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.   (This doesn’t mean inflation couldn’t result in currency and bond rejection!).

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.