Tyler Cowen discusses the general implications of runs on the new (shadow) banking system. Though this point leads directly into something that I have been thinking about
Another feature of this new order is that more and more financial transactions will be collateralized with the safest securities possible: United States Treasuries. Demand for them will remain high, and low borrowing costs will ease our fiscal problems. Still, the resulting low rates of return serve as a tax on safe savings, encourage a risky quest for yield and redistribute resources to government borrowing and spending. It isn’t healthy for the private sector when investors are so obsessed with holding wealth in the form of safe governmental guarantees.
Its actually not clear to me that demand will remain high, in the sense that the term spread will not reassert itself. To explain a bit more:
The interest rate on T-Bills is simply whatever the Fed wants it to be. T-Bills and excess bank reserves are essentially interchangeable. In normal times the value of excess reserves is the Fed Funds rate. Today it is the Interest on Reserves rate. However, both of those are essentially controlled by the Federal Reserve.
If we lived in a world with zero risk then one would expect the interest rate on 10 year Treasury bonds to simply be the weighted average of the interest rate on T-Bills for the next ten years.
However, there is risk so, investors (a) have to guess what that interest rate will be and (b) demand a premium for the risk that they are wrong. This is the term premium and its why interest rates on long term government bonds are persistently higher than short term government treasury bills.
To the extent that expectations or risk appetite in the bond market exert direct influence on US Treasury interest rates, it is through the term premium.
Right now the term premium is extremely low, indeed one would guess that it is negative. The interest rate on a 30 year government bond is only 3.3%.
While its possible that the interest rate on T-Bills averages only 3.3% over the next 30 years this is – hopefully – extremely unlikely. It implies that nominal GDP growth will average 3.3% over the next 30 years, as the Fed must ultimately align interest rates with nominal growth rates or the economy will persistently overheat or stagnate.
The more likely explanation is that the demand for safe liquid assets is so high that investors are willing to accept a negative term premium.
Will this continue?
The answer is almost assuredly, no.
This implies that long term interest rates on government debt is likely to rise and that conversely the value of long term government debt will fall.
US Government debt is in a bubble.
I am coming to believe that bubbles are a persistent feature of the modern global economy and extend from the fact that the world is aging. As this continues the bubbles will likely only get larger and larger.
The simple reason is that as individuals pass into middle age they attempt to increase their savings. One way to do this by loaning or renting resources to the next generation. However, as the population ages opportunities to do this are more and more rare.
This implies that savings can only take place through capital deepening. In essence this means more investment per worker. This expansion in investment per worker causes some types of capital to liquefy. That is, existing pieces of capital can readily find a buyer at fundamental values.
Yet, once capital liquifies it begins to earn a liquidity premium – like the one earned by US government debt now. This, in turn, drives the market price on the capital even higher and we enter a bubble.
In practice, the capital object itself doesn’t get moved around but a financial instrument entitling someone to the rents from the use of the capital or a debt secured by the capital. However, the effect is the same. The financial instrument becomes liquid, starts to earn a liquidity premium and then goes into a bubble.
My growing sense is that this process has been repeated over and over again since the late 1980s. First, in Japan. Then in Korea and South East Asia. Then in the US tech industry. Then in the developed world’s housing markets. Now in US and UK government debt.
Moreover, there is no obvious way to stop this from happening. On first thought it would seem that deflation could prevent this by causing cash to earn a positive rate of return. This basically just ratchets up the money bubble.
However, without negative nominal interest rates this worsens the ultimate problem of expanding the capital stock because it essentially subsidizes money as a store of value against capital.
So, I don’t know that there is a clear way to stop this from happening.
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Sunday ~ March 25th, 2012 at 12:54 pm
BSEconomist
I’m not satisfied with your thinking here. I’m willing to be convinced, but your argument is that gov’t debt is in a bubble because a) it earns a term premium and b) its value must eventually fall. This is a strange notion of “bubble”, so broad it seems to me as to be without meaning. A bubble is a deviation from fundamental values, not a situation in which “prices must eventually fall”.
The problem that I have, really, is that this sort of bubble talk really just leads to confusion. Otherwise, you can call anything you want a bubble and I wouldn’t care. Nothing in your analysis suggests that the US is headed for an imminent fiscal crisis if it doesn’t balance its budget, but that is exactly how some people will take it.
