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August 19, 2011 Fed may try the ultimate
confidence game: A CNN article speculates that, rather than another round of QE, the Fed may attempt "operation twist." That is, try to flatten out the yield curve by selling short-term bonds and buying long-term bonds. Consider first that a steep yield curve is seen as the sign of a healthy economy, and to try to flatten it out would really discourage natural long-term investing, as it would compress the spreads that account for time preference and interest rate volatility risk, the theoretical foundation for why a one-year bond has a lower interest rate than a 30-year bond. Also, about half the public debt is financed at a term of less than one year. The median duration of the public debt is three years. Governments traditionally finance the bulk of their debt at short-term adjustable rates, not only because the interest rate is lower and they save money that way, but mainly because to do otherwise would spook investors by signaling that the government may be gearing up for a higher inflation/higher interest rate environment. If a government starts restructuring its debt away from short-term rates that would be exposed to an interest-rate move, and towards long-term rates that would be well insulated from such a move, the most likely reason is that said government plans to push an expansionary monetary policy that will push inflation, and because it encourages all kinds of malinvestment, resource misallocation and faulty price signaling, nominal rates can't be significantly lower than inflation for any length of time. Therefore, nominal rates must rise in such a scenario. Imagine that you were loaning money to someone who also had the power to change the real value of that money over time (perhaps Ben from my LOST monetery theory thought experiment, found below). Logically, you would feel more comfortable loaning to someone with this power under terms that required the frequent renegotiation of the interest rate. If after years -- actually decades -- of loaning money on such terms, Ben came to you and said, "I would like to start borrowing money without renegotiating the interest rate for much longer this time," it would be cause for concern. The natural question would be, "Why?" And Ben's most likely honest response would be, "so that I can transfer real wealth from you to me." You would be disinclined to make such a loan. Such a move would send a stronger signal than when Angelo Mozillo (former Countrywide CEO) was dumping hundreds of millions of dollars in his Countrywide stock right before the music stopped and everything imploded, all while explaining it away as needing to send his grandkids to college. QE will be necessary as long as fiscal deficits exceed what traditional lenders are willing to lend. I see the potential for "operation twist" to be in addition to QE, not a replacement of. -- Also at SeekingAlpha -- August 13, 2011 Thought experiment: Imagine you were LOST on a desert island with about 100 people. Economics is much easier to understand now. After solving your most pressing basic needs such as food, water, and shelter, such a group would develop an economy of sorts if given enough time. A specialization of labor and an exchange of what is produced by that labor would evolve. Imagine our island economy. We might have John the hunter, Jin the fisherman, Jack the doctor, Michael the builder, Kate the dressmaker, Sawyer the bookseller, Hurley the chef, and Ben the central banker whose task it is to keep the island economy humming along smoothly. Ben issues the currency that the island economy uses as a medium of exchange. Now, imagine that economic activity starts to slow down on the island. John is selling less boar; nobody’s buying Kate’s dresses; people start cooking for themselves instead of paying Hugo to cook for them. Let’s think through the two different policy options that Ben the banker has:
The first option will “grease the wheels,” so to speak, by making people feel temporarily wealthier. You might not buy Jin’s fish at $10 when your island income is $100/week, but you may very well buy it when your island income is $200/week. There are a few problems with this method though. First, it only “works” temporarily. Eventually Jin will raise his price of fish, and consumption of it will fall to the previous level, and you’ll be right where you started. If Ben tries to keep it up by continuing to expand the money supply, eventually people will come to expect the higher prices, and Ben's fix will lose even its temporary effect. The only hope of maintaining even the temporary effect would be to keep consumers guessing about when he was going to increase the money supply by resorting to erratic and unpredictable changes in the money supply, and that would have all kinds of ill effects on long-term planning. Secondly, it assumes that there is no structural reason why consumers aren’t buying his fish. What if people just don’t like the fish that Jin is catching, or the dresses that Kate is making? What if buying less is a way of signaling that Jin and Kate need to produce something else? What if it is saying that people would rather sit on the beach and work less? Should Ben still try to override this? In the long run, won't such a policy deny the island of being able to buy the things they really want to buy and to work the hours they really want to work? The Paul