To be perfectly clear (as one discredited President was fond of saying), It would appear that the Treasury has a pretty considerable supply problem that is starting to hit now. Longer dated bonds slid in a serious way late last week and had another bad day today (although the 2 year action went well). And the Fed announced in March that it would buy a $300 billion in Treasuries over the next six months. $50 billion a month isn’t much relative to the burgeoning calendar.
Now we have the “run for the hills” view, with John Taylor (of Taylor rule fame) giving a pretty typical take in “Exploding debt threatens America“:
Under President Barack Obama’s budget plan, the federal debt is exploding,,, The federal debt was equivalent to 41 per cent of GDP at the end of 2008; the Congressional Budget Office projects it will increase to 82 per cent of GDP in 10 years. With no change in policy, it could hit 100 per cent of GDP in just another five years.
“A government debt burden of that [100 per cent] level, if sustained, would in Standard & Poor’s view be incompatible with a triple A rating,” as the risk rating agency stated last week.
I believe the risk posed by this debt is systemic and could do more damage to the economy than the recent financial crisis. To understand the size of the risk, take a look at the numbers that Standard and Poor’s considers. The deficit in 2019 is expected by the CBO to be $1,200bn (€859bn, £754bn). Income tax revenues are expected to be about $2,000bn that year, so a permanent 60 per cent across-the-board tax increase would be required to balance the budget. Clearly this will not and should not happen. So how else can debt service payments be brought down as a share of GDP?
Inflation will do it. But how much? To bring the debt-to-GDP ratio down to the same level as at the end of 2008 would take a doubling of prices. That 100 per cent increase would make nominal GDP twice as high and thus cut the debt-to-GDP ratio in half, back to 41 from 82 per cent. A 100 per cent increase in the price level means about 10 per cent inflation for 10 years.
Yves here. He just lost tons of credibility. Pull out your trusty HP calculator. it takes a hair over 7% inflation for ten years to double prices. We are supposed to take someone seriously who doesn’t understand compounding, or worse, does, but chooses to argue his point dishonestly to make things sound worse? Oh, he’s a senior fellow at the Hoover Institute. Silly me for asking. Back to the article:
The fact that the Federal Reserve is now buying longer-term Treasuries in an effort to keep Treasury yields low adds credibility to this scary story, because it suggests that the debt will be monetised. That the Fed may have a difficult task reducing its own ballooning balance sheet to prevent inflation increases the risks considerably.
Despite the sloppiness, I don’t disagree with the drift of the argument. However, there is a big assumption here, namely, that the Federal government leverage is in addition to Fed/private sector borrowings. If the economy is deleveraging, and the government borrowing is offsetting that effect, it could be salutary (I’d vote for the objective being to dampen the deleveragiing, not to try to counter it fully).
The Wall Street Examiner argues that, contrary to popular opinion, serious deleveraging is happening now, and is also showing up in the Fed’s special faciliites (no online source):
The PDs [Primary Dealers] receive the full benefit of the Fed’s Treasury and Agency purchases since those transactions are directly between the Fed and PDs, while the MBS trades generally are not. They clearly did not use that money to support prices in the Treasury market….
The Fed’s buying was enough to keep a bid under the stock market, but not enough to keep propping Treasuries.
Fed credit outstanding virtually collapsed in the week ended April 29, with reductions in alphabet soup programs outpacing direct Fed purchase of securities by nearly 8 to 1. The biggest reductions were in the major programs, TAF, CPR, PDCF, and currency swaps with FCBs. Banks’ deposits at the Fed were commensurately reduced. The Fed’s lending programs appear to be collapsing because the banks are deleveraging furiously.
The CP market has also shown big declines in outstanding credit. Since this also impacted the Fed’s CPR program, it’s apparent that companies have little interest in borrowing. The Fed is pushing on the proverbial string, but as long as the Fed is pumping cash directly into the veins of the Primary Dealers, there’s a good chance that the stock market will continue to get a bid for the time being. However, I expect that to change as the supply pressure on the Treasury market builds, and as Big Finance and Big Business continue to attempt to raise equity capital and sell junk debt. Under the circumstances if the Fed is unable to prevent the shrinkage of its balance sheet, crisis conditions will return.
Ironically, the media pundits have been worried about exactly the opposite problem—inflation as a result of the Fed not having a plan to reduce its balance sheet when the economy begins to improve. If the Fed’s current bout of shrinkage continues, inflation will be the least of our worries, and we can forget about an economic recovery any time soon…..
