"As noted, the flight to safety is taking on epic proportions."

Maybe Napier has been reading Izabella Kaminska on Alphaville:

Treasuries bubble danger Posted by Izabella Kaminska on Dec 10 10:25.

As noted, the flight to safety is taking on epic proportions. With that in mind our thoughts are going to what may happen next, or specifically, the implications of a Treasuries bubble. Here’s one view from Monument Securities (our emphasis):

Though a Treasuries bubble might appear unproblematic, however, its bursting could turn out to be more dangerous than the collapse of any other kind of bubble. If confidence eventually returned to other markets, investors would shun the low yields on Treasuries. The Fed would then face the choice of monetising most or all of the Treasuries market, as funds fled to higher-return investments, or else of allowing Treasuries yields to race higher. Because foreign holdings represent a significant proportion of the stock of Treasuries outstanding, a collapse in Treasuries prices might soon be reflected in a collapse of the US dollar, with the accompanying threat of hyper-inflation in the USA and depression elsewhere. At that point, many investors might wish they still enjoyed the comparative calm of the ‘credit crunch’.

Hmmmm, not good."

I've already accepted the fact that we might be in a Treasuries Bubble. In a way, it's implied in my Human Agency approach to these problems. But it's not preordained. However, that would seem to be what everyone who thinks like me is worrying about, and so the problem of inflation going forward is staring us right in the face, not, as some people felt about the housing bubble, being ignored.

I'm assuming that one of those people is Ben Bernanke, but time will tell.

"I explained that the deflation hype was rather exaggerated"

Emre Deliveli also sees Inflation ahead:

"At my inaugural column last week, I explained that the deflation hype was rather exaggerated, as the two commonly-quoted signs of deflation, U.S. October inflation and yields on American inflation-protected securities, were not accurate indicators at all. However, other market prices such as weakening oil and dividend yields on stocks surpassing yields on 10-year Treasuries have been pointing to deflation as well.

It seems that the market is definitely pricing for Deflationary Inferno even if deflation itself is not very likely. However, the alternative, Inflationary Purgatorio, is still far off the the markets’ radar. While many have learned to trust markets painfully, my overconfidence stems from the ongoing and prospective firefighting. After all, as a reader rightly noted, “numbers are important, but it is government policy that will shape the future”. And both fiscal and monetary policy are pointing towards eventual inflation.

The direction of monetary and fiscal policy

Even though he has been quick to announce his Economics team, you should not expect anything on the fiscal front until Obama settles in. This means that we are not likely to see the effects of fiscal policy on the economy until the second half of 2009 at the earliest. But once the stimulus comes, it is likely to be on the larger side because as this year’s Nobel Prize winner Paul Krugman notes, unlike monetary policy, fiscal policy is inherently asymmetric: It is easier to fix too much of it with contractionary monetary policy than too little of it with another stimulus package. Therefore, when it comes, the fiscal boost is likely to have an inflationary bias.

While fiscal policy is still far away, the Fed has had its hands full for some time now. While traditional monetary easing has not been effective, it has been complemented with more unorthodox tools such as intervening directly in credit markets. As the so-called quantitative easing is now semi-official, we can expect more of such creative policy from the Fed, whose balance sheet is starting to look increasingly like a hedge fund’s. In a similar vein, last week’s announcement that it would purchase USD 100bn in debt obligations from GSEs –government sponsored enterprises- is a first step in the monetization of public debt. With the low money multipliers, Fed’s actions are having a very limited impact on money supply for now. But the mere fact that the Fed is willing to shift to the extreme of policy means that it is not worried about inflation at this point."

This is what I believe is happening as well. Purgatorio is the Mezzanine Tranche of the Afterlife.

"Market implications, risks, and short-run outlook

Crises are always marked by the breakdown of time-tested relationships, but two interesting anomalies have emerged lately: Stocks have rallied while yields on the long end of the curve have fallen and the well-known positive correlation between dollar and long-dated Treasuries has broken. The scenarios I have explained above might shed some light on what is going on.

