Bastiat wrote: ↑
Sun Feb 04, 2018 12:46 am
nedsaid wrote: ↑
Fri Jan 26, 2018 9:42 pm
garlandwhizzer wrote: ↑
Fri Jan 26, 2018 12:24 pm
30 year Treasuries yielded 14.8% in 1981 because bond market participants saw more than a decade of ever increasing interest rates and inflation, currently at about 15% in 1981, and they expected that to continue for decades. That, of course, turned out to be totally wrong in spite of all the smart guys' pseudo-insight into the future. How nice would it be today if you could buy a bond that yielded 14.8% a year guaranteed for 30 years by the US government? Alas, those days are behind us. The take home message, however, is that the consensus can be totally wrong at any time about anything. Beware when markets of any type are at historical extremes.
Currently long term inflation expectations are the lowest in history. Today that same 30 year Treasury yields 2.85%, about the lowest rate in 4 decades. The 4 decade average yield rate on 30 year Treasuries is close to 6%, more than twice the current rate. Currently inflation is running at over 2%. Just as in 1981, bond market participants have extreme expectations for long term inflation rates based largely on past history and projecting that past history forward. Taking long bond duration positions looks great now on long term backtesting, just as it looked horrible in 1981 on long term backtesting. There is a real possibility that, as in 1981, the smart guys with their clever historical models will turn out to be wrong again. There are a number of reasons that have developed in recent years why interest rates and inflation may rise from the grave (co-ordinated world-wide economic growth, rising rates and inflation in the US, reversal of QE, massive levels of governmental and personal debt that will need to be financed, full employment but additional fiscal stimulus in terms of tax cuts, fiscal stimulus, etc.,). Whenever in the past all market participants have had a consolidated single point of view on any issue, it has often been the time historically to take the opposing position. I think it is a mistake to assume that inflation will remain in its grave for the next 3 decades. Long duration in the bond market may in the future be a headwind instead of the tailwind as in the past 3+ decades.
Garland, great post as always. I will make the same point here that I made in another thread. Government deficits have nothing to do with interest rates. Reagan and Obama ran relatively large budget deficits and interest rates did nothing but fall each time. Reagan's economy started slow and went to a boom, Obama's economy emerged from the financial crisis and slowly recovered. Relatively strong economy vs. a relatively weaker economy, it made no difference, interest rates still fell.
I used to run the basketball scoreboard when I was in high school. When someone scored a basket, all I had to do to add a couple of points was to click the button a couple of times. I didn't have to go into a storeroom to get the points. I never had to tell the referee to stop the game because I ran out of points. Financing deficits is pretty much the same thing. People forget that the government has its own bank and that bank can buy US Government debt anytime it wants. Furthermore, the bank (the Fed) has to turn its profits over to the Treasury. So pretty much, the government can give itself an interest free loan anytime it wants. Another piece of the puzzle is that the private sector is in surplus when the public sector is in deficit. The surplus in the private sector soaks up the deficit in the public sector. The bigger picture is that the books always balance and debits always equal credits. I also read somewhere that larger budget deficits tend towards higher corporate profits.
Remember how the savings rates got so low when the Clinton administration ran surpluses? I know other factors affect savings rates rather than just budget deficits, but the deficits are a large factor. Remember also that in our economy, debt is money. More debt is more money supply and less debt is less money supply. Think of World War II, the greatest stimulus package of deficit spending of all time. The public had jobs and money but little extra to spend the money on as we had wartime rationing. Hence we had a big savings rate and a lot of those savings went into War Bonds.
A couple of anecdotal stories about War Bonds said that the buyers lost about 1/2 of the buying power of the monies used to buy the bonds. Pretty much a combination of economic growth and inflation in effect paid down our debt.
In fact, I have heard the argument that the national debt doesn't finance anything at all, we have debt to back our currency and so that the Fed can target interest rates. That argument seems to be extreme, but it makes sense to me and it might well just be right.
I know this goes against textbook economics, but textbook economics in this matter have been just plain wrong. It is counterintuitive, but it seems that larger deficits can mean higher private sector savings rates, higher money supply, higher corporate profits, and lower interest rates. The standard explanations just never worked for me. The Reagan deficits in the 1980's should have kept interest rates high but instead the rates fell and continued to fall for over 30 years. Somehow, those high deficits were always easily financed. The "crowding out effect" just never seems to happen.
