old” bonds land on the FED balance sheet. But, the new dollars are still in the market and find their way to buy on the primary market.
Look at it this way, the Fed money sweeps away old bonds, making room for the newly issued bonds on the primary market.
Despite the complexity, the bottom line is that a new T bill is issued and finds its counter in new money issued by the FED.
This may help Aaar some more. The money supply consists roughly of M1 and M3. One is liquid (M1) used for transactions. The other M3 has low velocity and humans see it as an asset. Bill, Bonds, and other vehicles perform as assets. Think of the money supply as consisting of “types” of money that convert form.
I know this point is alien to MMR since you are fascinated with the Treasury and Government, but if you look at money instead for a moment you might see this.
Let’s suppose the FED creates money and buys bonds and bills on the secondary market. That will convert the money supply to M1. People will then have too much M1 and will want to convert it back to M3 for their safety needs. They will buy paintings, or land, and cause asset inflation, anywhere they can park and convert their M1 to an asset or a substitute asset. If the Treasury steps in with risk free TBills, their safety (asset) needs are met and they buy them.
So, the FED buying on the secondary market, sweeps the money supply, creating a pressure to buy on the primary. The bottom line, the FED creates the new digital money with a counter at the Treasury with NEW Tbills. In this way, the money supply M1 is INCREASED in volume.
We pretend it is an asset swap, the Tbill for new M1. But, the TBill comes from nothing and the new digital dollars come from nothing. I’m pointing another finger at economists and money thinkers, “Is money credit?” In this case it certainly is not, it is based on the law and faith of the people, especially when the FED rebate is considered.
REN,
You do not have this correct. Reserves are deposits at the Fed. They do not increase liquidity or increase inflation as you claim. They don’t result in people having more “money”. Reserves are used by banks for two things – settling payments and meeting reserve requirements. When the Fed increases reserves in the banking system the bank customers don’t suddenly have more cash that they want to spend. Most importantly, it doesn’t alter NFA so even if QE is performed solely with the private sector bank customers altering their balance sheets then they still don’t end up with a change in their net financial assets.
Swapping the bond for the reserve does not alter market liquidity. It forces a portfolio rebalancing, but doesn’t alter liquidity. It also doesn’t “make room for new issued bonds”. The new bonds get sold no matter what. You don’t have this correct and your comments are confusing people.
My understanding of Russia’s situation in the 90′s is that it already owed huge debt in other people’s currencies. So the default was mainly because of that, and not from the failure of its sovereign currency management, which was compromised from the outset because of existing foreign debt overhang.
That’s right. Russia fell under the spell of the Harvard boys and they made errors in their system. The idea was to convert the Russian economy to extraction of minerals, timber, etc. by way of debt monetization. In other words, all the land and resources, especially paid for Communist resources, can land on credit banker’s double entry ledger. This creates a debt fueled bubble, but the debt is in a foreign currency…. a big no no. Later the domestic currency, the Ruble comes under downward pressure due to the debt that must be paid in a foreign currency. Then the Bear Raiders, like George Soros attack, causing a financial collapse. They accelerate the collapse by shorting the currency down and by creating more Rubles/Peso’s etc. via more loans.
It is no wonder that Putin created the BRIC system in order to undermine the “dollar as reserve” world standard. Separate currency and trading bourses, outside of the dollar, are being constructed. When that happens a key force underlying the dollars power is gone.
There are a few countries in Europe with negative bond yields (at least out to 2 years), including Germany, Denmark and the Swiss. This begs a couple of questions:
1) Will the negative yields creep out the curve, say out to 10 years?
2) Will yields go negative in the US and/or other countries outside of Europe?
Not sure about #1, but #2 seems unlikely. Granted, US short yields have gone negative recently, but only for very brief periods. It seems that the sustained negative yields in Europe are related to the Euro currency situation. Countries with their own free-floating currencies do not appear to go negative for long, if ever. For example, Japanese yields did not go negative for any sustained period, even during the height of their problems.