The recent flattening of the yield curve hints that quantitative easing is well-understood by markets, but its implications are not: All that liquidity and fiscal stimulus could find its way to inflation, which would in turn raise interest rates. With a huge US and global bond supply, we could even end up with a considerable bond market crash and another recession before the recovery from the current one is completed. While this dreaded W-shaped outlook is unlikely to pose a threat before the second half of 2009, it is in line with the anomalies above and paints a rather confusing outlook for the dollar (to be continued)."

I have already posted that we might have a bond market crash, and you know my theory of why these rates are so low. I believe it has to do with an overreaction based on the fear and aversion to risk, and an accompanying flight to safety.

"Basically, the Fed is targeting a lower interest rate on GSE debt. Sound familiar? Yup, that’s monetizing government debt."

Rebecca Wilder at News N Economics with an interesting post:

"At some point the Fed may choose to monetize new debt issued by the Treasury (let’s say in order to raise $700 billion to finance TARP), but I doubt it. There is already a new $1 trillion of new liquidity sloshing around in the banking system, posing huge inflationary risks.
Well, circumstances have changed. Twenty-four days later, and in a rather nontraditional manner, the Fed is now monetizing government debt.
The time has come to officially monetize government debt. Yesterday the Fed announced that it would purchase $100 billion in debt obligations from Fannie Mae, Freddie Mac and the Federal Home Loan Bank next week. And furthermore, it will purchase $500 billion in mortgage-backed securities (MBS) – I like to call this FARP (Fed Asset Relief Program).

The purchase of GSE debt is a direct attempt to reduce the spread on government agency (GSE) debt over comparable Treasury debt, the relative borrowing costs. Basically, the Fed is targeting a lower interest rate on GSE debt. Sound familiar? Yup, that’s monetizing government debt.

The chart illustrates the difference between newly issued Fannie Mae debt and a comparable U.S. Treasury through 11/24/08. This spread has widened from an average of 29 bps (0.29%) spanning 2006-2007 to 90 bps spanning 2007-2008. Fannie Mae must pay more in order to finance its mortgage obligations, which limits its ability to roll over current obligations, and tightens the terms on new mortgage loans.

By driving down the spreads on GSE debt now, and later on mortgage-backed securities, the Fed gives the GSEs more flexibility in the mortgage market, and they can offer lower rates and better terms for potential homebuyers. That’s the theory.

I am interested to hear why the Fed is supporting the GSE debt and securitized assets that derive their value from the mortgages (MBS) rather than the mortgages themselves. The Fed could allocate a similar stock of resources to mortgages directly, where the effect would be immediate (mitigating foreclosures or offering better terms directly). However, I assume that the Federal Reserve Act prevents the Fed from doing such a thing – that sort of action probably lies in the hands of Congress. Although the immediate effects do appear to be quite positive.

Expect the Fed’s balance sheet to rise by another $100 billion (at least) in two weeks. It is official: the Fed is monetizing government debt."

So, the Fed is monetizing government debt.

Here's my comment:

Don said...

From Bloomberg: Rebecca, Can you tell me why they won't say so publicly, if you agree that this is what they're doing:

"The U.S. officials, speaking on condition of anonymity, said they don’t see the Fed purchases of mortgage bonds as a way of “quantitative easing,” or using central bank policy to add reserves to the banking system when interest rates are very low, even though the purchases will have that effect. "

Why didn't they just ask Poole? He's not shy.

"Quantitative easing was a tool of monetary policy that the Bank of Japan used to fight deflation in the early 2000s.

The BOJ had been maintaining short-term interest rates at close to their minimum attainable zero values since 1999. More recently, the BOJ has also been flooding commercial banks with excess liquidity to promote private lending, leaving commercial banks with large stocks of excess reserves, and therefore little risk of a liquidity shortage.[1]
The BOJ accomplished this by buying much more government bonds than would be required to set the interest rate to zero. It also bought asset-backed securities, equities and extended the terms of its commercial paper purchasing operation."

I'm not sure why, if it's going to have that effect, it wouldn't be considered a positive side effect.

