The other day I was directed via Twitter to this piece from Cullen Roche at Pragmatic Capitalism. Written in 2010, it was an attempt to debunk the view that there was a bubble brewing in bonds. In his tweet, he suggested that his piece was still relevant today in 2012. In fairness, not much has really changed since 2010, so if his post was merited then it is now. I’ll comment on those merits below while opining on more general thoughts about bonds and the monetary system in the process.
Roche begins by defining for the reader what a market ‘bubble’ is. He states that (emphasis his):
…a bubble (as it pertains to markets) is an irrational psychological market environment resulting in extreme disequilibrium and ultimately some form of systemic collapse. The keys here are extreme disequilibrium and systemic collapse. In order to have a bubble both aspects must occur.
I don’t see much wrong there, and it is important that a working definition of a bubble is given. Roche then continues, describing the basic rationale of your typical bond bubble advocate, namely that the idea that the fiscal burdens that the U.S. government will undertake are unsustainable. That, along with the idea that this will lead to a collapse in the U.S. bond market, is labeled a ‘myth.’ To explain why he feels this way, Roche constructs his argument by stating what the bond market is and how it works. To quote at length (emphasis his):
This brings us to a key question. What exactly is the U.S. government bond market? In a country with monetary sovereignty in a floating exchange rate system (USA & Japan, for instance) the bond market is really nothing more than a mechanism through which the central bank controls the money supply. It doesn’t actually fund anything as it does in Europe or under a gold standard. This is best understood by studying the bond auction data in the USA. Despite constant shrieking of a potential lack of buyers in government bonds over the years we continue to see incredibly high demand for US debt. The auctions are always oversubscribed. They never fail. Why is this? Why do the buyers keep coming back for more? The simple answer is because the government puts the buyers there. The auctions are designed not to fail. How is this you ask?
The government bond market is merely a monetary tool that the central bank utilizes to control the cost (or supply) of money by controlling the level of reserves in the system. So, when the government auctions bonds they are merely targeting reserves in the system. This action is mandated by Congress as an accounting tool and so is seen as a source of funding, however, in reality the Central Bank is merely draining reserves that the Treasury already spent into existence – reserves that were deposited at various banks (read this process in greater detail here). Therefore, it’s incorrect to argue that there won’t be buyers of U.S. bonds – with the banks earning 0.25% on their reserves and the government offering anything above that (depending on duration) the trade is a no-brainer for the banks who hold these reserves. The government is basically offering them free money and the Central Bank keeps control of the money supply in exchange (at least in theory). What is not occurring is some sort of funding mechanism. The Treasury could care less if the auctions are 2X, 3X or 4X oversubscribed. They don’t get extra money when this occurs. They don’t get a gold coin that can then be spent. So long as they meet the 1:1 bid to cover the auction is a huge success because they drained their targeted reserves and convinced Congress that we aren’t going bankrupt.
Most of the issue I have with the MMT perspective revolves around their obsession with the minutiae of monetary mechanics, which they then use as a base to make economic assertions as though economic laws have suddenly changed. When you disagree with their derived economic implications (note: not the mechanics themselves), they smugly accuse you of not understanding how the ‘modern economy’ works. As if fiat money is a modern construct. I’ll have to revisit this general issue in a more dedicated post, but for now let’s deal with the bond market.
What Roche is correct about is the fact that the United States does not necessarily need to ‘fund’ any spending it does. It does not necessarily need to collect taxes or raise foreign debt in order to spend, thanks to the fact that it has the power to issue unlimited amounts of currency. It can never run out of money because it can always print it. In an example of my aforementioned reservations with MMTers, they will focus on my use of the word ‘print’ in the last sentence, explaining that functionally what happens is that the Federal Reserve debits and credits the accounts of various actors in accordance with designated spending patterns of the government. This is true, but the fact that the Federal Reserve does not literally print bills on paper and distribute them does not change the fact that ‘money’ that did not exist before is now extant in bank accounts. The obsession with making sure we know it has been a digital process versus a paper printing exercise is baffling to me, because with respect to the economic impact there is no functional difference.
What the MMTers seem to miss, with respect to the quality of government bonds, is that the existence of sovereignty over money supply only removes default risk in the explicit, traditional sense. It does not remove the risk that the bond will be defaulted on implicitly, by paying the creditor with newly created currency (or digitized bank account credits for MMT political correctness) which by definition is of lesser value than what was lent.