The Fed is still pouring cash into the coffers of the PDs, and they are using some of it to buy stocks, hooking a new round of suckers in the process. We need to be vigilant, and be ready to jump off the train at the first sign that it is about to go
back into reverse.
The one bit in the reasoning that isn’t clear to me is how further debt and equity sales, which will entice buyers away from Treasuries, is consistent with deleveraging (unless the missing bit in the logic chain is that even with those actions, the net effect is serious deleveraging). Reader comments encouraged.
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umm .. excuse me. where did they get the information that the fed balance sheet is suddenly shrinking? all I have seen. as of may 20 I still see more than 2 TRILLION in reserve bank credit
Yes, para 4 of the WSE piece quoted would have been clearer if the author had missed out the words “and sell junk debt”. I suppose sufficiently junky debt is tantamount to equity: the dilution is postponed, that’s all. Marketing.
Wow. I couldn’t believe that compounding slip when I read it in the FT this morning. Makes you wonder… Also, my personal bias as a substantial net saver is that inflation is worse than deflation, so for me, in making his compounding error, Taylor is making the path to a doubling of prices sound BETTER, as he overestimates the annual inflation rate and/or the time required for a doubling of prices.
oozoo,
I probably should have included this bit:
There was little news of substance in the Fed’s balance sheet data last week. It shrank a bit, as the Fed’s direct buying of GSE and Agency paper wasn’t enough to offset the shrinkage in Alphabet Soup programs. The problem seems to be an unwillingness of market participants to borrow and take on risk. No amount of Fed pumping will fix that problem. Zero interest rates at the short end aren’t helping as both individuals and institutions are forced to dip into principal, or in the case of corporations and governments, sell more debt or equity, to pay the bills. I don’t see how the Fed will be able to reverse this trend. Furthermore, we are rapidly approaching the point where the market can no longer oblige those who would raise money to pay their expenses. The Fed can’t keep everybody
afloat.
When we consider US federal debt you need to not only think about its size relative to GDP but also relative to the global market. Many argue that Italy successfully runs their economy on federal debt approaching 100 percent of GDP. What is ignored is that this is small compared to the global market and occurred at a time when other countries were not ramping up their debt as well. During the first quarter of this year there was significant demand for US debt as a safe haven which means the global market for federal debt was inflated. The risk is that the global market for government debt is beginning to deflate at a time when issuance is ramping up. Resistance might be met not at 100 percent of GDP but at say 45 percent due to volume relative to market. Ramping up QE and buying of treasuries then becomes a serious consideration, with a risk that the dollar value is damaged.
With respect to deleveraging then reports seem to be mixed. Consumers appear to be in a forced deleveraging, although given half a chance would like the credit party to continue. Banks are in the process of changing business models and deleveraging with the help of government money. Quite a few pension funds and hedge funds don’t look to have learnt their lesson and are leveraging up again. It is really big business though that is driving deleverage, as never again will they be forced to worry about rolling over the amount of debt they have struggled to do over the last six months. Big business has changed and this would appear to be driving the current cycle despite what the FED is doing.
Oh come on Yves, what’s up with the cheap shots about the compounding bit? Taylor, being an economics prof at Stanford, surely understands far more advanced math than compounding. He’s not writing a scientific publication but an article for a rather middle-brow newspaper. The math is in the right ball-park so please stop nit-picking and try to address the substance.
ankarp,
The article was not in a middle brow newspaper, it was in the Financial Times, which is read mainly by professionals.
And I am sorry, there is a big difference between 7% and 10%.
I am not going to endorse pandering to an audience, particularly one that is not deserving of that treatment.
And the “middle brow” argument says you believe in promoting ignorance.
According to the FRB H.4.1 lending to PD shrinked from 20 bn in mid April to 0 as of May, 21st.
So the FED doesn’t pump anymore credit to PD, as the piece on WSE seems to suggest.
Martino
Firstly, if someone borrows then someone else lends. Or is the US government borrowing from itself via a chain of intermediaries? Back in the 1970’s I was talking to a UK cabinet minister about inflation, and he was of the view that there was not a lot of difference between five or ten per cent, it would all sort itself out.
I am not so sure there is deleveraging.
First, most banks are regaining short term deposits as investors (except foreign central banks) are getting out of T-bills because of increased risk appetite.
Second, part of these deposits are recycled into a new bout of carry trade (this time using the dollar as funding currency). This brings dollars to Central Banks of countries like Brazil. Such countries therefore diminish their draw down for the Fed swap lines.