Of the three countries that you mention (Germany, Denmark, Switzerland) only Germany uses the Euro.
Switzerland is desperately fighting against its currency strengthening against the Euro, but is still viewed as a safe haven.
Krugman misunderstands Japan so he shouldn’t be using it to prove his point. There is a very strong home market bias in Japan: (1) as evidenced by the large savings in the post office (this is true as well in Germany), (2) rising Yen even as the BOJ is buying foreign sovereigns… for 30 years!; and never going as far as the Swiss, (3) whenever the BOJ even hints of raising interest rates by 0.001bps, the Yen rallies 2% and the monetary base shrinks by $100B USD. It is not/was not a depression in Japan, it’s the inevitable struggle of rebalancing of their export-oriented mercantilist economy, the home bias and demographics.
The US just needs to recover from a decade of misallocation of resources (housing, public service unions). Krugman forgets that the countries he wrote about in Depression Economics all did pretty well later on, in spite of the US and IMF nailing their balls to the wall.
Think investing in the future, educating your kids, and stop special interest groups leaching off the economy (PS unions, financials etc.).
jt26:
You say the public service unions and the financial industry are leeching off the American economy.
I’ve seen some data on the financial industry, and I agree wholeheartedly they need to be a lesser factor in our economy.
“Wall Street currently gets 20% of all the nation’s output (and 40% of profits), but won’t stop until it gets everything.”
http://www.economonitor.com/lrwray/2012/07/23/why-were-screwed/
I hear constantly that the public service sector and their unions are an enormous problem, but not from credible sources, and seldom with any kind of careful analysis.
To what extent have they brought down the US economy?
Was it comparable in scope to Wall Street almost casuing a worldwide market meltdown? Is it fair to lump the two together?
While I’d like to see restraints on their demands, I also recognize that public and private sector unions are the only credible deterrent from Wall street completely taking over the political system in America.
I’d be interested in your careful analysis.
I read Wray’s piece yesterday. I try not to comment on MMT pieces here because the backlash is usually repulsive (and Wray has personally insulted me and other MRists in many of his pieces), but I have to say that that article is such a vast generalization and misrepresentation of our reality. First, Wray’s use of the term “undertaker” to describe capitalists is just ridiculous. It’s the same tactic you might expect to see from Austrian economists trying to incite emotion to create a particular political reaction. And then his desire to “obliterate Wall Street” is just more of the same ridiculous commentary. Wall Street is an essential cog in the machine. I’ve been a big big critic of the financialization of our economy over the years, but this is way overboard. And to claim that the housing bubble was purely the result of greedy bankers is just absurd. This is politics and ideology. It’s not economic commentary.
Honestly, I’d prefer that readers not even mention MMT or articles by MMTers here because any mention of it over the last 6 months has really dragged down the quality of comments and generally incites silly arguments that I regret having ever gotten involved in or allowed to occur here. I just totally disagree with the way they present their material, the way they engage with people and the ideas they promote. Rant over.
Google:
- california budget; pension obligations
- municipal budget
- average public sector salaries plus benefits vs. private sector
- take a look at your state and municipal budget and taxes vs. services; then compare that to your own (private) sector salary increase the last 5 years
Leach is perhaps too strong a word. Public sector unions are simply using their market and political power to get a better deal for themselves. Entrepreneurial or monopolistic?
” Entrepreneurial or monopolistic?” Both, only one should be acceptable.
I always wondered since Im not an economist or financial type besides what I learn here:
The institutional design that essentially ended insolvency….was this done on purpose?
It seems since we dont seem to “get it” that we cannot become insolvent, that it was just by luck that the system turned out this way once the gold standard ended. Because if it wasnt by chance, than the misconceptions about the debt, deficit, whatever, shouldnt be so prevalent then right?
I’m sympathetic to an arrangement where the Fed funds the Treasury directly (or a combined Treasury/Fed) just to make it more transparent for everybody.