Don the libertarian Democrat

November 26, 2008 2:20 PM

Here's Rebecca's reply:

"Rebecca Wilder said...

Hi Don,

Good to hear from you?

Honestly, I don’t know what else you could call it – government purchasing MBS and credit directly? That sounds like quantitative easing to me – and Kohn said that the easing has already started. http://blogs.wsj.com/economics/2008/11/19/feds-kohn-deflation-risk-bigger-but-still-small/

In my book, the Fed can call it whatever it likes – monetization, easing, whatever - it’s not like they are going to tell us anyway. To me, the Fed purchasing MBS is better than an outright purchase of Treasuries because the yields on those bonds are already so low. Why not target an market that is actually going to do some macro-economic good, like the MBS market. I wonder if they will purchase CMBS, too? Probably not, but those spreads are very, very wide.

Thanks for reading and Happy Thanksgiving!

Rebecca"

"But would government deficits in fact be money-financed?"

Nick Rowe considers how to fund deficit spending, say in a stimulus plan, say to get out of a recession. Kind of like the position we find ourselves in now:

"It's easy to say that money-financed increases in government spending should be used as a weapon of last resort, if the central bank runs out of ammunition as nominal interest rates fall to zero."

First, Here's Bernanke on being out of ammunition( He can't lower interest rates any more because they're at zero):

"As I have mentioned, some observers have concluded that when the central bank's policy rate falls to zero--its practical minimum--monetary policy loses its ability to further stimulate aggregate demand and the economy. At a broad conceptual level, and in my view in practice as well, this conclusion is clearly mistaken. Indeed, under a fiat (that is, paper) money system, a government (in practice, the central bank in cooperation with other agencies) should always be able to generate increased nominal spending and inflation, even when the short-term nominal interest rate is at zero. "

How can he:
1) Increase nominal ( face-value,current, not adjusted for inflation ) spending
2) Increase inflation
Thereby curing Deflation:

"Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation. "

We'll print more money and prices will go up. Isn't this alchemy?

So, Bernanke seems to believe that this works.

Here's Nick:

"But would government deficits in fact be money-financed?"

Let's find out:

"If the central bank targets the monetary base, the answer is trivial: if the bank wants to increase base money to pay for the deficit (printing money and giving it to the government to spend) then deficits will be money-financed; otherwise they won't."

So, it is money financed. Here are two good reasons not to issue bonds that pay interest in order to fund the deficit:

"The answer matters for two reasons. First, if deficit spending were bond-financed rather than money-financed, future taxes would have to be higher (or future spending lower), to pay the extra interest on the higher future debt. Anticipating higher taxes in future, some people might cut consumption today in response. This offsets some of the effect of increased government spending (and in the extreme case of Ricardian Equivalence, offsets it completely, so an extra $1 of government spending crowds out $1 of private spending). Second, even ignoring any effect on current spending, a higher future government debt is a Bad Thing (bad for future taxpayers, bad for the government's credit rating, bad for its ability to fight future emergencies, etc.).'

1) Future taxes will have to be higher than printing money because it has to pay for the deficit ( Stimulus, Spending ), but also pay the interest on the bonds.
2) Some taxpayers might save instead of spend in order to prepare for less income when the tax increases hit, thereby hindering the recovery from recession by lessening spending
3) Higher Debt is always worse than Lower Debt.

"In simple models where the central bank uses an interest rate instrument, the stock of money is demand-determined, and the demand for money is determined by three things: the price level (positive relation); real income (positive relation); and the nominal rate of interest (negative relation)."

Demand for Money: Goes Up: Prices go up: Income goes up: Interest rates go down
If Prices and Income go up, there will be more demand for money, and interest rates will go down

"The stock of money is, well, a stock." ( A fixed amount at any one time )

"And the flow of government spending is, well, a flow. " ( Constantly going out )

"So if a temporary increase in the flow of government spending has a cumulative cost of (say) $100, we can say that it is 100% money-financed if it causes a permanent increase of $100 in the stock of money."

The increase is funded by dollars that remain in circulation.

