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June 02, 2005

Why Oh Why Can't We Have a Better Press Corps? (Yet Another New York Times Edition)

Does Ben Stein really think that Alan Greenspan does not know that there is a large and ongoing inflow of capital to the United States from Asia?

Ben Stein: To: Alan Greenspan, Chairman, Federal Reserve Board, Washington, D.C.

Dear Mr. Greenspan:

You have always been a great friend to the little Stein family. You invited us to your viewing of the Fourth of July fireworks for many years. You spoke warmly and kindly of my father on his 80th birthday and after his death.... In the same spirit of friendship that you have shown to my family and to the nation and world, I hereby offer you some possible mental and emotional relief on two perplexing economic and monetary policy issues.... [Y]ou recently pronounced that you were puzzled by what you called the 'conundrum' of why long-term interest rates were so low, as the economy gathered steadily more strength and as inflation heated up, albeit to a lukewarm temperature.

May I suggest a reason for the low long-term rates? It has to do with a certain circularity in the world flows of capital. American consumers and businesses buy far more from the Japanese and the Chinese than the United States sells to them. The difference is in the hundreds of billions of dollars annually. The Asians do not respend this money in America by buying Big Macs. Instead, they use a large chunk of it - again, hundreds of billions - to buy Treasury bonds.

That creates a floor under the dollar, keeps their own currencies low and makes their products very competitive. But this voracious buying of Treasury bonds - at varying lengths of maturity - keeps a high floor under bond prices as well. That, in turn, keeps the interest rate low, because interest rates move inversely to bond prices.

In other words, interest rates are suppressed at very low levels by the recycling of the trade deficit into Treasury bonds. It may be just that simple. In turn, this keeps the mortgage rates low.... Maybe I am missing something here, but this is at least a possible answer to your conundrum...

Greenspan does not think there is a "conundrum" because he fails to understand that Japan's and China' central banks are purchasing U.S. bonds. Greenspan thinks that there is a conundrum because he believes that those who are selling U.S. bonds to Japan's and China's central banks should be more eager to sell them and should be selling them at lower prices. It is highly likely that the value of the dollar will decline by 30% sometime over the next ten years. That means that people holding dollar denominated bonds are taking a big risk of serious capital losses, and should be eager to sell them until their prices fall so far that they are yielding about 3% per year more than assets of equivalent riskiness denominated in other currencies. U.S. short-term interest rates are headed higher--perhaps by one percentage point, perhaps by two, perhaps by more--over the next year or two. People should be very eager to sell long-term bonds when their yields aren't equal to expected short-term yields plus an allowance for risk. Yet market prices tell us that they are not eager to sell at all.

Investors holding U.S. bonds at current prices and yields are taking on huge amounts of exchange rate risk and interest rate fluctuation risk for no extra return relative to what they could get in other assets. That's the conundrum: the relationships of asset prices are out of whack.

Those who know no economics often focus on the actions of one single group and use that to account for what's going on in markets. That's a mistake. It's a common mistake. But it's an elementary mistake. What's going on in markets is the result of everybody's actions: some people are eager to buy, some people are eager to sell, and the result is an equilibrium market price and volume. You can't get an economist's license (except at the American Enterprise Institute) if you pretend to explain things by looking at just demand. You have to look at supply too--and it is the low supply of long-term bonds by those eager to sell that is at the heart of Greenspan's conundrum.

Posted by DeLong at June 2, 2005 12:19 PM