Monday, November 1, 2010

A Giant Black Friday Sale On Money

Banker friend Ó Coileáin has useful things to say on why we should borrow more money and ignore the mouth noises made by people who own Treasury bonds:
There's two states in which government borrowing dominates private borrowing:

1) Interest rates are high. If I can get 8% or 10% on treasuries and the government looks reasonably healthy, why invest privately for a small percentage pickup? I have lots of space to make up margin by funding cheaply, particularly if I'm a bank. In the real economy, lots of stuff fails to happen because it can't generate a safe 8-10%. Think of this as a "high time value of money" world.

2) Flight to quality. If everything else in the world is so scary that you don't want to touch it, you buy treasuries and wait. Rates get cut to zero, but you don't care because you're worried about blowing up from risk. Here, lots of real economy stuff fails to happen because investors are too spooked to fund. Think of this as a "high risk premium" world.

There's a big difference in investor attitudes between (1) and (2). In (1), inflation may be high but you're still making a nice outsized return supposing that default is unlikely. You buy treasuries because they yield a lot. Investors are happy. In (2), nobody owns treasuries because they want to, they own them because the rest of the world is worse. Probably you've been badly burned recently and are skittish about doing anything levered or risky despite the tiny return on your treasuries. Investors are unhappy.

There's also a difference from a "return to normalcy" perspective. If the world stabilizes back to 5% or so long term interest rates if the time value of money is high, treasury investors make money: interest rates down, value of bonds up. In the high risk premium world, rates are low and stabilization means treasury investors lose money: interest rates up, value of bonds down. That is, in the second scenario bond investors are actually short economic recovery.

The key point here for me was Bill Gross of PIMCO saying a few months ago that treasuries are the "least dirty shirt." It's not that he wants to own treasury bonds, more that he doesn't want to own anything else. There are risks to government bonds, but they're less bad than the alternatives if you're spooked.

The usual suspects (Delong, Krugman) say "hey, we can borrow for 10 years at 2.63%! Let's do that!" And they're right as far as that goes -- and the people who argue that markets can turn on a dime usually don't have much analysis to support the conclusion. What's truer: interest rates are probably only as low as they are because bond markets are spooked out of their minds. Markets will likely become un-spooked only slowly; there could also be a shock to confidence in treasuries relative to other things, but what that might look like is unclear.

I think this actually makes the case for short-term deficits better -- it's like a giant Black Friday sale on money and we should take advantage before it goes away! This, of course, is exactly what current treasury buyers are afraid of, since we're talking about actions that will raise inflation and interest rates, restore normalcy, and thus lose them money if they only own treasuries. They do know this; they're just too spooked to go buy something else. So we hear the cries of unhappy bond investors essentially begging the government not to take advantage of them. Happy bond investors in scenario (1) don't complain, they cheer recovery; unhappy bond investors whine loudly in an effort to dodge what they clearly have coming.

Point being, revealed preference is what you do, not what you say -- for all the screams of bond investors wanting to avoid inflation, they're still buying at 2.63% for ten years and until they actually stop it's just jawboning. Economically, I think we would do well to extend maturities (kind of the opposite of QE2 unless it's never reversed) and just generally let bond investors have it with a small dose of inflation. After all, bond investors have seen a thirty-year rally in treasuries: they deserve to be disappointed for once.
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