Brad DeLong's Semi-Daily Journal (2004)

A Platonic Dialogue on Financial Markets

Aristodemos: The U.S. trade deficit is the largest the world has ever seen, and U.S. nominal interest rates are lower than euro rates. Can anybody come up with another example of a case in which a country with a 5% of GDP current-account deficit had lower nominal interest rates than its trading partners?

Sophia: Well, it certainly makes it very hard to teach the international macro pieces of Econ 1.

Dikepolis: Can you say "exhorbitant privilege"? The East Asian financial crisis persuaded a lot of central banks that they needed to hold lots more dollar-denominated assets for system stability purposes--even if those assets had low yields. And the supply of dollar-denominated assets in foreign hands has not yet caught up.

Aristodemos: But it must be catching up, mustn't it? $500 billion a year of net capital inflow in a world that has less than $40 trillion of annual GDP...

Studentios: So what should U.S. long-term interest rates be?

Aristodemos: On the international side, to reduce an unsustainable 5% of GDP trade deficit down to a sustainable 2% of GDP trade deficit requires--according to standard rules of thumb--a 30% decline in the trade-weighted value of the dollar. That should take place in the medium to long run of less than a decade. That implies that the yield on U.S. 10-year Treasuries should be 3 percentage points above the yield on Europeans...

Xenophilos: On the domestic side, we expect investment as a share of GDP to rise by 2 further percentage points in the medium run as the recovery takes hold. We don't expect the private savings rate to recover. We don't expect the government budget deficit to fall. We do expect the net capital inflow to decline from 5% of GDP to 2% of GDP. That's a 5% of GDP investment financing gap to close, which would normally requires a 2.5-5 percentage point increase in interest rates.

Sophia: The market doesn't see it.

Auletis: Who ordered the grilled marinated eggplant with provolone cheese on sprouted whole wheat?

Thrasymakhos: The market is not Argos. The market is not a thousand-eyed beast. The marginal trader in the market is trying to produce good bankable results in the next year so he or she can get promoted.

Sophia: And then there are housing prices. A bunch of it is that they're not building much in Manhattan or DC or San Francisco or inner Los Angeles. But a bunch more is that interest rates are so low that practically anything can be financed. But when interest rates go up...

Aristodemos: Which means I should call my mother and tell her to get a fixed-rate mortgage on the condo in Colorado she bought last weekend...

Auletis: And the salmon nicoise?

Aristodemos: That was me.

Xenophilos: Well that's public spirited of you! Increase the proportion of Fannie Mae's assets that are unresponsive to interest rates while every single one of its liabilities is highly geared to the Fed Funds market!

Aristodemos: Yes. You did notice St. Louis Fed President William Poole yesterday? "Poole raised concerns with the GSEs capital positions, which he said are 'undesirably thin' and leave the firms 'unnecessarily vulnerable' to surprise shocks. The firms should strengthen their capital positions and stop using a strategy of borrowing short and lending long, Poole said."

Xenophilos: Is Greenspan's praise of floating-rate mortgages part of a double-team? Poole whacking the mortgage agencies on the liability side, and Greenspan trying to get them more floating and fewer fixed-rate assets?

Aristodemos: Quite possibly. But I don't want my mother having any more floating-rate debt right now.

Auletis: The ragu of well-exercised grass-fed pork spiced with turmeric and cinnamon?

Sophia: These are all connected. Real-estate prices make sense given the domestic yield curve. The domestic yield-curve puzzle is the same thing as the apparent failure of uncovered interest parity. But we look ahead to medium-term fundamentals and we don't understand what the market is doing...

Croesos: if you wander around Wall Street, you hear four things: (i) the Asian central banks and Asian rich will buy it all and keep interest rates low; (ii) we've had a permanent shift in the income distribution and the wage share has fallen permanently, so higher retained earnings will take pressure off the capital markets; (iii) John Kerry will save us; (iv) Bush is really a deficit hawk, and after the election and the withdrawal from Iraq Josh Bolten, Steve Friedman, and John Snow will take care of the deficit.