Fed’s balance sheet may be shrinking, but investors’s balance sheets are increasing. Looks like zero sum game to me,or even more leverage on an aggregated global basis !
The only ways to really deleverage is diminution of asset values. The massive deleveraging that has been occurring on houses and equities has been largely compensated by :
-first monetization by the Central Bank and the government,
-second by interest rates that have been strongly lowered, thus increasing the present value of bonds.
20 years after the popping of the bubble, Japan has still roughly the same ratio of GDP per capita divided per disposable income : what has been lost on equities and houses has been offset by fixed income and cash(specially Govt Bonds). Ironically, during these 20 years, a lot of countries actually converged to the high ratio of Japan !
Effective deleveraging requires therefore that fixed income and cash loose value also. This can occur through:
#1 massive defaults, “a la” Great Depression, and/or
#2 high inflation around 10% (mmm…I mean 7% !), “a la “seventies, and/or
#3 negative nominal interest rate (using the Taylor rule!) in lieu of government meddling with markets.
I read (but I don’t know if it is true) that in California during the dot com bust, there were some bumper stickers saying “Please Mr Greenspan, one more bubble!”. As it happened the wish has been granted, but with what consequences ! I think Mr Taylor’s main fear is that engineering dollar funded “one-more-bubble” – with the not so hidden agenda of getting to outcome #2 – will further increase global leverage and make the ultimate adjustments even more painful.
I’d agree that Taylor surely knows that he should have used 7% rather than 10%. His use of 10% IMHO indicates that he has a rather low opinion of his fellow human beings, who I presume he presumes don’t understand sophisticated mathematics like compounding. And that’s really part of the root of the problem – the economists think everyone else are idiots, so by process of elimination, they are the smartest guys in the room.
a
the 1st paragraph does not make sense either.
From the wall street examiner: ¨The PDs [Primary Dealers] receive the full benefit of the Fed’s Treasury and Agency purchases since those transactions are directly between the Fed and PDs, while the MBS trades generally are not. They clearly did not use that money to support prices in the Treasury market….¨
and
¨The Fed is still pouring cash into the coffers of the PDs, and they are using some of it to buy stocks,..¨
From the posting below about GM:
Yves: ¨And they appear to be hugely screwing up now. The primary dealer community is very long Treasury bonds when the market is taking a dive, a lot more supply is in the pipeline, and ….¨
Are primary dealers really very long Treasuries? Still?
Now that the financial armageddon scenario seems not to have been allowed to play out, and the flight to safety starts to reverse, and a lot of people suggest going short treasuries, are they still very long?
So, the PD´s have used the FED´s money not to buy treasuries, but to reflate the stock markets. They have been very successful!! If they slowly start to sell some of it in the future, are the PD´s allowed to keep the huge profits?
I think there was another howler in the next paragraph of the article:
“And 100 per cent inflation would, of course, mean a 100 per cent depreciation of the dollar.”
As I understand it, a 100 per cent inflation would mean a 50 per cent depreciation of the dollar (the dollar’s value is cut in half). A 100 per cent depreciation of the dollar would mean the dollar is worth exactly zero.
In fairness, when I read the 10% inflation number he floated, I took it in the context of the very basic math he was doing and assumed he meant an annual increase of 10% of THE FIRST YEAR’S price level for 10 years, rather than a sustained 10% year-on-year price increase. He could have been more clear, or used the traditional calculation, but I don’t think his use of this method torpedoes the merits of the rest of his writing, since the point he was making centered around a price increase over one decade of 100% from year one. Enjoy the blog greatly!
To ankarp:
As Yves noted, there is a huge difference between 7% and 10% when compounding over a 10 year period. With a 10% inflation rate, one could double prices in roughly 7.25 years. Taylor’s miscalculation leads him to assume an additional 2.75 years of double-digit inflation, the effect of which would be enormous. Also, the economy would respond to 7% inflation much differently than 10% inflation.
“Middle-brow newspaper”? Is that a joke?
*****
Anyway, there are other problems with Taylor’s analysis. For example, he never justifies any of his targets.
Why a 10 year horizon? If one stretches that out to 15 years, then only a 4.7% inflation rate is necessary to return to 41% D2GDP.
Why a return to 41% D2GDP? One could achieve a 51% target in 10 years with a 4.8% inflation rate. A 61% target needs only 3% inflation.
*****
There are some serious issues with using inflation to implicitly default on debt, such as higher interest rates and falling living standards. That isn’t really the point though. Rather, it is troubling to see a prominent economist make such a huge and public error in a polemical piece.