"In normal economic times, if the government increases spending, so aggregate demand increases, the central bank will need to offset that increased aggregate demand completely to keep inflation on target. In a closed economy, the central bank raises the rate of interest to do this. This increase in the nominal rate of interest reduces the demand for money, so the money stock falls."

To stop inflation, if the government spends more money, the demand for money goes up, then interest rates are raised, causing the demand for money to go down, canceling each other out, thereby stopping inflation.

"The central bank is forced to sell interest-paying bonds to buy back non-interest-paying money.'

The banks increases the interest rate inducing people to loan in money, which it keeps.

"So the government debt in public hands (i.e. not owned by the bank, because since the bank is owned by the government anyway that doesn't matter) actually increases by more than the $100 the government borrowed to finance its spending. "

Because of the interest.

"The extent to which increased deficits are money-financed is actually temporarily negative in normal times. "

Because of the interest.

"But when the temporary increase in government spending comes to an end, the interest rate returns to where it was before, so does the stock of money, and so the government spending was 0% money-financed, 100% bond-financed."

When the interest rate goes down, the demand for money increases, and flows back into the economy from the bank, where it's been hiding.

"In normal times, the only effect of government spending on the demand for money is via its effect on the rate of interest. The central bank makes sure it doesn't affect real income or inflation."

As the demand for money goes up, it lessens the demand by reducing interest rates, keeping a kind of equilibrium going, as the two actions more or less balance out, the money supply even.

"But in abnormal times, when the central bank has lowered interest rate down to zero, and it's still not enough to prevent a recession, or prevent inflation falling below target, the result is very different."

People keeping buying the bonds down to zero interest because they're safe, backed by the government, and not moved by the normal disincentive to save and buy bonds of low interest rates. They can't be moved by this disincentive in time of fear and aversion to risk, and flight to safety, which is what we have now.

"To keep things simple, assume that a cumulative increased government expenditure of $100 will work very quickly to bring back normal times. And assume that the alternative scenario is to wait for a deus ex machina to bring the economy back to normal in 10 years. Let's focus on money demand after those 10 years have passed, so the economy is back to normal under either scenario."

Plan A: We print more money and put it in circulation by the government spending it on something
Plan B: We keep the money supply even

"The price level after 10 years will be higher if the government increased spending than if it waited for the deus ex machina. "

Because we've printed more money and put it in circulation.

"It's higher because inflation has been at the 2% target for those 10 years, rather than in a deflationary spiral."

Prices have gone up in Plan A because we put more money in circulation and inflation ( rising prices ) ensued. In Plan B, the money supply remained the same or, what, went down?

"This will mean money demand is higher. "

Money demand is higher because prices and incomes are higher.

"Real income after 10 years will be higher if the government increased spending than if it waited for the deus ex machina. "

Correct.

"A 10 year recession would have caused lower investment and hence a lower capital stock, so less output and income. This will also mean that money demand is higher."

In Plan A.

"So with higher price level and real income, money demand and hence the stock of base money will be higher after 10 years if government spending increases than if we wait for the deus ex machina. So the increased government spending will be, at least in part, permanently money-financed."

Prices, Income, Money Demand, Money, all went up together. Some of the increased money supply will remain in circulation.

"Could it be 100% money-financed, or even more than 100% money-financed?'

Could it all remain in circulation?

"Suppose a cumulative expenditure of 10% of annual GDP is enough to rescue the economy. Suppose the money base is also 10% of GDP. That means the money base would have to double (comparing the two scenarios) to make the government expenditure 100% money-financed. That means money demand would have to double, which could only happen if nominal income were also double after 10 years (comparing the two scenarios)."

So, the money supply would have to double, and demand would have had to double. Then the amount of nominal income would have had to double.

"By the Rule of 70, that would require nominal income growth to be 7 percentage points higher for 10 years under the first scenario than under the second."

10 goes into 70, what, 7 times. That's the rule of 10. So, 7% higher in Plan A in income than in Plan B. Can it happen?