‘JKH’ has presented this as an option, and Brett Fiebiger has suggested this as a basis for systemic reform, at the MR site.
This might remove the private sector as a potential check on government, but would put fiscal responsibility squarely on Congress (specifically the House), where the Constitution intended it to reside.
I don’t know of any major sovereign currency issuer that operates on this basis, but if one existed, it would provide a valuable study in how such a system might fare.
That’s basically what MMT is. But it’s an option, not what we have. Personally, I see the logic in why our system is designed as it is. The govt is a user of the currency in a certain capacity. If you merge the Fed and Tsy you really eliminate the govt being a user of the currency in any way since the PD’s don’t even have to buy the bonds to fund spending. I don’t see that the current arrangement is problematic, just misunderstood.
China issues Yuans directly out of their State Banks. They have four large State Banks, that function to create money, the same as the FED. They also do magician tricks to move funds from the left hand to the right hand, making debts disappear.
So, yes, any State type bank is a defacto currency issuer that can issue without debt if they so choose. The communist government sets the peg low on purpose, which draws in jobs, and allows the shape of the economy to modernize quickly.
Michael Pettis has made a consistent point why China has trouble rebalancing (world trade). It is because of government’s control of credit. Essentially, the government sets interest rate so low that it in fact transfers large amount of wealth from the private sector to the government. As a result, the consumers are always poor and the outcome is contrary to any, if there is, intention to transition to a consumer driven economy.
Any fiscal and monetary policy is a way of wealth transfer. There is no way to get around it. I am not questioning a sovereign’s ability to control its money supply and, as we have seen, its interest rates. But such policies are not that much far away from what China is going, are they? So it is not clear such policies are in any way fair, and can ultimately resolve the problems we face.
I really dont see why it is such a contribution to economics that the government won’t literally run out of money because it is the one that makes it. Economists know this, yet as far as I know they still say that debt/GDP ratios matter. Why not submit these theories to the proper academic journals before unleashing them on the internet?
You’re right. The internet can’t handle it. We should be gentle /sarcasm
Most mainstream economists talk about the U.S. becoming “the next Greece” without any reference to debt/GDP ratios (which aren’t particularly useful by the way), but rather in terms of the U.S. running out of money.
Pierce-
What mainstream economists are suggesting that the US will become the next Greece? I listen to Bloomberg every day and I never once hear that mentioned. Are serious academics or bankers suggesting this?
Now if you are thinking of the politicians, that is possible, however I think the argument is more philosophical over how much of the economy we want to turn over to the government.
What does the fed chairman himself say about this policy “To achieve economic and financial stability, US fiscal policy must be placed on a sustainable path that ensures that debt relative to national income is at least stable or, preferably, declining over time,” he told members of the House Budget Committee.”
My monetary paper is ranked #3 on the entire SSRN database….
I’m not sure what the goal of this theory is. If it is widespread acceptance it better find its way into a peer reviewed journal. That’s how the academic world works, and universities are where ideas get taught to people.
Doesn’t matter to me if people accept the ideas or not. It’s just how the system works. Reject it if you want, but if you do, I hope you’ll offer a better explanation of how the monetary system works so people can learn from you and make better informed decisions. I am not here to shove some political ideology in people’s faces. I am just here to help shed light on how things work….
And the money multiplier is academically accepted and peer reviewed, but is it correct? Absolutely not. EMH and CAPM is academically taught and accepted, is it correct? Absolutely not. If the money multiplier was correct, then the 0% required reserve ratio in Canada implies unlimited money creation and rediculous levels of inflation – this is clearly not the case in Canada.
Damn. Saying, ‘I’m right, I don’t care if it’s accepted or not,’ is not going to convince people.
If economics is a science, then Chris H. is right — you need to make your case to your fellow scientists.
Personally, what I think you’ve done is create a model, which probably will collapse if it’s put under any strain — if, for example, the government does do what you say it can, and start openly printing money without the charade of putting it on the Fed’s balance sheet.
Just like MPT — it made perfect sense right up until the unthinkable happened.