Pretty much what backs currency is productivity. Inflation happens when you have too much money created versus too little increased production. Hyperinflation happens when you create huge amounts of money and productivity collapses. Interest rates on the debt that backs the currency is also a factor in how strong a currency is versus other currencies.
This is why I stated that to me, inflation is the thing to watch. The Fed controls short term rates but inflation expectations control mid and long-term rates. Which brings me to another point, that is governments can always shorten up the average maturities of their debt by increasing the issuance of short term instruments and buying long term instruments off the market.
I'd just like to point out that some of what is being presented in this post as fact is in actuality conjecture that is not widely accepted by economists. Specifically: WWII being good for the global economy (broken window fallacy); Public deficit equals private surplus (ignores capital surplus); etc.
There isn't really such a thing as "textbook economics" in this area, just different schools of thought. You're presenting essentially the Keynesian view, but there's also the Austrian, Chicago, Monetarist, Classical, and many others. Keynesianism is not established fact.
Yes, the point of view that I described is probably neo-Keynesianism. I have posted on this issue many times and the fact is that no one theory or school of thought fully explains how the monetary system works.
What is not conjecture is that the Federal Reserve Bank has to return its profits to the US Treasury. So to the extent that the Fed buys US Treasury Debt, the US Government is essentially making an interest free loan to itself.
I have been very dissatisfied with the standard explanations for a couple of reasons. First, it has never been shown that there is a relationship between deficits and the level of interest rates. As I pointed out, both the Reagan and Obama Administrations ran relatively large deficits and yet interest rates fell. The "crowding out" effect where supposedly government crowds private borrowers out of the credit markets just never seems to happen. Somehow deficits, even large deficits seem to be financed rather effortlessly. As someone described it, pretty much entering numbers into a computer.
It also isn't conjecture that the level of interest rates on sovereign debt does effect the strength of a nation's currency. All other things being equal, money will flow to the sovereign debt with the highest interest rates. Of course, in the real world all other things are never equal. The underlying productivity of a nation's economy and a nation's perceived political stability are also factors in the strength of a currency. Also, the confidence the rest of the world places in a nation's economic policies also affect the strength of a currency.
The other thing I didn't cover is the effect of trade deficits in all of this. China and Japan have large trade surpluses with the United States so it shouldn't be surprising that they own large amounts of our US Treasury Debt. It is also not a big surprise that China and Japan have made substantial investments here. You have to do something with those excess dollars. This would be a factor when you talk about surpluses and deficits in the private and public sectors. Japan runs big budget deficits but has very high productivity and runs large trade surpluses. Though Japanese interest rates are very low, the trade surpluses and high economic productivity help make the YEN a strong currency.
As far as WWII being "good" for the economy, it certainly was good for the United States but not for Japan or Europe. There is no doubt that the War jolted the economy out of the Great Depression. I would not recommend war as an economic policy. It is just that it so happened that WWII stimulated our economy, that we were on the winning side, and that our economic capacity was not damaged during the war. Germany and Japan were just devastated, I am certain they have a different view of how the war affected their economy.
I am also not saying that governments can just spend with impunity and run deficits with no economic effect. The risk with too high of deficit spending is not with outright default but debasement of the currency through inflation. An argument can be made that inflation is technically default as you pay back debts with debased currency.
I actually have a lot of sympathy for the views of Milton Friedman and the monetarists. The problem is that money supply is hard enough to define and even harder to control. It seems that the Fed gave up on money supply targets a while back ago. I am not even convinced 100% by the explanations of how money is created. My views lean conservative and not liberal, so one should be surprised that it seems like I am a Keynesian. What I will say is that Keynes was right about a lot of things and he made huge contributions to the understanding of economics. But Keynes had his limits and Keynesian economics don't explain everything. One example is that I believe that markets and not governments set prices.
I also have some sympathy with Austrian views, looking for behavioral explanations for economic activity and having skepticism of mathematical models. I believe much more in the efficiency of markets than in central planning.
The problem with economic views is that any good idea taken to an extreme breaks down pretty quickly. As much as I believe in free markets, I still want the Health Department to inspect the restaurants. Also with ideas, there seems to be a happy medium where things work best. It isn't so much that free markets are good and government is bad, it is that both have their roles in a modern economy and somewhere there is a balance between the two. Pretty much, politics decide which way and how far the pendulum swings.
A fool and his money are good for business.