Note: I could be off on my calculations, as I wrote this at 6am. But I am also not John Taylor.
Usually I agree with Yves. This time I’m not so certain we can inflate out way out.
I say this not to question anyones math. I DO question the numbers everyone is using.
GDP is off by 40%. http://www.chrismartenson.com/crashcourse/chapter-16-fuzzy-numbers
Without getting into the HP calculator discussion I’d merely like to question what our current government debt burden is IF we were to use “real” numbers and not “Enronsque” numbers?
Take care
Yves,
From what I’ve seen, there’s been very little in the way of junk debt offerings. Companies with investment grade ratings, on the other hand, have been much more successful in raising cash. Equity sales don’t increase leverage; they simply dilute equity holders.
What’s clear to me (and I speak with dozens and dozens of business owners) is that virtually no one is borrowing money. Those that want to can’t get it. I know of one small builder that sells start-up homes. Business is decent for them now. They have no debt and plenty of cash. They would be buying up parcels of land right now but had their credit cut off by one of the big banks. This is a typical story I hear. So if a good small company with stable cash flows and no debt can’t borrow money, there’s little reason to believe big companies can borrow at will from banks. They’ve had to go to the bond markets, and there only the strongest are successful.
Thus from my point of view on the ground it’s clear that companies are deleveraging. Probably in a big way. It makes sense. We’re greatly in debt. This is a necessary step. The Fed is trying to keep individuals and companies from doing so, as that’s the only way to keep asset prices from dropping. But asset prices need to drop. They’re overvalued. The Fed just doesn’t want to admit it. Look at all of its statements from the last three years. At the height of the housing bubble Bernanke was saying house prices would level off. Either he’s disingenous or really, really ignorant about these things. He’s trying to divorce effects from causes. Reality doesn’t work that way. Thus we’re going to continue to deleverage for a long time to come, no matter what trickery he continues to come up with.
I thought everybody knew the “rule of 72”: the number of years it takes an investment (or prices, in the case of inflation) to double is the number 72 divided by the rate of growth. In this case, if prices should double in 10 years, 72 divided by 10 would give a required inflation rate of 7.2%.
“With no change in policy, it could hit 100 per cent of GDP in just another five years.”
Why would there be no change in policy? In 5 years the financial crisis should be long over, one way or another.
One fact that I don’t see taken into account anywhere is the composition of the US national debt. The current debt is $11.3 trillion. $7 trillion is held by the public. I saw someone quote recently a figure of 29% (or $2.03 trillion) for how much of this is held by foreigners. The remaining $4.3 trillion is money which the government owes itself. Most of this is related, I believe, to Social Security surpluses.
Not all debt is the same and I think this should be considered in discussions like these.
There’s plenty to worry about, but I find it difficult to worry about an increasing government debt (within reason) causing damage in the short to medium term. As Yves points out, government borrowing can be an offset to private deleveraging.
John Taylor asks “So how else can debt service payments be brought down as a share of GDP?” Japan’s answer was lower interest rates, and though it is a minority opinion, I suspect the answer will be the same for the US today (and probably some other sovereigns). Here are detailed thoughts (feedback welcome) on why treasuries should have no trouble getting funded in the medium term. David Rosenberg’s piece from yesterday suggests the recent surge in yields is entirely due to a resurrection in inflation expectations. That seems unlikely to last.
Interesting that deleveraging may have progressed meaningfully in recent months. The Fed Z1 data as of end of Q4 2008 shows no aggregate private sector deleveraging at that time (household deleveraging had just begun but aggregate corporate and financial debt were still rising).
Most of the US Treasury debt is short-term, no? How do you inflate it’s value down, when the instant that intent is perceived all the T-bill holders will either demand enough increased interest to cover the inflation loss or simply refuse to roll and instead take their cash at maturity? It’s late and my brain is slowing here, but it seems to me that the only way the Fed will be able to inflate the value away will be by monetizing substantially all of the short-term Federal debt, not just some small marginal amount.
Curious:
Yeah that is one of the problems with using inflation to partially default on debt.
Wolfgang Munchau has a good article on the subject over at the FT (link below).
If you look to my previous post, there are ways that you could inflate without destroying the bond market, but they require some flexibility with targeting. Not a preferred solution but people are thinking about it.
http://www.ft.com/cms/s/0/b498f790-4893-11de-8870-00144feabdc0.html?nclick_check=1