More specifically in this particular case, the fact that the current price of gov’t bonds exceeds flow value of the expected payments does not mean that gov’t bonds are in a bubble and the reason is right there in your post: they also have value as collateral. More importantly, they have value as collateral precisely because their fundamentals are so well anchored. The collateral value itself would be expected to fall as the economy recovers if we just presume (correctly) that a healthy economy generates collateral faster than an unhealthy one. So the price has not deviated from fundamentals and in fact, I would argue that the current term structure could in principle be sustained in perpetuity–it is just unlikely that that would be the case. I haven’t even brought up the effect of the market interest rate.
Your broader point that asset bubbles are the new normal for the world economy is actually something I myself worry a great deal about. It does seem that the supply growth of new assets has fallen behind the demand growth of assets, which makes sense in an aging world, and also that such a situation tend to produce bubbles. I think this danger, though, is lessened in a world with enough safe assets and therefore printing government bonds would generally reduce the risk of bubbles both by restraining excessive savings and giving what savings there are a place to go less prone to bubble generation–gov’t bonds have an easily calculated fundamental value contingent on the path of interest rates.
Sunday ~ March 25th, 2012 at 1:18 pm
cantillonblog
I trade bonds for a living, and I think you are spot on about bonds being mispriced on a longer-term view. I wouldn’t characterize it as a bubble exactly, because that implies certain specific things like people buying the asset, perhaps with leverage, expecting to make substantial capital gains. There doesn’t seem to be evidence of that happening here – except action by central banks. After a thirty two year bull market in bonds, there is now a mass psychological extreme that expects deleveraging for a couple of decades before the situation is normalized. Likely this dynamic is close to exhausting itself.
The reason for bubbles relates to Iain McGilchrist’s work “The Master and His Emissary”. Capital is no longer managed by wealthy individuals, or those working directly for them. Instead we have a bureaucratic system whereby it is managed by intermediaries who have no genuine investment expertise but make asset allocation decisions based on bureaucratic decisions and who have no accountability for their past mistakes. So for example, many pension funds are forced into owning nominal fixed income at any price to hedge their long duration liabilities because of the risk of mark-to-market moves that would impair their solvency. It makes no sense, but nobody can do anything about it, because there is no one person or body responsible for the rationality of the system as a whole.
Sunday ~ March 25th, 2012 at 1:26 pm
cantillonblog
There is a confusion here between the long-standing English-language use of the word “bubble”, and the horrible economist and sophister use. The latter used to mean any deviation from fundamentals has sucked all the meaning out of the term.
BSeconomist – interesting name you have there! If one simply needs collateral, why bother taking the duration risk? One could simply use T Bills. Your point would apply if it was only 30 year Treasuries that had low yields, and 30 year interest rate swaps were at levels consonant with reasonable expectations about the future path of 6mo LIBOR. But that is not in fact the case – the whole structure of long-term rates is clearly pricing in an adverse scenario for growth.
One can decompose yields into a real and inflation component. It’s clearly real yields that are depressed. Breakeven inflation does not appear massively out of line. So what we have here is a very pessimistic pricing of prospective growth along with talk that appears to justify it:
http://cantillonblog.com/?p=875
Sunday ~ March 25th, 2012 at 1:42 pm
Gov’t debt is the safest dollar valued asset « BS Economist
[...] Karl Smith had an interesting post up this morning suggesting that government debt is in a bubble. I think this is one of those rare examples in which he is confused. The problem I have is this: although there may be bond buyers with heterogeneous valuations of the stream of (nominal) payments from government bonds, there is no state of the world in which government bonds are less safe than other (nominal) streams of payment. The government prints the money behind all these nominal transactions. Even with the possibility of voluntary default, I don’t see how you could see it any other way… if the US gov’t doesn’t have enough money to pay its debts (or choses not to print more to do so) then why on Earth would you expect GE to have the money to repay its debts? [...]
Sunday ~ March 25th, 2012 at 2:16 pm
Lord
Money will seek to go into capital but that is not something to be thwarted but encouraged. This would make it less of a bubble by increasing their value along with their price and higher inflation would help. Eventually new discoveries and inventions may raise rates, but until then it should flow into all low return investments available and as they scale up new opportunities for discoveries and inventions will open up. .