Auletis: The chunks of deep-fried lard with extra grease?

Dikepolis: Something's screwy: If people expect the deficit to not be a problem, the yield curve will not steepen and there will be no pressure on Washington to reduce the deficit. If people expect the deficit to be a big problem, the yield curve will steepen drastically and there will be enormous pressure on Washington to reduce the deficit...

Thrasymakhos: You all do realize that your complicated training in solving dynamic forward-looking rational expectations models has left you blind? Since 1982, the rule has been: "If you are long bonds, you win. You win big." In only four out of the last twenty-two years have people who were long dollar-denominated bonds suffered bigtime. Thus there has been an intensive and powerful force of natural selection causing the rapid evolution of the kinds of people at the bond trading desks. To put it bluntly, everyone who is not insanely optimistic about bond prices has been fired. All that are left are people who ignore fundamentals and are happy only when they are long bonds.

Aristodomos: Do you have a model?

Thrasymakhos: No. Simulations only.

Aristodemos: But when it starts to unwind, and optimists and bond bulls start getting fired when their bosses look at their last six months of results?

Thrasymakhos: Then we shall see how good our central bankers really are.

John Quiggin and Bob Reich have interesting things to say about this as well...

John Quiggin and Bob Reich have interesting things to say about this as well:

Crooked Timber: John Quiggin: Interesting? : "I’ve been meaning for a long time to collect my thoughts about US interest rates, and where they are and should be going. As is often the case, I’m largely in agreement with Paul Krugman, at least as far as long-term rates are concerned. On the other hand, I’m a bit more hawkish in relation to short-term rates than Brad DeLong, with whom I agree on a lot of things.

I’m planning on reworking this piece as I have new thoughts, and in response to comments. so please treat it as a work in progress.

Warning: long and boring (but maybe scary) post over the fold.

Interest rates

Much of the discussion has the same confused character as debates about the desirability of budget deficits. The essential problems are similar. In the short run, both interest rates and budget deficits can be controlled by governments (central banks count as part of government for this purpose). Other things being equal, low interest rates and budget deficits tend to stimulate economic activity, and are therefore appropriate when the economy is in recession1.

In the long run, however, government budgets must balance2. Similarly, interest rates must be determined by the intertemporal consumption plans of consumers and the available opportunities for investment. The problem is that the long run can be a very long time coming and no-one knows when it begins. Even the 10-year bond rate is clearly affected by judgements about the policy stance of the central bank.

The link between short-term rates and long-term rates can be seen by considering arbitrage or, as it’s sometimes called, the ‘carry trade’. If a central bank is committed to keeping short-term rates at, say 1 per cent, but market forces dictate a long-term rate of 5 per cent, speculators can make as much money as they want by borrowing short and lending long.

Another way to look at is to note ten years is just (about) 40 terms of 90 days. So, on average, the annualised rate of interest on 90-day loans has to be about the same as the 10-year bond rate, sometimes higher and sometimes lower.

The interest rate problem is therefore really two problems. First, what is a reasonable value for the rate of interest in the long run. Second, given that the short-term rate is currently below the long-term rate, how soon should it be increased.

The first question itself is in two parts. The face-value or nominal interest rate is in part a compensation for future inflation, and in part a real interest rate, reflecting the existence of profitable investment opportunities, and the impatience of consumers. The real interest rate has generally been somewhere between 2 and 4 per cent. Given that savings rates are exceptionally low at present in the US and elsewhere (denoting high levels of impatience) the rate ought to be at the high end of the range, especially if you believe that technological progress has opened up lots of investment opportunities.

As regards inflation, the combination of low short-term rates and exploding budget deficits is bound to produce an acceleration if it persists long enough. Given that there’s a significant chance of a rapid acceleration, and that the bogey of deflation has now largely disappeared, it seems reasonable to pick an average rate of around 3 per cent.

Combining the two suggests that the long-term nominal rate of interest for the US ought to be between 6 and 7 per cent. The ten-year bond rate currently just below 5 per cent and has been below 4 per cent until quite recently, reflecting the influence of very low short-term rates. But the same reasoning implies that, at some point, the ten-year bond rate is likely to overshoot the equilibrium range.