Meant ‘MPT’ or Modern Portfolio Theory there in the last sentence.
Economics is not a science, it is much more akin to theology, particularly the mainstream. At some point the dominant neo-liberal paradigm loses credibility because it is ALWAYS wrong. In the last four years it has shown nearly zero predictive capacity. MMT/MR/post-Keynesian work has shown predictive power far in excess of what is accepted in Washington and in the Wall Street Journal. Being correct over and over again should count for something.
I agree, but in order to defeat someone by claiming their work is based on ideology (as opposed to facts), you must be sure that your own isn’t also based on ideology. Unfortunately, the PKers fail miserably here. In fact, I’d argue that some PK groups are even more ideological than the people they criticize. We can’t be purely descriptive and I admit that MR’s failure to offer prescriptions makes it somewhat “incomplete”, but I believe the best way to squash myths is to focus on the descriptive realities rather than cloud them with prescriptions. If we can convince the world that the world works in a certain way then the conclusions and solutions become far more limited and we stop wasting time on silly things like QE and start looking at policy that has real teeth. If the machine works in a certain way then it becomes obvious that you don’t step on the gas (when trying to slow the machine) when the breaks perform that specific action….We need more of that sort of thinking and less of what comes across as ideology.
Why are yields negative at some parts of the curve in Germany, Netherlands, Austria?
Add Switzerland to that but they have their own currency
I guess I am saying that despite all you’ve said, yields are lower in many parts of Europe than they are in the U.S., yet they don’t have their own currency like the U.S. does.
There is an anomaly there which I am curious to understand
You need to factor in that you need to hedge the currency exposure if you buy a US bond so yield may be worse.
Another factor that Krugman tries to dispel is the expectation of low growth.
I tend to agree with this but it has a massive home country bias.
Australian yields are compressing due to a massive safety bid (AAA debt) yet we just registered +4% GDP growth over the last 12 months.
The low growth meme might apply to some nations, but not all when it comes to why yields are compressing
Cullen,
using MMT, is there not a ‘solution’ for those Euro countries shut out of money markets to effectively create a ‘shadow’ fiat monetary system , perhaps via issuing ‘IOU’s in the form of short dated notes or bills that can be bought by local institutions creatiung a ‘local currency’ bond market and a ‘hard currency’ bond market just like any other emerging markets? Issue too much ‘local currency debt’ and the cost rises with the market pricing it rather than some regulator imposing quantitative controls. Ultimately too much issuance risks the ‘peg’ of the shadow currency (vioa a currency board?)but local savers are currency neutral and external savers at least have some mechanism to ‘hedge’ currency risk. Be interetsed in how MMT can solve this problem!
I haven’t used the MMT framework in over 6 months….
http://pragcap.com/understanding-modern-monetary-system
http://pragcap.com/how-is-mr-different-from-mmt
when i look at Swiss, Danish yields than safe haven buying IS part of the picture.
fear of a breakup of the eurozone is driving money towards countries with their own (stable) currency (and printing press).
so i would argue that the catalyst for higher yields will be a resolution of the euro crisis. one way or another.
either the ECB´s treaty is changed to allow them to buy sovereign bonds, or the workaround in form of a levered ESFS (bank license) or the breakup of the eurozone.
once we get a final solution to the issue those capital flows will reverse and us treasury yields will rise. don´t know by how much, but i doubt that the fed will be able to control it.
Even Hugh Hendry who advocated that one should buy T-bonds, says “get out of T-bond (or BUNDS) at a yield of 2.5% (don’t get too greedy). Perhaps he’s aware of what one C.R. doesn’t know ?
The german yield curve has started to steepen as well.
Where did you see this? I google him everyday in the hopes he will have done a new interview and have seen nothing that makes him believe we are going to see inflation.
Inflation and interest rates are only indirectly related. Interest rates are the result of the balance between demand and supply (of capital).
Rising interest rates are actually DEFLATIONARY.
