David R. Henderson  

Altering the Federal Debt Structure: Go Long

California's Laffer Curve: Pla... How Deep to Cut: A First-Pass ...
One advantage the United States has that Canada didn't is low interest rates. Interest rates today are much lower than when the Canadian government altered course. The yield on the ten-year Treasury bond in late June 2010, for example, was only about three percent. So, one thing the U.S. government could do quickly is to convert some of its shorter-term debt to ten-year debt, paying a higher interest rate in the short run but protecting itself against interest rates greater than three percent over the next ten years.
This is from my Mercatus study, "Canada's Budget Triumph."

I thought of this when I read the latest post of John Cochrane, aka "The Grumpy Economist." I advocated a partial shift in the federal debt from short-term to long-term debt so that the feds could protect themselves from an increase in nominal interest rates. John Cochrane advocates the Full Monty:

As I think about the choice between long and short term debt, I feel like screaming "Go Long. Now!" Bond markets are offering the US an incredible deal. The 30 year Treasury rate as I write is 2.77%. The government can lock in a nominal rate of 2.77% for the next 30 years, and even that can be paid back in inflated dollars! (Comments at the conference suggested that term structure models impute a negative risk premium to these low rates: They are below expected future short rates, so markets are paying us for the privilege of writing interest-rate insurance!)

His reasoning is similar to mine, although more spelled out and nuanced:
Here's the nightmare scenario: Suppose that four years from now, interest rates rise 5 percent [he means "5 percentage points], i.e. back to normal, and the US has $20 trillion outstanding. Interest costs alone will rise $1 trillion (5% of $20 trillion) - doubling already unsustainable deficits! This is what happened to Italy, Spain, and Portugal. Don't think it can't happen to us. It's even more likely, because fear of inflation - which did not hit them, since they are on the Euro - can hit us.

Moreover, the habit of rolling over debt every two years leaves us vulnerable to a rollover crisis. Each year our Treasury does not have to just borrow $1 trillion to fund that year's deficits. It has to borrow about $4 trillion more to pay off maturing debt. If bond markets say no, we have a crisis on our hands.

Going long buys us insurance against all these events. And bond markets are begging us to do it! Most large companies are issuing as much long-term debt as they can.

Cochrane also uses his extensive understanding of financial markets to handle the various concerns that might occur to the cognosenti. The whole thing is worth reading.

He cautions, though:

Obviously, these moves need to be coordinated with the Fed. There is no point in lengthening if the Fed just twists it away. I notice a tendency of the two institutions to follow parochial concerns and to forget that there is a single budget constraint uniting them!

I add my own caution, and it relates to why I didn't advocate shifting all of the debt from short-term to long-term: the shift is a signal. If the feds did so in one fell swoop, people in the market might fear that it's a signal that the government plans to raise inflation substantially. That's why I had in mind shifting about $2 trillion.

In case I haven't mentioned it on this blog--I vaguely think I have--I informally mentored John and his friend Chris Ballinger when they, on leave from UC Berkeley's Ph.D. program--were junior economists at Marty Feldstein's Council of Economics Advisers--Greg Mankiw was another junior at the time--and I was a senior economist.

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CATEGORIES: Finance , Fiscal Policy

COMMENTS (13 to date)
8 writes:

The Treasury will start issuing floating rate bonds soon to avoid the rollover crisis.

Another issue with shifting the debt is current demand. There may not be enough demand at 2.8%. Maybe the real signal they are afraid of sending is that if they tried to borrow for 30 years in size today, they'd have to pay 4 or 5%.

Steve writes:


You make no explicit mention of supply and demand. Negative long swap spreads imply that investors crave long-term debt and that there is simply not enough being issued to satiate these investors. If suddenly the US Treasury issues trillions in long-term debt, would that not cause the price of purchasing such debt to decrease thus causing long rates to rise?

Phil writes:

Debt structure often comes up in my budgeting class when the perceptive student notices the interest burden on the debt has not risen in the last five years despite the large increase in total debt. What is interesting is that while the percentage of debt held by the public in 30-year bonds is down from 21% of the debt to 12% in the last 10 years, the percentage held in short-term T-bills has also fallen (from 29% to 16%). The net amount in T-notes (2-10 year duration) increased from 50% to 72%. The rollover crisis is indeed a concern, but could be worse if there was more in very short term debt.

If we moved $2 trillion from Notes to Bonds as David suggests, the distribution would be approximately: 16% bills, 52% notes, 32% bonds - an historically high amount in long-term debt, but bought at historically low prices.