Coming to the short-term rate, there is a trade-off between the need for stimulus now and the inevitable price of higher rates in the future. There’s been a big dispute between those, like The Economist who want to put rates up immediately and those like Brad de Long who want to keep them low while employment remains depressed (one reason may be disagreement about how far the economy is from its ‘natural’ equilibrium).

What would be the consequences of an increase in short-term and long-term interest rates. Higher short-term rates would depress consumption, particularly things like purchases of new cars. This could be problematic for Ford and GM, which are essentially finance companies with a manufacturing arm these days.

But the real puzzle relates to long-term rates and mortgages. Most US homeowners are in the enviable position of having fixed-rate loans which they are free to refinance if they wish. This is an amazingly generous one-way bet, but it’s not clear who is on the other side of it. The securitization and hedging of mortgages has become so complex that no-one knows who really holds them.

If interest rates rose a lot, refinancing would stop. Moreover, homeowners would be forced to stay put, since moving would entail taking on a new mortgage at a much higher rate. The big problems, though, would be on the other side of the market, where the mortgagees would have assets that, on standard analysis might have halved in value. I discuss this a bit more here.

There are a lot of other scary possibilities relating to derivatives markets. These haven’t been seriously tested since the big expansion of the 1990s. Most people seem to think everything will be OK, but no one can be sure.

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The New York Times > Opinion | Robert Reich: The Mixed-Up Politics of the Deficit: WALTHAM, Mass. — If soaring deficits are such a big problem, why haven't long-term interest rates also risen? Could it be that John Kerry is wrong when he says that the Bush administration's deficits threaten to become a "fiscal cancer that will erode any recovery and threaten the prospect of lasting prosperity" — and Dick Cheney was right when, according to former Treasury Secretary Paul O'Neill, he said that "deficits don't matter"?

It's unlikely. The more plausible explanation has more to do with politics than economics: the parties have reversed roles, or at least perceptions of them have changed drastically. The Democrats have become the eat-your-spinach party, preaching the virtues of fiscal restraint, while Republicans invite Americans to a free lunch.

The evidence is compelling. In the last three years, upper-income Americans have been treated to vast tax cuts, with promises of more, while government spending has ballooned. This year's deficit, according to the White House's latest estimate, will be a record $521 billion — an estimated 4.2 percent of the total economy. If President Bush succeeds in making his tax cuts permanent, future deficits will be much larger.

According to most mainstream economists — and the stock market, which yesterday dropped below 10,000 for the first time in six months — a day of reckoning awaits. No less an authority than Alan Greenspan, chairman of the Federal Reserve and a former enthusiast of the Bush tax cuts, has warned that the deficits pose "a significant obstacle to long-term stability."

The Fed is now widely expected to raise short-term rates at its meeting next month, and the yield on 10-year Treasury notes has been inching higher. But if the market were behaving rationally, long-term rates would already be far higher in anticipation of an interest-rate crunch. Who in their right mind would lend dollars today, to be repaid in 3 or 5 or 10 years, without insisting that debtors pay substantial interest?

John Kerry's economic plan — rolling back the Bush tax cut for people earning more than $200,000 and re-establishing strict rules requiring that any new spending be offset with other spending cuts or new revenue — is based on this view. Yet so far, the vast increase in government borrowing hasn't affected long-term rates that much.

Capital markets do not always behave rationally, of course. Perhaps bond traders just aren't paying attention to the gathering storm. Maybe they've been distracted by the Fed's low short-term rates. Maybe they're Republicans.

Another explanation is more consistent with economic and political rationality. Bill Clinton, and now John Kerry, have taught the bond traders on Wall Street an important and comforting lesson: no matter how big deficits grow under Republican presidents, eventually a Democratic president will come along to clean up the mess. That confidence is helping to keep long-term rates down, despite the current out-of-control deficits.