Alan Greenspan was raising interest rates from July ’04 through July ’07 but yet inflation was still increasing. There are many moving parts to inflation than just interest rates.
Yes, and the FED cut rates from mid 2007 through to late 2008. Inspite of oil going up from about $ 70 to $ 140 in mid 2008. So, in spite of rising inflation the FED cut rates. And those rates going lower actually encouraged MORE speculation in oil.
Deflation is the situation where money increases in value against e.g. T-bonds. And that requires rising interest rates.
I think of deflation as the money supply declining relative to the real volume/velocity needs of the economy. Higher interest rates encourage M1 type liquid velocity money to convert to M3 type money. In effect, the liquid trading fraction of the supply goes off and hides, effectively reducing the supply. In other words, with no new money inputs, higher interest rates causes the money supply to shrink.
Bond vigilantes can only influence the currency user part of the money supply. Currency issuers have a different set of rules that apply, hence much of the Euro peon confusion.
There’s no such thing as a ‘velocity of money’.
Michael Hudson had an excellent piece in which he shreds Paul Krugman to pieces. He thinks the FED should “print” in order to help the economy.
http://michael-hudson.com/2012/05/paul-krugmans-economic-blinders/
Printing lots of money was precisely the solution Greece, Italy, Spain, Portugal, France chose in the 1970s and that pushed interest rates (much) higher in those countries. That’s why Greece, Italy, Spain, Portugal are in such deep do-do right now.
“You understand how the Treasury, a currency user, can always fund its account by using the Primary Dealers as funding agents”
I’m not sure if this has ever by any reputable economist been put in doubt?
If they all understand this, then why is it universally believed that the USA can go bankrupt like a household or a business? Clearly, most economists haven’t connected all the dots on this point.
I don’t believe in alleged ‘universal believes’. So pls. let me phrase it differently: which reputable economists explicitly denied this eco 101 basic?
Since you’re in Germany you might instead point me to all the economists who have been pointing out this fundamental difference between the USA and Europe for all these years? I know Krugman only just started to understand how having your currency can matter. And I can’t think of many who actually understand why this even matters. Krugman clearly doesn’t understand it still. And he’s basically the 800 lbs macro economic gorilla….
You seem to know of all these economists who understand that the USA has only a solvency constraint and can’t be attacked by bond vigilantes. But where are they? Where are all the papers covering this topic? All I see here in the states are comments about how we have a solvency constraint, might become Greece, need to get our budget under control, etc. If you think I am wrong then I’d love to see the evidence. But this view is not at all consistent with what I see and hear on a daily basis. And I certainly don’t see guys like Krugman saying we have an inflation constraint only….
Cullen you don’t want to address the questions I had above?
I would argue that the solvency risk in those nations is low currently. That could change though. For now, the bond market reflects this low solvency risk in those nations. That’s all I think there is to it.
By ‘bankrupt,’ people mean that the currency will become worthless if you print too much of it.
I don’t think so. Economists like Rogoff and Fergusson have been saying for decades that the USA might have a solvency crisis….They make no distinction regarding institutional design features….
Sorry I will push you on this a little as I’m very skeptical. The theory that “government debt limits are silly” seems to me a silly theory. Many people do not want the government to continue to take market share from the private sector. There are real economic reasons for that as well as philosophical ones.
Now, you mentioned Rogoff. I have not read Ken Rogoff’s book, or sat in his classes at HARVARD, so I can’t say for sure, but what I’ve seen of his work doesn’t mention default risk.
The Rogoff article from Bloomberg suggests that US will have trouble growing with high debt rates. He gives his reasons for this but I checked the entire article and do not see any mention of US Default.
Now, regarding Bond Vigilantes. Alan Greenspan, who actually ran the federal reserve for years actually worries about bond vigilantes. I know you are aware of this because I Googled it and found an article you wrote about it. Surely he would know about the primary dealer mechanism? Where does the monetary theory promoted on this website and fed bank chairman disconnect. The argument cannot be that he does not understand how the fed conducts day to day business.