"Yep, that's in the right ballpark: 2% inflation vs (say) 3% deflation gives us 5% difference in inflation; and 2% real growth vs (say) 0% real growth gives us 2% difference in real income growth; 5% + 2% = 7% difference in nominal income growth, which would make it 100% money-financed."

This works, but the figures come from where?

"So yes, if increased deficit spending were used as a policy of last resort to prevent a deflationary recession, a significant chunk of that spending, perhaps all of it, perhaps even more than all of it, would in fact be money-financed.'

I'm glad to hear it, because that's my plan, I believe.

Now, let's look at Buiter's plan. Here's his statement of the benefit of printing money, but also the risk:

"The private financial sector has to deleverage massively, but would (with credit markets and wholesale financial markets closed for business) do so in an unnecessarily destructive way if left to its own devices. The household sectors in the US, the UK and a number of other European countries have to deleverage (start saving seriously) on a significant scale. Left to its own devices, the short-run Keynesian aggregate demand fall-out from a necessary reconstruction of household financial wealth could be disastrous. So the public sector has to leverage up (borrow) at the same time the household sector is forced to deleverage.

This process of monetisation of private sector financial instruments can continue almost indefinitely. It is restricted only by the total stock of private financial instruments outstanding and by the central bank’s willingness to add private securities with higher and higher degrees of default risk attached to them to its balance sheet."

By the way, that deleveraging massively in a free market way, which Buiter says would be unnecessarily destructive, is why I favored the Swedish Plan. My view, which is only mine, is that this aversion and flight from risk which we have now, would have been, if you can imagine it, significantly worse than what we have now without government intervention, and the social cost would have massively increased the potential of permanent government intrusion into our society. My reason for believing this has to do with Human Agency. In this situation, the people in charge of handling this mess, their plans and intentions, rested on government intervention. That was the only prism through which they could see this crisis in this instance. To try and fight such a pervasive and powerful perception would have been disastrous, and the people who believe that it could have a woefully inadequate view of Human Agency and Political Economy. It would be like asking me to see without glasses. The mess made would be horrific.

So, I see Buiter disagreeing with Nick in the following ways, although both agree on printing money:

1) There's a chance ( as we saw with the CDSs this week on US Bonds ) that investors will withdraw because they feel we will default ( How they'll feel about inflation I've no idea )

2) The deficit financing will not be as much money-financed as Nick believes, and so there's a disagreement about how much taxes will have to be raised and/or budgets cut.

"Can the central bank make such a monetisation commitment and retain its inflation-targeting or price stability pursuing credibility? Only if, when stability and normal functioning are restored to financial markets, when banks are lending again and when the economy has regained a high degree of capacity utilitzation, the monetisation is undone. Under current extreme conditions, there is a massive increase in liquidity preference in the financial sector and throughout the economy. Additional real money balances are absorbed without inflationary consequences.

But when the good times come back (and they will!), the additional central bank liquidity injected into the system will be burning holes in the pockets of bank loan officers and of lenders and spenders generally. To prevent an inflationary surge, the public debt will have to be demonetised again, by the central bank selling public debt to the private sector and the overseas sector. That is only consistent with sustainable public finances and the absence of high and rising sovereign default risk premia, if the government ensures that additional taxes and/or lower public spending will be forthcoming when the economy recovers.

That commitment by the central bank to demonetise the public debt in the future has to be credible today, lest there be an immediate increase in long-term nominal interest rates when the central bank monetises public debt and deficits, due to higher long-term inflation expectations. That commitment by the government to run sufficiently large primary budget surpluses (budget surpluses excluding interest) has to be credible today, lest there be an immediate increase in sovereign default risk premia as the government increases its borrowing.

There can be no doubt that, if public spending is not cut, future taxes have to be higher if the government borrows more now and permanent monetary financing is not an option. It is also virtually certain that tax rates will have to be higher. The government will get some help from the positive effect on the main tax bases (income, profits, consumption) of the expansionary fiscal measures, but not enough to prevent the need for future higher tax rates (taxes as fractions of the relevant tax bases)."