More than a decade ago, the federal deficit was more than $300 billion — about 5 percent of the economy. President Bill Clinton and Congressional Democrats reversed this profligate trend by slashing spending and raising taxes. The strategy was hard to swallow, and not at all popular — not a single Republican member of Congress voted for Mr. Clinton's 1993 budget. Some of us in the president's cabinet thought he had gone further than he needed to; there was too little money left for education, job training and health care.

But there is no disputing that the plan had the intended effect. Deficits that had ballooned under Ronald Reagan and George H. W. Bush were brought firmly under control. Bond traders breathed great sighs of relief. Wall Street beamed.

Mr. Kerry has wisely and responsibly decided to take the same route. If he becomes president next January, he will inherit a budget mess not unlike that which Mr. Clinton inherited. And Mr. Kerry has already committed himself to following Mr. Clinton's lead and imposing fiscal restraint. He has scaled back some of his more ambitious spending plans, and has somberly told his Democratic audiences that the country must get its fiscal house in order before addressing the larger needs of society.

Undoubtedly, Mr. Kerry's resolve has contributed to the bond traders' calm. In the event that Mr. Kerry is not elected and President Bush gets a second term, the fiscal picture will become substantially worse. But bond traders will still take comfort in the knowledge that another Democrat will eventually come along to fix it.

You see, Democrats and Republicans are engaged in the economic equivalent of Nixon going to China: Republican presidents can get away with utterly irresponsible fiscal policies because there's no one to their right who will make too much trouble for them. Democratic presidents can get away with fiscal austerity because there's no one to their left who will make their life too difficult. But the irony should not be missed. John Kerry's promise of fiscal responsibility might just save George Bush's presidency.

And so does Bill Poole:

Poole: The so-called line of credit the Treasury Department would extend Fannie Mae (FNM) and Freddie Mac (FRE) in a time of crisis should be repealed in an effort to make clear that the government does not guarantee the government-sponsored enterprises' debt obligations, St. Louis Federal Reserve Bank President William Poole said Thursday.

"The authority of the Secretary of the Treasury to provide temporary funds, in the amount of $2.25 billion each to Fannie Mae and Freddie Mac, should be repealed. This provision is too small to have any practical value in handling a crisis, and is of symbolic value only," Poole said in prepared remarks at the Chicago Federal Reserve Bank's Conference on Bank Structure and Competition.

The Treasury Secretary is currently allowed to purchase up to $2.25 billion of either company's debt in a crisis.

Poole did not mention the U.S. economic outlook in his prepared remarks.

Fannie and Freddie are congressionally chartered, which investors assume means the government will bail them out in a crisis, but there is no government guarantee of their obligations.

Poole raised concerns with the GSEs capital positions, which he said are "undesirably thin" and leave the firms "unnecessarily vulnerable" to surprise shocks. The firms should strengthen their capital positions and stop using a strategy of borrowing short and lending long, Poole said.

The GSEs have financed a large fraction of their portfolios of long-term mortgages with short-term debt. Under the most conservative financial strategy, they would issue long-term bonds to match their long-term mortgage assets, Poole said.

Poole stressed that the U.S. government must put policies in place that would be used in case of a crisis with the GSEs to convince the market that there is no government guarantee of the GSEs obligations.

"Should either Fannie Mae or Freddie Mac become financially stressed, the only way to avoid market chaos will be to have clear procedures in place, in advance, to handle the problem," Poole said.

He praised the Office of Federal Housing Enterprise Oversight, which regulates the GSEs, for moving ahead with a new rule that would spell out how the agency would take over and wind down the companies' operations in a crisis - known as conservatorship procedures.

Poole acknowledged that should there be a financial market crisis involving the GSEs, the Fed will be responsible for managing the problem. But he stressed that while the Fed has the power to deal with a liquidity problem, by making collateralized loans, "it does not have power to deal with a solvency problem."

"The reasons why it is important to strengthen the capital positions of the GSEs should be clear. It is important that ambiguities as to the status of the GSEs be cleared up, and that conservatorship procedures to deal with a crisis be put in place," Poole said.