By Karl Smith
Tyler Cowen discusses the general implications of runs on the new (shadow) banking system. Though this point leads directly into something that I have been thinking about
Another feature of this new order is that more and more financial transactions will be collateralized with the safest securities possible: United States Treasuries. Demand for them will remain high, and low borrowing costs will ease our fiscal problems. Still, the resulting low rates of return serve as a tax on safe savings, encourage a risky quest for yield and redistribute resources to government borrowing and spending. It isn’t healthy for the private sector when investors are so obsessed with holding wealth in the form of safe governmental guarantees.
It's actually not clear to me that demand will remain high, in the sense that the term spread will not reassert itself. To explain a bit more:
The interest rate on T-Bills is simply whatever the Fed wants it to be. T-Bills and excess bank reserves are essentially interchangeable. In normal times the value of excess reserves is the Fed Funds rate. Today it is the Interest on Reserves rate. However, both of those are essentially controlled by the Federal Reserve.
If we lived in a world with zero risk then one would expect the interest rate on 10 year Treasury bonds to simply be the weighted average of the interest rate on T-Bills for the next ten years.
However, there is risk so, investors (a) have to guess what that interest rate will be and (b) demand a premium for the risk that they are wrong. This is the term premium and it's why interest rates on long term government bonds are persistently higher than short term government treasury bills.
To the extent that expectations or risk appetite in the bond market exert direct influence on US Treasury interest rates, it is through the term premium.
Right now the term premium is extremely low, indeed one would guess that it is negative. The interest rate on a 30 year government bond is only 3.3%.
While it's possible that the interest rate on T-Bills averages only 3.3% over the next 30 years this is – hopefully – extremely unlikely. It implies that nominal GDP growth will average 3.3% over the next 30 years, as the Fed must ultimately align interest rates with nominal growth rates or the economy will persistently overheat or stagnate.
The more likely explanation is that the demand for safe liquid assets is so high that investors are willing to accept a negative term premium.
Will this continue? The answer is almost assuredly, no. This implies that long term interest rates on government debt is likely to rise and that conversely the value of long term government debt will fall.
US government debt is in a bubble. I am starting to believe that bubbles are a persistent feature of the modern global economy and extend from the fact that the world is aging. As this continues the bubbles will likely only get larger and larger.
The simple reason is that as individuals pass into middle age they attempt to increase their savings. One way to do this by loaning or renting resources to the next generation. However, as the population ages opportunities to do this are more and more rare.
This implies that savings can only take place through capital deepening. In essence this means more investment per worker. This expansion in investment per worker causes some types of capital to liquefy. That is, existing pieces of capital can readily find a buyer at fundamental values.
Yet, once capital liquefies it begins to earn a liquidity premium – like the one earned by US government debt now. This, in turn, drives the market price on the capital even higher and we enter a bubble.
In practice, the capital object itself doesn’t get moved around but a financial instrument entitling someone to the rents from the use of the capital or a debt secured by the capital. However, the effect is the same. The financial instrument becomes liquid, starts to earn a liquidity premium and then goes into a bubble.
My growing sense is that this process has been repeated over and over again since the late 1980s. First, in Japan. Then in Korea and South East Asia. Then in the US tech industry. Then in the developed world’s housing markets. Now in US and UK government debt.
Moreover, there is no obvious way to stop this from happening. On first thought it would seem that deflation could prevent this by causing cash to earn a positive rate of return. This basically just ratchets up the money bubble.
However, without negative nominal interest rates this worsens the ultimate problem of expanding the capital stock because it essentially subsidizes money as a store of value against capital.
So, I don’t know that there is a clear way to stop this from happening.