A decade ago when 21% of the debt was in 30-year bonds, the average interest rate on those bonds was 8.3%; today's average is 5.6% with marginal rates below 3%. At such historically low costs of borrowing, we are foolish for not shifting that debt into longer term instruments.

One question: to what extent has the Fed's "twist" strategy impacted the market for debt at various maturities?

Mark writes:

Isn't it true that one reason long-term interest rates are so low is because the Federal Reserve, through "Operation Twist" and now QE3, has increased the demand for long-term Treasury bonds and mortgage-backed securities? Doesn't this mean that when interest rates start to rise, either the FED has to a) sell this debt at a substantial loss, or b) has to hold it to maturity. In either case, the Fed's ability to sop up all the liquidity it has issued over the past five years is hindered.

More importantly, the argument for shifting to longer-term bond issuance is simply arguing to further monetize the debt.

Warren Gibson writes:

Lengthening maturities would lessen the chance of a future interest/debt spiral, but at the cost of increased near-term interest expense and hence worsening short-term deficit. Trading short-term pain for long-term gain is not what politicians like to do.

Justin Rietz writes:

I'm unclear as to why it matters, under a scenario in which the U.S. Gov't "goes long," whether the Fed performs another Operation Twist. The U.S. Gov't would still face the same interest payment time structure.

Is it because the Fed would be less likely to cause a rollover crisis?

David R. Henderson writes:

@Justin Rietz,
I'm unclear as to why it matters, under a scenario in which the U.S. Gov't "goes long," whether the Fed performs another Operation Twist. The U.S. Gov't would still face the same interest payment time structure.
Let's say the USG goes long by converting $5 trillion of short-term debt into long-term debt. Then let's say that the Fed buys all of this long-term debt and sells $5 trillion of short-term debt, a large version of Operation Twist. Then, if interest rates spike, the USG has to pay out a lot more than otherwise. Whereas, if the new Operation Twist hadn't occurred and interest rates spiked, a lot of what the Treasury paid to the Fed would come back to the Treasury.

MingoV writes:
... so that the feds could protect themselves from an increase in nominal interest rates...
The Federal Reserve needs to be protected against itself? Interest rates are low because the Fed decided that cheap loans (for the government, businesses, and consumers) are more important than decent returns on investment for savers. The low interest rate can be maintained for years if the general economy doesn't improve (a highly probable outcome for all of Obama's second term).

Anyone paying attention knows that inflation will increase greatly once the economy improves enough to free-up all the corporate cash reserves. We don't need a "signal" from the Fed switching to longer-term bonds, bills, and notes.

Justin Rietz writes:

@David R. Henderson:

Whereas, if the new Operation Twist hadn't occurred and interest rates spiked, a lot of what the Treasury paid to the Fed would come back to the Treasury

So, the USG would have less to refinance under a no-Operation Twist scenario, correct?

mikedc writes:

Anyone have a good estimate of the relevant elasticity?

Costard writes:

The 30 year may be 2.7% but the the 10 year is 1.6%, and the interest on shorter maturities is essentially zero, with real rates negative.

This is a strong incentive for the Treasury to shorten duration, particularly with the budget so far in the red. The administration will not see any advantage in growing federal deficits by several hundred billion/year for no immediate gain -- not when it can backload the interest rate adjustment on to subsequent (and possibly Republican) administrations.

Apres moi, le deluge.

David R. Henderson writes:

@Justin Rietz,
So, the USG would have less to refinance under a no-Operation Twist scenario, correct?
Anyone have a good estimate of the relevant elasticity?
Which elasticity?

Preston Hay writes:

One might think of this in three periods. Over the very near term, shifting to a longer term debt would increase the interest payments (as Warren Gibson points out, the politicians who are in power do not want that).

Over the medium term (ten years is not so long), the shift would reduce payments.

But over the true long term, it really doesn't matter, because the difference in paying $300B per year or $400B per year is in the noise if our "leaders" don't start making some sense.

If we persist in acting stupidly in the global economy, the GDP will continue to grow at a low rate and income can never catch expenditures. Future financing may be possible only at a high interest rate.

In 1960 the interest paid on 10 year bonds was below 4%. In the period between then and now, this rate averaged above 6% and reached a maximum of 14%. Of course, if the USG had to pay this later amount today, every cent that they collect would go to interest on the national debt. Never, ever say it can't happen.

So, twist, QE or bail, the economy must be brought to a balance and I would argue that this must start by bringing manufacturing back to this country so we can grow again. But that is another longer discussion.

I found all responses to be interesting and useful. Keep up the good chatter. And hope that we can run our present "leaders" back to their homes. And return our country to sanity.

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