In other words, when a country without monetary sovereignty (like Greece) runs into problems owing to overextensions of debt issuance, it will be forced into default because creditors will no longer lend and existing debt burdens are too difficult to service. In contrast, a country with monetary sovereignty (like the United States) that gets into difficulty owing to overextensions of debt issuance can simply call on its central bank to buy debt issues. So again, Roche is correct to point out that there will be no auction failure because there will always be enough Federal Reserve driven demand available. This isn’t the complete story, but it suffices for this piece.
So What’s the Problem?
The problem emanates from the fact that a greater portion of US Treasury debt issuance is bought via money created by the Federal Reserve. In other words, the deficit spending done by the US government is being enabled by Federal Reserve policy. Once again, the minutia concerning the exact mechanics of this process is largely irrelevant to the ultimate economic consequences. Unquestionably, the net result is the injection of newly created money into the economy by the Fed through the vehicle of Treasury securities.
The government rationale for embarking on this increased deficit spending is the existence of a depressed economy that needs support. The natural inclination of the private sector has been to draw down its debt levels and to reduce consumption spending, as the price level is such that spending has stalled and the debt required for financing that spending has also stalled. Hence, the government steps in to support spending at this elevated price level.
In the interest of this flawed response to the problem the high price and debt levels have posed, the government will need to continually increase the amount of debt and money supply to prop up asset prices, just like the housing bubble needed an increased amount of marginal debt to perpetuate at higher housing prices. Any slowdown in government largesse will be met with declines in asset prices, ultimately leading to another breakdown in the economy. The relatively neutral action by Federal Reserve following QE1 and QE2 illustrate this point. Both periods led to stock declines nearing recognized bear market levels, and serious threat of economic decline. Long story short, the Federal Reserve and Federal Government are going to have to maintain loose policy in perpetuity. They are not the proverbial training wheels; they are actually the big wheels themselves.
In light of that, where will all the requisite debt come from? As discussed before, technically the US doesn’t need foreign money to issue debt. Roche points out that in 2010, when the piece was written, the largest foreign creditors to the US were backing off. He writes:
Over the years the classic hyperinflationist or defaultista argument has been that China will stop buying our debt or that Japan will stop buying our debt. But the problem with this argument is that China is not our banker. Japan is not our banker. What do we care if they buy our bonds?
In recent months Chinese net holdings of U.S. debt declined…But U.S. treasury yields continue to plunge. The demand for this paper is enormous even though the largest holder of these bonds appears to be getting scared off.
Although China has increased their overall exposure to US debt since Roche wrote this piece, it has been much less than the Federal Reserve. Just 3 months after Roche wrote, the Federal Reserve became the largest single holder of US debt. Since that time, it has increased its holdings by 85%, compared to a 30% increase for China. According to the WSJ, the Federal Reserve bought 61% of Treasury issuance last year.
This increasing reliance on the Federal Reserve to be the ultimate buyer of US Treasury issuance underlies the crux of the bond bubble argument. Returning to the definition of a bubble as given by Roche:
…a bubble (as it pertains to markets) is an irrational psychological market environment resulting in extreme disequilibrium and ultimately some form of systemic collapse.
The ‘irrational psychological market environment’ is another way of saying that the item in question is continually bid higher, far past any rational understanding of the fundamentals. It’s what enabled tech stocks to be bid up to over $1 billion in market capitalization despite having revenues of $600,000, advertising costs of $12 million, while selling its merchandise at a loss. With respect to Treasury debt, the irrationality is the continued bidding up of treasury bonds despite the fact that yields are inadequate compensation for the inflation that exists currently, and the inflation that will exist owing to continued debt issuance.
This view makes the assumption that the Federal Government will continue to issue debt to prop up the system, and that the Federal Reserve will continue to increase its balance sheet to accommodate that debt. These are solid assumptions in my view, based on the pledges by Ben Bernanke, and the actions taken in 2008. The Federal Government and Federal Reserve have shown they have no interest in allowing a collapse in the price level, and will engage in the spending and debt issuance necessary to continue forestalling that collapse.
The increased money that flows into the economy via deficit spending and the Federal Reserve provides the impetus for the increase in the prices of food, energy, stocks, commodities, healthcare, education, etc. I find it bizarre that so many argue against that point, only to turn around and advocate increased ‘demand boosting’ efforts. All that ‘demand’ is doing is bidding up the prices of goods and services. The problem with this is that income levels do not rise with the increase in prices, meaning that at some stage, the consumer will not be able to keep spending at the higher price level. This can be seen by noting that average real wages have been in constant decline since the ‘recovery’ began in 2009. The consequence of this is that when private spending inevitably stops, the government and Federal Reserve must act again to stabilize the price level, issuing more debt and creating more currency.