Sunday ~ March 25th, 2012 at 3:12 pm
rjs
the shadow banking system is not an “investor”; it uses treasuries as money in the same manner that you use a ten dollar bill in your wallet
Monday ~ March 26th, 2012 at 1:28 am
Shadow Banking Bubbles and Government Debt Read more… « zumoit
[...] Banking, Bubbles and Government Debt Read more: http://modeledbehavior.com/2012/03/25/shadow-banking-bubbles-and-government-debt/ Share this:TwitterFacebookLike this:LikeBe the first to like this post. [...]
Monday ~ March 26th, 2012 at 3:10 am
Economist's View: Links for 2012-03-26
[...] Shadow Banking, Bubbles and Government Debt – Modeled Behavior [...]
Monday ~ March 26th, 2012 at 3:30 am
Links for 2012-03-26 | FavStocks
[...] Shadow Banking, Bubbles and Government Debt – Modeled Behavior [...]
Monday ~ March 26th, 2012 at 4:40 am
TomGrey
The first order effect of relatively too little saving (=investment), too much consumption will dominate the bubble effects — until there is enough “too much consumption” to cause demand based price increases in manufacturing goods. Then there will be higher value in investing.
But the aging of a wealthy population, without enough children/ future to sustain the community, more importantly implies a much less wealthy future community.
Monday ~ March 26th, 2012 at 9:37 am
K
Karl Smith: “While its possible that the interest rate on T-Bills averages only 3.3% over the next 30 years this is – hopefully – extremely unlikely. It implies that nominal GDP growth will average 3.3% over the next 30 years, as the Fed must ultimately align interest rates with nominal growth rates or the economy will persistently overheat or stagnate.”
I think there’s a Nobel waiting for you if you can demonstrate that theoretically the natural short rate must equal the GDP growth rate. Even over the long run. Along with the equity risk premium, the “correct” level of the risk-free rate is probably one of the deepest and most important problems in economics. What model do you have in mind?
Thursday ~ March 29th, 2012 at 2:19 pm
Woj
If “the Fed must ultimately align interest rates with nominal growth rates” than 30 years is not a long enough period. Over the past 50 years the Fed’s effective rate has been, on average, more than 1% lower than nominal growth. In fact, during the past 20 years nominal growth was 4.7%, while the Fed’s effective rate averaged ~3.3% (the same yield as current 30-year Treasuries). I show this data using Bloomberg charts in a post here: http://bubblesandbusts.blogspot.com/2012/03/economy-needs-bubble-but-treasuries-are.html.
Maybe this explains why the “economy will persistently overheat or stagnate.”
Monday ~ March 26th, 2012 at 10:51 am
Wolfrum’s Morning: This is just BS « William K. Wolfrum’s Morning « William K. Wolfrum Chronicles
[...] Emma Zahn: Shadow banking, bubbles and government debt. [...]
Monday ~ March 26th, 2012 at 12:57 pm
Monday links: a dangerous response | Abnormal Returns
[...] Government debt and the recurring feature of bubbles in modern capital markets. (Modeled Behavior) [...]
Monday ~ March 26th, 2012 at 1:28 pm
cig
This posts reminds me of a quote from Karl Smith: “prices clear markets”.
If there’s a juicy premium for liquidity, people will create contracts with attractive liquidity characteristics and pocket the premium. It’s of course difficult to create an exact replica of US treasuries if you are not the US government, but I think that you can get close enough in to put limits on the premium. It’s likely to take time though, markets don’t clear instantly.
Monday ~ March 26th, 2012 at 11:36 pm
Jay
But……….. but………….. What about all the lefties that are complaining that banks can borrow at 0% from the Fed (they never bother to mention the maturity or risk profile of the debt) and lend the money back to the Treasury at 3% (again they never bother to mention the maturity or risk profile of the debt) and make a guaranteed 3% profit! This has been called “the Banksters fleecing of America” by the financially literate lefties.
Tuesday ~ March 27th, 2012 at 12:12 am
Tank
The way to stop a bubble is to stop the government and the fed from influencing how money is allocated to capitol.
