US Treasury Bonds

We are back, apparently, to the thorny discussion of inflation. Depending on who you talk to inflation is an imminent scourge and thus Obama should stop all he is doing and become a Republican immediately, or else it is, at mots, a medium term threat that in no way inhibits whatever is left of Obama’s ‘change’ agenda.

Today in the Financial TimesMartin Feldstein wades in on the side of the ‘let’s turn Obama into a Republican’ camp.

I really hate it when economists who teach and preach economics as a ‘science’ turn into ideologues advocating political positions masquerading as economic analysis. I realize that it hard to separate politics and economics – they are inextricably linked – but then stop advocating economics as a science.

Judging from Feldstein’s argument in the FT this won’t happen any time soon.

Let’s start with the headline which includes an imperative: Obamamust reassure markets. Notice that:must.

What is the basis for this strong assertion? Well, it turns out to be the same thing we’ve discussed here before: the recent rise in medium and long term US government interest rates. This rise is characterized by Feldstein as being dramatic, he tells us that they have ‘almost doubled’. They rose from 2.26% to 3.98% between December 2008 and this month. Let’s set aside the pedantic observation that a ‘doubling’ of 2.26% would be 4.52% which is over 0.5% higher than they are and in the context of an analytical base of 2.26% an additional 0.5% is non-trivial. Clearly Feldstein is dealing in hyperbole. Which must therefore be a scientific trait.

This breathless announcement presumably is meant to shock us. How in the world did rates shoot up so suddenly with such extreme speed?

Feldstein then plunges into his analysis:

The key is to compare the rates on plain US Treasury bonds with those on inflation proofed US Treasury bonds [aka ‘Tips’]. The difference, or spread, between non inflation proofed and inflation proofed bonds of the same maturity is clearly inflation. Or, rather, the estimate of inflation that buyers of plain US bonds are adding to the basic bond yield – the Tips rate – in order to compensate for expected inflation.

That spread was 0.19% back in December, but is now 2.07%.

A little simple math and we find that the rise in expected inflation implied in these changes, i.e. the rise in the spread from 0.19% to 2.07% – or a rise of 1.88% – more than accounts for the increase in bond rates.

Ergo: the ‘rapid’ rise in inflation expectations accounts for the rise in medium and long term rates.

This is obviously bad. At least if we get the tone of Feldstein’s message.

But he doesn’t want to stop there. This is, according to him ‘deceptively easy’. So he sets about adding more reasons for the ‘almost doubling’ of US bond rates.

First he adds the notion that the ‘liquidity premium’ has narrowed. This ‘premium’ is the haircut in rates that an investor is willing to accept in order to own an asset with a very high certainty of being sold easily. That’s a mouthful so let me explain.

Liquidity is a characteristic or ‘property’ of all assets. It is a measure of the ease with which an investor can liquidate the asset and get cash back. One of the huge problems we have had during this crisis is that whole classes of assets suddenly became ‘illiquid’ – no one could sell them at any price. The markets for these assets failed. The auction bid preferred markets a good example. These assets were long term assets that are priced on a weekly basis through a bidding process. As long as the bidding goes well, as it did for years, then the assets can be bought and sold weekly, even though they have long term maturities. This ability to churn was key. Longer term assets usually have higher yields – they are riskier by definition. Some banks and investment advisors wanted to sell these assets to customers looking for good yields during the low rate environment of the past few years. The weekly bidding process gave an illusion of liquidity, so the assets had the allure of both high rates and ease of sale: they were ‘liquid’. But the credit scares of last fall killed the bidding process: no bidders turned up at the auctions, so the assets suddenly became totally illiquid. An investor who thought they had a cashable asset now found that they actually held a long term bond.

This is long example of the reason that investors are usually willing to accept a lower yield in return for the certainty of being able to get cash back. The difference between the illiquid and liquid yields is called the ‘liquidity premium’.

Back to Feldstein:

He notes, without providing any data, that the rise in bond rates also includes a diminution of the liquidity premium. Why? Because, he argues, in the extreme crisis right after the Lehman debacle in September last year liquidity was much sought after and thus the premium rose to unusual heights. Now, as the crisis ebbs, the premium is returning to more normal ranges. So US bonds which are regarded as the world’s most liquid asset have lost a little, but all, of their allure: they are back to their usual relative advantage rather than having an excessive advantage.

This too is not good.

