Via Crunchy Con, a post on Asia Times about the deficit and it's funding by David P. Goldman:
"The United States government needs to borrow US$1 trillion a year, before a new stimulus package, or handouts for the auto industry, or healthcare reform, or a dozen other spending programs promised by the incoming administration of president-elect Barack Obama. Where will the Treasury find the money?
A bizarre jump in the US Treasury's real cost of borrowing points to severe market disruption if the Treasury deficit continues to rise. It appears that the Treasury market is also a victim of global de-leveraging. The new administration has far less budgetary flexibility that it seems to think."
So, it will get costlier to service our debt. This problem will occur sooner than later because people around the world are going to avoid risk and increase capital.
"Equity, commodity and Treasury bond markets all are registering a deflationary crash in precisely the same way. That seems clear enough. The dog that barked, but shouldn't have, is the "real" component of Treasury yields.
The answer to the mystery of tripled real Treasury yields is to be found in the collapse of leverage in the global
financial system. Indirectly, the rapid expansion of leverage in the global banking system contributed to demand for Treasuries. When de-leveraging commenced in August, an important component of demand for Treasuries declined sharply. That is bad news for Washington, but even worse news is that it will continue to decline sharply, just when Washington most requires global support for the US government debt market.
Global leverage indirectly increased demand for Treasuries in three principal ways:
1. It fed the boom in raw materials prices, increasing demand for Treasuries on the part of central banks as well as financial institutions in commodity-producing countries.
2. It pushed up the value of emerging market
currencies, prompting emerging market central banks to intervene in foreign exchange markets by purchasing dollars which then were invested in Treasuries.
3. It contributed to the rise in global equity prices, which prompted investors to diversify their portfolios and purchase safer assets including Treasuries.
The carry trade, in which investors borrow low-interest currencies (dollars or yen) and buy high-interest emerging market currencies, created demand for Treasuries by funneling money into emerging markets that ended up as dollar reserves in their central banks. "
Here he explains why the demand for our bonds rose and are falling.
"We do not have Treasury data past August, and it well may be the case that a similar exception will emerge during the second half of 2008, as foreign investors increase their net purchases of Treasuries while stock markets crash, and for a symmetrically opposite reason. Investors may prefer safer assets.
We cannot directly estimate the impact of de-leveraging on the Treasury market, but it seems clear that the explosion of leverage during the past five years had a profound, if temporary, impact on the world market's demand for US government securities."
Now he's explaining what, for him, is an anomaly; namely, when this crisis began, instead of not buying our bonds, investors bought them because they considered our bonds safer than other investments around the world. This happened even though our interest rates were low. Now he seems to be saying there's no direct relationship between de-leveraging and the demand for our debt, which I took to be his thesis.
"We can observe in the movement of market prices, though, a close relationship between the breakdown of the carry trade and the rise in real Treasury yields. Withdrawal of leverage from the system forced market participants to liquidate carry trade positions."
I would have thought this had to do with exchange rates, but maybe he's saying that de-leveraging caused their movement.
"The Treasury market benefited from the explosion of bank leverage during the past 10 years, as emerging market central banks became the most important new buyers of US government securities. De-leveraging and the collapse of commodity markets combine to destroy global demand for Treasuries, limiting the US government's capacity to borrow from overseas sources."
What goes up, must come down. People bought our debt during leverage, but they won't when they de-leverage.
" Other major holders of US Treasury securities are likely to wish to reduce their holdings rather than to increase them. China's accumulation of foreign reserves represented "rainy day" savings for the nation, and the severity of the present crisis shows how well-advised China was to accumulate a large volume of reserves. China has announced plans to spend the equivalent of 20% of gross domestic product in a stimulus program which is likely to increase the country's demand for foreign capital goods.
China's trade surplus is likely to diminish sharply, both due to falling export demand and import growth arising from the stimulus package. Chinese reserves are likely to cease growing and may even decline as a result. Oil-producing countries, moreover, may have to spend reserves in order to maintain import levels as a result of the collapse of oil prices. "
Not even China.
"It is far from clear from whom, and on what terms, the US Treasury will obtain $1 trillion a year, or even more, to finance its deficit. The overseas well has run dry, and domestic financing of the deficit would require a drastic increase in the savings rate at the expense of spending, or outright monetization of the debt by the Federal Reserve. "
Okay. We could buy our own bonds, basically save, in other words, but that would reduce consumption spending, deepening our recession. The Fed could also print money ( read inflation ) .
"One way to increase the government savings rate, of course, is to increase
taxes, but that is an unlikely course of action during a severe recession. "
We could reduce our need to borrow by increasing taxes, but that's bad in a recession, because it reduces consumption spending, causing the recession to deepen.
"If the deflation persists, the Federal Reserve may be compelled to purchase US government debt. "
The Fed can stop deflation by causing inflation.
