Arnold Kling  

Interest Rates: The Strange Interlude

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Russ Roberts pointed me to an essay from last year, by Edmund Phelps.


The bond market will see that, in the long run, the pile-up of government debt - and any pile-up of entitlements - will make things much worse than they would have been. As people try to sell off some of their government bonds and shares to each other to finance higher consumption, they will cause bond prices and share prices to be depressed.

Phelps wrote the essay as part of a Keynes-Hayek debate. According to Felix Salmon, the Keynesians won. Salmon complained that the Hayekians did not want to do anything. I guess the point that Keynesian policies could make matters worse did not impress him.

One point that Keynesians would make in response to Phelps is that we are not seeing the high interest rates that his analysis predicts. On the contrary, they would claim that there is a shortage of safe assets.

My reply would be to ask, if the markets love government debt and crave safe assets, then why does the Fed have to buy such a large share of what the Treasury issues? If the private sector really wants all this lovely "collateral," then the Fed should be able to stay on the sidelines.

Instead, many private investors are scared of long-term Treasury bonds. We would rather earn nothing in money-market funds than take a chance on longer-term Treasuries.

For Keynesians, the low interest rates on U.S. securities are a sign from the markets that it would be a good idea to issue more debt. The rest of us doubt that the Fed could hold interest rates down forever. At some point, interest rates will double, and the holders of long-term Treasuries will take huge losses. Yet few of us are confident or aggressive enough to take big short positions in Treasuries. The result is a strange interlude.


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COMMENTS (8 to date)
Methinks writes:

Long term treasuries are quite volatile and the yield is around 3%. Munis, on the other hand, are exempt from federal taxes and 15 year munis yield around 4% (more on a tax adjusted bases). The default risk of a diversified muni portfolio is negligible. When considering "safe" assets, why would you buy Treasurys instead of munis or high grade corporate debt sporting higher yields?

Effem writes:

Hard to take any analysis seriously that dismisses the Fed's ability to expand it's balance sheet and therefore set interest rates at any level they like in perpetuity (provided they are willing to deal with the inflationary & political consequences).

Methinks writes:

The demand for Treasurys is also pretty fleeting. They've gotten far more volatile lately. We've seen them sell off as much as 30pbs in a couple of days recently - that's a 10% move. A few years ago, 30 year Treasurys sold off 50bps in one day. It's a super liquid market, so if you need to park a large amount of capital for a short period of time, moving it into Treasuries is a pretty good option (perhaps the only option), even considering the volatility (short holding period reduces risk).

Also, other "safe" assets are both less liquid and more risky. If you have a choice to park capital in Bunds or Treasurys, you'll opt for the more liquid Treasurys - the sovereign debt of the country that is the tallest pygmy. We're doing better than the countries disintegrating into atoms. So far. Yay.

I don't know how this spells "sustainable demand for U.S. debt" for Keynesians. Seems like it's saying more about the fear in the rest of the world than it is about how awesome the market thinks the U.S. is doing.

Woj writes:

"if the markets love government debt and crave safe assets, then why does the Fed have to buy such a large share of what the Treasury issues?"

I don't necessarily agree with the Keynesian point of view, but I think one could argue that the Fed's purchase of Treasuries is not solely about interest rates. By removing Treasuries (safe assets) from the private sector, the Fed is encouraging investors to purchase the next closest 'safe' assets.

If the Fed was not doing various forms of QE, it's possible the private sector would have taken up the slack to keep rates low. However, in that case money may have shifted to Treasuries instead of stocks and other categories of debt. The result would be low rates but also a lower stock market (reduced wealth effect).

This is not to say QE is or was a good idea, just a different approach to the question.

Woj writes:

Another thought...

"For Keynesians, the low interest rates on U.S. securities are a sign from the markets that it would be a good idea to issue more debt. The rest of us doubt that the Fed could hold interest rates down forever."

Ignoring for a moment the very real potential downside of expanding government, my reply would be this: even if the Fed can hold interest rates down forever, will they be able to prop up other asset markets (e.g. stocks) forever? The Greenspan put lasted for quite a long time but ultimately failed miserably. Will the Bernanke put fair any better?

Yancey Ward writes:

You haven't yet reached the demographic inflection point. It is getting closer, but is still in the future for the US. I think that inflection point has been reached in Europe. The Keynesian argument seems to rest on the belief that no one sells net debt instruments to fund personal consumption at some point.

Mark Little writes:

I have not read much of Phelps, but clearly I should. Thanks for the link.

Interesting, isn't it, that the Keynesians believe markets are incompetent to employ resources without large and ongoing government "stimulus", yet make appeals the wisdom of financial markets--worthy of an efficient markets theory disciple from the Booth school--when using current low interest rates to justify deficits?

One quibble I have with Phelp's statement is his remark "... the Fed – to create a massive increase of the money supply." If the Gorton school of thought is correct, that the crisis was a run on the shadow banking system, then the expansion of the Fed balance sheet served not to increase the money supply but to compensate for the monetary contraction of the run.

If so, then what we saw from the Fed was not "monetary stimulus" but a return, as Minksy urged, to the role originally intended for the Fed as lender of last resort. All that non-treasury junk taken onto the Fed balance sheet is just the re-discounting of illiquid debt in the normal LOLR function of a central bank acting in response to a panic. That's what an economist participating in the debates on the design of the Fed system in 1912 might have expected, before the monetarist fantasies became fashionable.

Phelp's comment "At present, the public debt and the accompanying entitlements are already enormous: about 66 trillion dollars in all" is notable. It seems to be the almost universal opinion these days that while entitlements are a big problem they are in a different category than the national debt. Treasury securities held by the public are real debts that must be repaid, but Treasuries held by the Social Security trust fund are asserted to be a fiction.

I doubt that. If the U.S. ever winds up where Spain and Portugal are heading (and where Greece is), my bet is that Chinese owners of Treasuries will take a hair cut before voting Social Security recipients do. I wonder if Phelps would agree that Federal debts to the SS trust fund are at least as real as other debts. (And thus the U.S. debt to GDP ratio is already over 100%.)


Joe Cushing writes:

"One point that Keynesians would make in response to Phelps is that we are not seeing the high interest rates that his analysis predicts. On the contrary, they would claim that there is a shortage of safe assets."

If I know anything about Hayekian predictions is that they never predict WHEN something will happen, they only predict WHAT will happen--IF X CONTINUES TO HAPPEN. I trust these predictions very much like I trust predicting that a ball will go flying down field if a picture continues to wind up and and throw it.

" Yet few of us are confident or aggressive enough to take big short positions in Treasuries."

The problem with taking short positions is the inability to predict WHEN. A short investor could be wiped out waiting for the market to turn the way it will inevitably turn. The other problem is that the prediction is conditional. If X stops happening the prediction can change. If the government shrinks the way it did under Harding, the short position is wrong. So to take the short position you are making two bets that go beyond the scope of the Hayekian prediction. It's probably reasonable to predict that government won't shrink the way it did under Harding but Hayekians have nothing to say about this. You could take a guess as to when the market will crash but Hayekians have nothing to say about that either.

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