Secondly Feldstein adds in the ‘crowding out’ argument.

Allow me to explain this one too.

Some economists regard high government spending as an anathema because it soaks up cash from the economy that would otherwise have gone towards private investment. They assume that the level of savings – the pool of cash for investment – is relatively fixed at any point in time. And given that, they also assume that the level of investment is equal to the level of savings [this equality is one of those classic ‘economics 101’ things!] Put these two together and you arrive at the conclusion that, as the government sops up savings for its investment, in our case to fund its deficit, it automatically diminishes the amount available for private investment. According to these economists this is damaging: the long term productivity of the economy is reduced because they assume government spending is less productive than private spending. Another result of this ‘crowding out’ is that interest rates are presumed to have to rise in the future: in order for the private investment to be satisfied rates will have to rise to encourage the necessary savings.

The problem with this is that it ignores extreme circumstances. The relationship is not always true. The most obvious time when the relationship breaks down is when the economy finds itself in a ‘liquidity trap’. Such a trap is a time when no amount of movement in interest rates will induce more savings or produce more investment. The key link that economists assume exists between interest rates, savings and investment breaks down and the economy drifts into no mans land.

That’s where we are now.

So the linkage Feldstein is trying to make doesn’t apply right now. There is no crowding out. So the fear of rates rising because of such an effect are not presently an issue. What he is talking about is a prospective crowding out effect sometime in the future.

OK.

So now we have all three of Feldstein’s analytical conclusions: inflation fears, liquidity premium and crowding out effects are all conspiring to send yields through the roof.

What should we do?

Cut social spending.

That’s his prescription. We cannot raise taxes to cover our deficits because that would be a disaster – think the 1930’s. So wemust cut spending. Which spending? Social spending.

Before I get too upset about the obviously political nature of this prescription, let me note a few things:

1. US bond rates are still relatively low by historical standards. So the panic seems premature.
2. The implied inflation rate embedded in those rates, about 2.0% according to Feldstein, is exactly in line with the announced and highly publicized target levels the Federal Reserve Board has established. So there seems to be nothing unusual about them at all: the market is accepting the Fed’s target as the expected range for inflation. Duh.
3. Liquidity premiums have fallen from crisis levels back to normal levels. This is not something to panic about: we should be happy for any evidence of a return to normalcy.
4. We are in a liquidity trap so the crowding out argument is weak at best. Again no panic.
5. And, in any case, a long term inflation rate of 2.0% seems entirely ordinary. Nothing there to invoke panic either.

But to ideologues trying to invent an economic argument against expanded social spending this is the best they’ve got. Which is to say that they don’t have much. All they can do is to point at a very ordinary rate increase and try to make it seem extreme. Then they point to the presumed root cause: the target of the right wingers will always be government spending. Or, to be more, precise the kind of government spending they don’t approve of.

So to ideologues like Feldstein itmust be the prospect of government spending that is causing this horrible rise in yields that is already threatening the safety and soundness of our economy.

OK I added a bit there, but he does point out that rising rates will affect the speed of the recovery through more costly mortgages and business loans. That is, of course, if there is any real demand for business loans: just how much spending does a business need to make when it is already running at below 70% of capacity? Which is where the manufacturing side of our economy is right now. Why add more unusable capacity?

Feldstein doesn’t mention that latter point becasue it’s kind of awkward.

Let me get back to my annoyance.

Felstein’s analysis is boiler plate. It takes normal economic thinking and applies it to a phenomenon – rising rates – and then tries to create an aura of emergency. Why?

Because he is implacably opposed to social programs.

He doesn’t use economic analysis to attack social programs head on. He uses the usual GOP trick of setting up a red herring and then bashing it down. He implies that rising rates are unequivocally related to social programs. Rising rates are bad. So social programs are bad.

But the budget includes very large non-social programs – defense spending … shall I be argumentative and call it what it is? ‘offense’ spending?

Why is this not reduced?

So the Feldstein objective appears to be using economic analysis to support an a priori political predilection. There is nothing inherent in the rise in interest rates to connect it, inevitably, with social programs. That’s just the connection Feldtsein wants to make. We could just have correctly called for cuts in offense spending.

So the entire FT article can be reduced to an exercise in ideology.

No wonder those free-market economists are getting a bad rap. They engage in too much politics.

But then again so does Krugman on the left.

So much for the ‘science’ of economics.