Tuesday, May 26, 2009

What did I tell you about bonds?

Lot of jargon here, but important:
The interest yield on 10-year US Treasuries – the benchmark price of long-term credit for the global system – jumped 33 basis points last week to 3.45pc week on contagion effects after Standard & Poor's issued a warning on Britain's "AAA" credit rating.
The yield has risen over 90 basis points since March when the US Federal Reserve first announced its controversial plan to buy Treasury bonds directly, a move designed to force down the borrowing costs and help stabilise the housing market.
The yield-spike may be nearing the point where it threatens to short-circuit economic recovery. . . . The Obama administration needs to raise $2 trillion this year to cover the fiscal stimulus plan and the bank bail-outs. It has to fund $900bn by September.
"The dynamic is just getting overwhelming," said RBC Capital Markets.
The US Treasury is selling $40bn of two-year notes on Tuesday, $35bn of five-year bonds on Wednesday, and $25bn of seven-year debt on Thursday. While the US has not yet suffered the indignity of a failed auction – unlike Britain and Germany – traders are watching closely to see what share is being purchased by US government itself in pure "monetisation" of the deficit.
(Via Instapundit.) OK, who's been warning you about this? March 23:
My own point of view is that last week's Fed buy-up of Treasury notes represents the fateful step into the fiscal/monetary abyss of Weimar America. We are so f****d now that the only question is what kind of financial rubble we will find most useful in rebuilding the shattered wreck of an economy that will be left desolated by the remorselessly descending spiral of inflation/stagnation that now begins in earnest. . .
When that disaster finally hits -- when capital freaks the hell out and the bond market goes sideways -- the lone sanctuary of sanity and calm will be Galt's Gulch.
I've tried to explain this in more detail at the American Spectator. I'm not an economist, of course, but you don't have to be an economist to understand (a) bonds are sold in a market, (b) the pace of deficit spending means a huge increase in the supply of debt, and (c) the loss of capital in the meltdown means weak demand for securities.

OK, so even if there were enough demand to buy up all these bonds (i.e., the Treasury notes issued to pay for the deficit spending), if the Treasury sucks up that much capital, what will be the impact on the stock market? And what will this mean for the amount of capital available to private borrowers including businesses?

Bill Clinton was elected in 1992 after promising all kinds of new stuff during his campaign. But then he sat down to talk to his economic brain trust (Larry Summers, Lloyd Bentsen and a lot of Goldman Sachs people) and they said, "Uh-uh. You pile on all kinds of fresh deficit spending, and the bond market will tank."

Like Obama, Clinton was an Ivy League law grad who didn't know jack about macroeconomics, but his background in Arkansas gave him that kind of Chamber of Commerce pro-business attitude that most Southern governors had. So when his financial advisors explained the basic reality of capital markets and why new deficits would hinder recovery, Clinton took it seriously and canceled a lot of his promises.

This infuriated a lot of people, including Labor Secretary Robert Reich, and James Carville famously said, "Man, I wish I was the bond market. Then people would respect me."

That basic story has been told by Robert Reich, William Greider and others, and I had it in the back of my mind in December when I first wrote "It Won't Work" in December and followed up with "It Still Won't Work" in February. Clinton wisely heeded the warnings about the bond market, whereas Obama pushed recklessly ahead, and so we march down The Road to Weimar America.

UPDATE: Welcome, Instapundit readers! In the comments, Jimbo begins a dissertation by telling me that I "don't understand how reserve accounting works in a floating exchange rate fiat money system." And I don't for a minute claim to do so.

However, I do understand that supply and demand function in every market, including bond markets, stock markets and currency markets. Furthermore, I understand that "currency" and "capital" are not the same thing. When the government prints currency, the mere act of printing does not create capital.

What we are dealing with, in this recession, is a capital shortage. The collapse of the housing bubble wiped out a massive amount of value. People had borrowed money against that value, and the creditors whose capital was invested in those loans are now trying to figure out exactly how many cents on the dollar they might be able to collect, and how soon.

Ergo, there is a severe liquidity crunch, which the federal government is attempting to remedy through deficit spending. But deficit spending is borrowing, and so money that might otherwise be invested in the (job-creating, growth-inducing) private sector is instead being siphoned off into government bonds.

Something is wrong here. Whatever the result of such a policy, it will not be economic growth. Exactly what "reserve accounting" has to do with this, I don't know. What I'm seeing is the monetary cat is chasing its fiscal tail, and taking an educated guess that the result will be stagflation.

UPDATE II: Linked at RCP Best of the Blogs.

15 comments:

  1. James Carville famously said, "Man, I wish I was the bond market. Then people would respect me."No James, the market is just backdrop. Your problems go much, much deeper, and haven't abated since the Clinton administration.

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  2. A nonissue. You don't understand how reserve accounting works in a floating exchange rate fiat money system. (Don't feel bad, not many do - including most of the people in charge of the system, and most of the economics profession)

    Operationally, deficit spending adds reserves to the system. Bond sales drain them. As long as there is a non-zero interest rate, there can never be any problem selling the bonds, since the only other option is that some people would rather hold on to a non-interest bearing government liability (cash or reserves) rather than an interest bearing one (bonds). There is no other option - all other transactions just move reserves around. The only way for them to be actually drained from the banking system is for either the Treasury or the Fed to exchange them for bonds. In fact, the only real reason for the government to issue bonds at all is support a non-zero interest rate.