Even if one chooses to take the stance that there is no inflation, that individual would be deluded to think that the Fed and government are not going to push until there is. Even the current CPI defined inflation of 2.3% renders 10 year Treasury debt negative in real terms, as it traded at a rate of 1.69% earlier today. In other words, any buyer of 10 year debt today with the intention of holding to maturity is voluntarily losing money. That fits any definition of ‘irrationality’ if you ask me. Of course, that does not preclude Treasury debt from yielding lower from here, it just renders such a trade even more irrational than one placed today.
Irrationality alone doesn’t make a bubble. The resulting ‘extreme disequilibrium’ portion of the bubble definition fits the aforementioned increasing disconnects between incomes and prices that the Federal Reserve-enabled deficit spending gives rise to. Yet, given this disconnect, the Federal Reserve and government are going to have to keep the pedal to the metal so to speak. As stated above, Washington is now ‘the big wheels’ on the bicycle as opposed to the training wheels. Any let up, any creep higher in interest rates will serve to destroy the debt driven consumer spending model, which means asset prices go lower, which means the banks and the economy collapse. Said another way, the need and impetus for the simultaneous existence of ever lower interest rates (to drive debt expansion) and increased inflation (to prevent prices from ever falling again) is exactly what gives the bond market bubbly characteristics, if not make it a bubble already. Those simultaneous conditions exactly represent an irrational environment (low yields+high inflation) that results in extreme disequilibrium (prices running away from incomes).
Talking about systemic collapse, the final piece of the prototypical bubble, Roche writes:
Some market participants have gone so far as to compare the U.S. bond market to the Nasdaq bubble. This is simply not a fair comparison. The Nasdaq declined 90% from peak to trough. If you buy a 10 year government bond and hold it to maturity you will receive your principle back in full in addition to the coupon payments. If inflation jumps from the currently low levels to 5% you will be sacrificing 2.5% per year in real terms. Certainly not a winning pick, but nowhere near what the apocalyptic results of the Nasdaq bubble were.
Should inflation print 5% in the CPI, the Federal Reserve would be under massive pressure to raise rates. As I’ve argued throughout this piece, the slightest tightening measures would invite unwanted collapse, thus it is my contention that the Federal Reserve will continue its policy of low rates. However, anything short of an aggressive tightening will only increase the incentive for currency holders to trade their dollars for hard assets, further driving prices up. This is essentially what happened in the 70’s, until Volcker jacked the Fed Funds rate to 20%. The Federal Reserve will not willingly do that today, given such a rate would absolutely obliterate an economy that was far, far more levered than it was in the early 80s.
Returning to Roches’ 5% inflation hypothetical – the 10 year was roughly 2.6% when Roche wrote, meaning that a purchase then meant an instant loss of 2.4% in real terms. If the Fed refused to raise interest rates at that point, over time inflation would further increase, meaning that in subsequent years that 2.4% loss in real terms would grow even larger. If the Fed did raise rates (such that the 10 year yields 5%, a figure closer to historical norms and one that would cancel out inflation in this example), it would represent a capital loss of 48% (a 10 year bond with a face of 1000 yielding 2.6% would need to be priced at 520 to return the same coupon at 5%). A purchase at today’s level of 1.69% would result in a 66% loss of capital should the Fed hike to 5%. That qualifies as apocalyptic given that 5% is a historical norm, let alone a higher rate that may be necessary should inflation get out of hand. As mentioned above, a stubborn refusal to raise rates in the face of 5% inflation would merely stoke inflation earlier, risking hyperinflation if it continues to play itself out.
Note – THIS IS NOT A CALL FOR IMMINENT HYPERINFLATION. This is merely the illustration of the predicament the Federal Reserve and government find themselves in. For hyperinflation to occur would require the loss of confidence in the currency. That is a psychological matter that is nearly impossible to predict with accuracy. Thus the people who have made such predictions with specific dates have made themselves to look foolish. Equally foolish, however, are those who deny hyperinflation is even possible at all. A more reasoned assessment is to note, as the ‘hyperinflationistas’ have done, that the ingredients are undoubtedly in place. What isn’t is the catalyst, but the continued intention for yields to remain low while rising inflation is needed makes that catalyst more and more likely. Which is why the description of an:
irrational psychological market environment resulting in extreme disequilibrium and ultimately some form of systemic collapse.
Is most certainly applicable to the bond market at this time.