Krugman babysitting co-op Paul Krugman ran this same thought experiment on the Capital Hill baby-sitting co-op 14 years ago and reached a very different conclusion. Krugman saw a baby-sitting exchange co-op as a case study on the need for an active central bank with an elastic currency. The co-op had an exchange system where one hour of sitting service that was provided entitled the sitter to a claim check to receive one hour of sitting service. The co-op quickly developed a cash-hoarding problem that Krugman saw as justification for an activist central bank. Parents would try to save up claim checks for summer weekends and drinking holidays, which lead to an imbalance between those who were willing to buy sitting service and those who were willing to sell sitting service. The market fell far out of equilibrium. So what is the best method to get it back to equilibrium? Krugman said there should have been a central bank that could issue more claim checks. I say they should have allowed the price of sitting service to float. Everyone knows that an hour of sitting service on an average Wednesday evening is not worth the same as an hour of sitting service on New Year’s Eve, but that’s exactly what their system tried to enforce. Their system essentially created a price ceiling for sitting service. A better system still would have used an internal script, but would have allowed buyer and seller to negotiate the price. This way someone will sit for New Year’s because they know it will buy them a week’s worth of regular sitting. The lesson is that price ceilings don’t work, not that markets can’t function without a central bank. It’s really the difference between screwing in a light bulb by twisting the bulb, vs. holding the bulb still and turning the house around the bulb. -- Also at my Seeking Alpha blog -- August 13, 2011 Can't downgrade U.S. There’s a difference between nominal default and real default, and the ratings agencies measure only the probability of nominal default. The U.S. may very well be on course to default on its debt obligations in real terms through inflation and currency debasement. However, there is no chance of defaulting in nominal terms, because the only requirement is to repay in a currency that the government can always print more of. Could you ever lose at Monopoly if you could write your own money? It would make for an interesting experiment to see how the other players would adjust their strategies. The S&P downgrade also completely ignored the concept of relative risk, which is really the only kind that matters for investing. The absolute risk of U.S. Treasuries, even in real terms, is unimportant. It is only their risk relative to other fixed income investment options that matters. Consider the handful of U.S. corporations that S&P still rates at AAA; are they really a lower risk than U.S. Treasuries which S&P now rates at AA+? Is it really a safer bet to loan Microsoft money than to loan the U.S. government money? No, not in nominal terms, or even in real terms. In nominal terms, the government can print money, Microsoft cannot. But even in real terms, since Microsoft's obligation is to repay you in dollars, the exact same inflation risk that applies to government debt also applies to Microsoft debt. Every U.S. corporate bond is denominated in dollars. Every U.S. state or local municipal bond is denominated in dollars. Any risk of real default on U.S. Treasuries through inflation applies to every single bond issued in this country. In terms of relative risk, there is no change, and U.S. Treasuries remain the risk-free investment in relative terms. The irony of the entire situation is that the U.S. government empowered the ratings agencies far more than any competitive market would have ever allowed. They are probably the best example of a government-made monopoly. As early as just after the Great Depression, and after the recommendation of the Federal Reserve, bank regulators began using ratings agencies to determine capital requirements, and insurance regulators began using them to determine which bonds were legal to hold. In 1973, the five ratings agencies in existence were given formal cartel/permanent oligopoly status by the SEC. A rule change required investment banks dealing in securities to hold a higher level of reserves, unless they were dealing in rated securities. The caveat was that the rating had to come from one of the five (since consolidated to three) ratings agencies. The ratings agencies have huge profit margins, 52% for the only one that has the publicly traded data, while providing a product that is of laughing-stock quality. Investors showed that they will not heed the “warning” of the ratings agencies as they still treated Treasuries as a safe haven, moving enough money into them to cause interest rates on government debt to plummet, the exact opposite of what would have happened had people actually believed that the government carried more risk. If Moody’s and Fitch also downgrade, things could get interesting. Most of the big sources of investable wealth in this world (insurance companies, pension funds, sovereign wealth funds) are barred from holding anything but AAA-rated securities. A downgrade from the other two agencies would lead to an epic scale dumping of government debt under current rules (emphasis on the current rules part). -- Also at my Seeking Alpha blog -- |
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