    Real world example: Japan. Japan has run deficits in excess of 7% of GDP for years, has a debt-to-GDP ratio over twice the U.S.'s, and it's interest rates are just barely over 0 (even after Moody's dropped its credit rating to below Botswana's!). And no, it has nothing to do with it's status as a creditor nation, the postal savings system, or any of the other "explanations" people have for a very simple matter of accounting: any sovereign currency issuer can do the same with it's own currency.

    The can be real deleterious effects if the deficit gets too big (or if it gets too small), but there is no solvency risk, and there is no real risk of a hyperinflationary cycle in a country with a functioning tax system (taxes give value to the currency, and with a progressive tax system the budget automatically tends toward surplus as economic activity increases.)

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  3. This is hearsay, but it's a good story so I'll pass it on anyway. President Clinton, after being told the bond markets will kill him if he piled on too much debt, threw one of the famous Clintonian rages.

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  4. Mr. McCain - I beg to difer1
    The bush men – Bernanke and Paulson – are telling us and have told us that inflation is not a problem and will not be a problem! Are you implying that anyone aligned with the Bush Clan would be disingenuous? Maybe even lacking integrity!
    How long before I can replace the wall paper on the master bedroom with $1,000,000 bills?
    An old exJarhead
    Cerritos, Cal

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  5. "Are you implying that anyone aligned with the Bush Clan would be disingenuous? Maybe even lacking integrity!"

    Certainly sir. Now are we permitted to confront the problem of looming massive inflation? Apparently you are still a jar head.

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  6. I don't see how the destruction of the economy would be bad for Obama - it would be a sterling opportunity to grab even more power.

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  7. In your Wiemar America post you mention that unemployment is accelerating. The numbers certainly are getting worse, but I maintain that employers that purchase labor have been accelerating those purchases ahead of the minimum wage hike coming at the end of June. In other words, we'll be seeing much more unemployment.

    Second, in responding to jimbo you wrote: 'I understand that "currency" and "capital" are not the same thing. When the government prints currency, the mere act of printing does not create capital.' You're hinting at Say's Law.

    As for jimbo... this insight of his speaks volumes: "...with a progressive tax system the budget automatically tends toward surplus as economic activity increases." I don't remember Andrew Jackson relying on a progressive tax system or the then non-existent income tax when he paid of the national debt.

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  8. I dunno. I've been trading bonds for 25 years and most of what jimbo wrote is gibberish to me. That's not to say he's FoS, just that he's speaking a different language than the Street.

    But 10-year T-bonds at 3.5% not only isn't a problem, it doesn't say much about any down the road. I think the diagnoses is correct but the current bond market is not a symptom you can point to.

    Sometimes markets are wrong and bond buyers are sometimes suckers.

    Last thing, there's no liquidity crunch. There's loads of money around. But no one's lending (except to the Treasury--thus the low rates.)

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  9. jimbo, the flaw in your argument is that the vast bulk of the economy is composed of people who don't understand reserve accounting &c. What they see is more money going out of the Fed, and less money coming back in taxes. They know what happens when the same thing happens to their own finances: Bankruptcy. Hence, at some point confidence in Treasuries will evaporate, and the dollar will collapse.

    You bring up Japan as an example for your case, and I will respond with Zimbabwe. Mugabe thought he could print his way out of his problems, and hyperinflation was the result. Do you imagine that the same thing can't happen to the dollar if Obama tries to print his way out of our problems?

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  10. President Jackson also took a cyclical downturn and turned it into a seven year Capital 'D' Depression, so quoting him as your economic ideal may warrant a re-think.

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  11. Jimbo said:

    "As long as there is a non-zero interest rate, there can never be any problem selling the bonds, since the only other option is that some people would rather hold on to a non-interest bearing government liability (cash or reserves) rather than an interest bearing one (bonds)."So, there are no investment options but bonds? Dear me, no. The bonds have to compete with other investment vehicles. Investors weigh the real returns and the likelihood of inflation eroding same in making their buying choices.

    You can't get something for nothing.

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  12. "...there is no solvency risk, and there is no real risk of a hyperinflationary cycle in a country with a functioning tax system (taxes give value to the currency, and with a progressive tax system the budget automatically tends toward surplus as economic activity increases.)"

    Boy, you sure seem to minimize the potential problems. Sure, the budget will balance by running up greater debt, brilliant!!!!

    "taxes give value to currency"

    What does that even mean?

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  13. James Carville famously said, "Man, I wish I was the bond market. Then people would respect me."Well,

    He's STILL not the bond market.

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  14. "...with a progressive tax system the budget automatically tends toward surplus as economic activity increases"The key word there is "tends". In other words, the Master of the Obvious is saying tax receipts rise as economic activity increases. Who'da thunk it?

    When bond interest rates rise, it pushes up rates across the board. Jimbo is shooting a line of BS. Don't bother with it.

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  15. The "crowding out" effect, often predicted but never seen, will finally show up, as US deficits break all records.

    The best case scenario is that we're, over the next few years, trading some current growth for less future growth. The worst is that we just get the hyper-inflation, with little aid to current prsoperity, but a s***-load of debt to work off over God knows how many generations.

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