"Another possibility is that risk appetite among investors at home and abroad will continue to fall, inducing a portfolio shift towards Treasury securities. In this case "crowding out" will occur through risk-preference. It will not be so much that competing borrowers are crowded out of the lending market, but that investors will stampede away from risk. In this scenario, even a very low federal funds rate will not help to restore economic activity. "
Investors won't invest in new businesses because they're afraid of risk, so they'll save. This is a version of the Paradox Of Thrift. Instead of spending money to get us out of a recession, people will hoard it by saving, deepening the recession. One way out of this so-called paradox, is that the savings go into banks where it gets loaned out cheaply and people can use that money to invest in long term projects like infrastructure, causing hiring and spending, therefore helping to get us out of the recession and making us wealthier because we've added infrastructure. This is my answer, by the way. He's postulating a version of Ricardian Equivalence by saying that even my theoretical investors will be too afraid to invest in infrastructure.
"The point of lowering the risk-free rate is to push investors towards riskier assets. In a normal business cycle, falling output leads to lower yields on low-risk bonds, which in turn encourages investors to add risk to their portfolios by investing in businesses. "
That's what I just said will happen.
"If the safest of all investments, namely US Treasuries, suddenly offer much higher real yields, comparable to the boom years of the late 1990s, why should investors take risk? "
Okay. If I'm an investor, and I can get a high rate of interest from safely investing in Treasuries, why would I bother to invest in riskier businesses in the real world.
"In any of these scenarios, the result of global de-leveraging is dire: the more the US government tries to bail out businesses and households, the more bailing out the economy will need. The Bush administration's response to the financial crisis, and the likely content of the Obama administration's economic program, will deepen and prolong the economic downturn. "
I guess he's positing a greater and greater aversion to spending and risk because we'll all be buying Treasuries, which won't do us any good.
"It is not generally remembered that the premise of the Reagan administration's tax cuts was Robert Mundell's work on the optimal level of government debt. Mundell, who won the Nobel Prize in 1991 for his work on international
economics, observed that an increase in government debt might represent an improvement in market efficiency, if it corresponded to an increase in incomes. That might occur if a reduction in taxes caused an increase in the deficit, while stimulating economic growth. In that case, Mundell argued, a tax cut would increase efficiency if the additional revenues arising from the growth effect were larger than the interest on the bonds issued to cover the ensuing deficit. "
I just like explanations.
"The capacity of the US and the world to finance an increase in the federal deficit was much greater, and the incentives arising from reducing the top marginal tax rate from 70% to 40% were much greater than any incentives that might be envisioned from tax cuts from the present level. "
Back then, marginal tax rates were really high, but now they're not. I'm not sure why we couldn't cut other taxes or get some revenue back from tax cuts this time. Anyway, he's claiming that it won't be enough to help.
"Even the best-designed economic policy would be hard-put to provide growth incentives without a substantial increase in the savings rate and a corresponding reduction of consumption, implying a very sharp economic contraction. If the Treasury tries to spend its way out of recession, the results are likely to be very disappointing. "
As near as I can tell, this is the Paradox Of Thrift, which I don't see as a major problem. The way to shift the tendency to save is to offer incentives not to. He's claiming that this time it will do no good. I don't agree, and we should certainly try.
Okay. This scenario is around in different forms. One scenario uses the same info he does to argue simply that we shouldn't have a huge stimulus and vastly increase our deficit and debt. He's more dire than that. He's positing a kind of mechanical downward spiral that we can't get out of.
Anyway, all one really has to know is that to counter this downward spiral we simply have to offer incentives for people to alter their spending and investment choices. One way to do this is to fashion a tax cut aimed at encouraging investment instead of everyone just buying bonds over and over. See, I don't believe that risk taking is dead, or even that dormant. So, I basically don't agree with his analysis of the Paradox Of Thrift or the total death of risk taking, killed by high interest debt from the government. But he's interesting, and I loved the charts.
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Tuesday, March 10, 2009 at 11:39 am
That was an interesting post, and I especially liked this quote:
"It's time to go back to old-fashioned banking, if there are any banks left standing to do so."
And this:
“For the banks, this is unlike all other recessions because it hasn't shown any relief in terms of net interest margin,” Goldman said. “The poor performance of net interest margin, which is a critical measure of bank profitability, is a stern warning to the banks that they have to take a much more old-fashioned approach to lending.”
Companies paid an average of 8 to 10 basis points for access to untapped credit lines, Goldman said in an October report written for research firm Laffer Associates. A basis point is 0.01 percentage point.
“They gave away these revolving credit deals like party favors,” Goldman said. “They should be changing those deals. If banks have to lend money at their own cost of funds, we'll never get out of this mess.”
Thanks for focusing so much attention on what Citi is actually doing and up against.