Mustn’t there also must be demand by other investors for the treasuries. It wouldn’t seem to be a very credible currency if the only market participant was the fed. Primary dealers have to sell the notes to somebody, right?
It just seems to me unfathomable that all of these smart people with years of banking experience, PHDs and such would be unaware of simple mechanics. Surely they must be looking at other factors when determining that the governments fiscal house is not in order.
Hi Chris,
No problem with push back, but let me defend my position.
First, Rogoff has certainly said the USA could default. See this article. http://www.moneynews.com/StreetTalk/Ken-Rogoff-US-Default/2010/03/05/id/351739?s=al&promo_code=98A6-1
I actually mention Greenspan in my monetary primer. He’s admitted that his model for understanding the monetary system was flawed. Interestingly, Greenspan understands that we won’t default. He’s said so publicly. But he always warns about rates “suddenly” spiking higher. It’s as if he doesn’t understand what the mechanism for this would be. It certainly wouldn’t be default risk because the dealers know the US govt will always be good on payments. So the only real risk is inflation. How might this play out? I described that here. http://pragcap.com/what-happens-if-and-when-the-interest-rate-rises
I really honestly don’t believe these men understand how this institutional relationship works. I know that probably sounds crazy, but I don’t know what else to tell you. Given the results of the economy in recent decades, would it really surprise you that much to find out that the people in charge don’t know how the machine works?
http://seekingalpha.com/article/715551-why-the-treasury-bond-bull-market-is-already-over
Thought provoking article.
Are you still short treasuries? Also you never answered my question above. Where did you read Hugh Hendry recommend selling bonds?
Tried to find the webarticle but it seems to be taken off line.
If the 30 Year T-bond future breaks through 154 then I am out.
Any idea when the interview took place?
It is ludicrous to assume that experts know everything, even fundamental aspects. I am expert and I know other experts. I know that some of the simplest technical concepts are not fully understood by everyone that is called and an expert. I freely admit that I realize things today that I should have realized years ago given the knowledge I know I had at the time. But people do not work that way. People are not perfect.
But that is different than refusing to listen or understand those that have different views than you (see Krugman v. Keen). We may not be perfect but we can at least keep our thinking malleable. On the other hand the experts, or neoclassical economists, are narrow minded individuals who are hostile to views that don’t mesh with their own.
Did anyone look at the 30 year T-bond future today ? Currently, as I write this, it has dropped to 149.
Cullen, Did a little research and found a good article RE our discussion above. Reinhart (Rogoff’s colleague) and Gross both dispute default risk, and what they are actually afraid of.
http://www.theatlantic.com/magazine/archive/2011/06/the-vigilante/8503/?single_page=true
It doesnot look like a bubble AT THIS POINT. Mainly with banks your money could inflate away, with banks it could inflate away as well AND the bank might go bust. You simply want to be as sure as possible that your money comes back. Seen the risks in other assets the prices look realistic, money has to be put somewhere.
However the situation could especially in some countries be reversed and reversed very quickly. If (a big if) inflation picks up (not considered a big risk by most), or if say Germany starts guaranteeing Southern debt. Just to name 2.
In this respect there is a difference between say Germany and the US.
The US is a printer. Germany a likely one. Likely in the way that when it starts to have problems the rest will have fallen of the cliff and printing is likely the only option left.
Germany is ‘blessed’ with a currency that gives it advantages (capital flight to the North). Well advantages mainly as far as the costs of borrowing is concerned that is. And a split would lead to a revaluation. On the other side it might end up guaranteeing the half of the EZ that is de facto bust (or banks there or its own banks after a mass-bust).
In this respect Germany has more downside risk imho. Not only is the currency less stable, but mainly the main risk is that by a political decision it will have guarantee. Inflation is more a process you can see it developping and usually have more time to react. A political decision however can fall from the sky and be an instant game changer. More upside a break up revaluation mainly, but also more downside a guarantee risk. In general more volatility.