2008: Without Fannie, Freddie, and HUD mandating/encouraging loans to the riskiest home buyers, there would not have been a bubble. If you are try to blame CDOs and credit ratings agencies… think about who was the first to use these, Fannie and Freddie.
And in regards the bond bubble: Yes, after 2008 bonds would have increased in value just because people were looking for a different risk profile, but interest rates did ridiculously low until Bernanke started making promises to ballon the feds balance sheet.
You would be surprised at a free markets ability to avoid bubbles. Now the 2000 tech bubbles is a counter point to what I am saying… but this type of market bubble was much less devastating to the average american as it wasnt blown up by government interference. Wall Street suffered more from the tech bubble than main street.
Tuesday ~ March 27th, 2012 at 12:42 am
cantillonblog
What we are all missing here is some longer-term perspective on how we ended up here, and how our experience compares to that of previous generations in the West over the past few centuries. It’s understandable in an age when history begins at the first data point on a Bloomberg terminal that people think the past has nothing to teach us, but they are wrong.
Growth since the early 70s has been horrible – one sees this in the pattern of unskilled hourly real wages since then. One can think about the accumulation of debt as being a response to this difficult environment. We humans, being mortal tend to have rather a short perspective on things, and one of the most common mistakes we make is extrapolating the recent past into the indefinite future. Nature however tends to exhibit more of an ebb and flow. Her pulsations whose cycle extends beyond the experience of a single generation tend to be overlooked in the age of twitter and soundbite politics.
The fact that real wage growth since the 70s has been horrible does not mean that this will continue be the case for the next few decades. If I am right, then the Kondratiev cycle bottomed in 2008, and the future outlook will look rather different. At the moment, sentiment is terribly pessimistic. Which is why Tyler was smart enough to write a book on this theme (people will buy what makes sense of how they feel – they don’t want to be told something sharply at variance with how they feel), and why 10 year TIPS trade at negative real yields.
The question we ought to ask ourselves is are we perhaps succumbing to a misattribution of mood kind of error. Is it possible we are extrapolating the recent past indefinitely into the future and that we are on the verge of making the error of pessimism that so many years ago Pigou warned us of. I suspect that we are. If I am right, treasury yields are likely to chop around at low levels for a few more months, but in a year’s time should be very much higher than present levels. And in two years time sentiment about the long term prospects of the economy should be rather more constructive than it has recently been.
Tuesday ~ March 27th, 2012 at 3:54 am
Monday links: a dangerous response
[...] Government debt and the recurring feature of bubbles in modern capital markets. (Modeled Behavior) [...]
Friday ~ March 30th, 2012 at 1:17 pm
Expanding the debt bubble to a tipping point - London Ontario Alternative News for Local Business, World News, Sports & Entertainment Plus FREE CLASSIFIEDS
[...] Shadow Banking, Bubbles and Government Debt (modeledbehavior.com) [...]
Friday ~ March 30th, 2012 at 6:49 pm
jdwilson
Can you please discuss your claim that, “The simple reason is that as individuals pass into middle age they attempt to increase their savings.” I have been thinking about this, and wondered if the problem is more that as individuals pass into retirement they will (a) seek safer investments and (b) spend their retirement savings. As the “boomer” generation retires, won’t this create unprecedented effects on the structure of financial markets?
Wednesday ~ June 13th, 2012 at 10:38 pm
Ron Paul: Allow markets to work free of government interference | The Rand Paul Review
[...] instance in our history where these policies have been used, markets have created ever expanding bubblesthat threaten the very fabric of our economic system, and future debt obligations have risen [...]
Thursday ~ June 14th, 2012 at 7:52 am
Ron Paul: Allow markets to work free of government interference - Rise of the Right
[...] instance in our history where these policies have been used, markets have created ever expanding bubbles that threaten the very fabric of our economic system, and future debt obligations have risen [...]
Tuesday ~ June 26th, 2012 at 7:02 pm
Bursting the Bubble-Bubble « BS Economist
[...] while at the same time, government bonds were supposed to be in a ‘bubble’ as well (see here and especially here). Today Matt Yglesias points out (citing this) that Norway is in a property [...]