Where do I come down? And where do I get the right to even have a say?

I don't know who's correct, but I believe that it would be in our best interest to say and mean that, if we have to, we will deal with this problem through tax increases and spending cuts, because I do fear inflation, and huge debt, and simply feel that right now we have no choice but this.

"That commitment by the central bank to demonetise the public debt in the future has to be credible today"

Willem Buiter with a new post in the FT:

"Monetise public debt and deficits

November 22, 2008

The diminished role of monetary policy

The paralysis of financial intermediation today means that monetary policy (cuts in the official policy rates) have become largely ineffective in stimulating demand. Such cuts now appear to have little if any effect on either the marginal cost or the availability of external funds to non-financial enterprises and households. For individual open economies, the exchange rate provides a mechanism for stealing aggregate demand from the neighbours. If most of the neighbours are also in a situation of deficient aggregate demand, this redistribution of global effective demand - which is all that changes in exchange rates accomplish - robs Peter to pay Paul and is not part of a global solution at all.

The continuing importance of liquidity policy

Central banks are doing the right thing by massively expanding their balance sheets to put as much liquidity into the economy as possible. The balance sheets of the Fed and of the Bank of England have doubled since the crisis started and the balance sheet of the Eurosystem has expanded by about 50 percent. This has been accomplished through open market operations of various kinds, through which the central banks have increased their holdings of private securities by expanding the monetary base, mainly by increasing bank reserves with the central bank and other central bank loans.

Central banks will have to continue to do this. The private financial sector has to deleverage massively, but would (with credit markets and wholesale financial markets closed for business) do so in an unnecessarily destructive way if left to its own devices. The household sectors in the US, the UK and a number of other European countries have to deleverage (start saving seriously) on a significant scale. Left to its own devices, the short-run Keynesian aggregate demand fall-out from a necessary reconstruction of household financial wealth could be disastrous. So the public sectorhas to leverage up (borrow) at the same time the household sector is forced to deleverage.

This process of monetisation of private sector financial instruments can continue almost indefinitely. It is restricted only by the total stock of private financial instruments outstanding and by the central bank’s willingness to add private securities with higher and higher degrees of default risk attached to them to its balance sheet.

Read it all. I don't paraphrase Buiter. Here's my comment:

“That commitment by the central bank to demonetise the public debt in the future has to be credible today, lest there be an immediate increase in long-term nominal interest rates when the central bank monetises public debt and deficits, due to higher long-term inflation expectations. That commitment by the government to run sufficiently large primary budget surpluses (budget surpluses excluding interest) has to be credible today, lest there be an immediate increase in sovereign default risk premia as the government increases its borrowing.

“There can be no doubt that, if public spending is not cut, future taxes have to be higher if the government borrows more now and permanent monetary financing is not an option. It is also virtually certain that tax rates will have to be higher. The government will get some help from the positive effect on the main tax bases (income, profits, consumption) of the expansionary fiscal measures, but not enough to prevent the need for future higher tax rates (taxes as fractions of the relevant tax bases).”

I agree with this, since, although I don’t like it, I believe that to combat the fear and aversion to risk ( Which, from my point of view, explains bond spreads, as a flight to safety of such magnitude as we now see entails an even greater flight from any risk ), we are going to have to cut taxes and have a stimulus. The fear from investors is that we will overprint money or default, so we need to assure everyone that we will raise taxes or cut expenses in the future.

However, even if we put this in legislation, like Britain and Japan have talked about, raising the problem of people saving during a downturn to anticipate loss of revenue in the future ( Although, as Peston says, you can lower the VAT with a cutoff date, prodding people to spend now. We can’t ), will anybody believe it. I mean, in the U.S., we haven’t shown a very great desire to confront these types of hard choices recently.

So, I agree we should say this and mean it, but, aren’t we basically stuck? In other words, we have to follow this plan whatever investors believe about us, and deal with the fallout as best we can in the future, because the other options are even more dreadful?

Posted by: Don the libertarian Democrat | November 22nd, 2008 at 8:09 pm | Report this comment