Right now interest rates are at levels far and away lower than I at least ever imagined I would see. Interest rates are extraordinarily low not just in the short term but all the way out the yield curve -- if the United States government were to issue a nominal consul, its yield would be about 3.7% nominal. That would be an extraordinary low return in nominal dollars for giving your money to the federal government in perpetuity. If the U.S. government were to issue a real consul right now -- I have no idea how to price it, because it would be a security that would have a duration of at least seventy years or so right now. I never thought I would see anything like this in my lifetime.
Right now the profit share in the U.S. economy is at levels far and away higher than I at least ever imagined I would see. And, given the high profit share and the extremely low return on Treasury notes the stock market is far and away lower than I at least ever imagined I would see. With downward pressure on real wages from elevated unemployment making it more likely that profits will grow faster than the economy rather than shrink, the 9% point gap between the S&P earnings yield of 7% and the Treasury note real yield of -2% -- I never thought I would see anything like this in my lifetime.
But we are going to get out of this, at some point.
The question is: when we do get out of this, what is the financial economy likely to look like?
The big elephant in the room upon exit, as far as what the financial economy is then likely to look like, is that when we exit this we are going to have more debt relative to GDP than U.S. government has had at any time since the immediate aftermath of WWII.
I see three interesting episodes in the trajectory of the debt-to-annual-GDP ratio since WWII. The first is the extraordinary run down of the debt-to-annual-GDP ratio over 1945-1975. This was not accomplished by running nominal budget surpluses: the nominal debt numerator in the ratio did not fall. It was 100% accomplished by inflation and economic growth raising the denominator. Yet that drives the debt-to-annual-GDP ratio to crash by a factor of four across a little more than a generation with relatively small primary surpluses, in large part because the nominal growth rate of the economy exceeds the nominal interest rate the Treasury has to pay on the debt by a fairly substantial margin.
To some degree, this wedge arises because the federal government takes steps, especially over 1945-1953 period to make sure that the interest rates remained extraordinarily low. Before the Federal Reserve-Treasury Accord at the end of the Truman years, the Federal Reserve and the other banking regulators viewed their job as forcing people to hold Treasury debt at low rates of interest as a way of supporting the World War II effort. Unlike episodes of financial depression in developing countries -- which we economists argue have had large destructive effects on countries' ability to mobilize capital for productive investment and growth -- when we try to find any damaging effects of financial repression on American economic growth over 1945-1970, we cannot find it. That doesn’t mean we want to go back to the days of Regulation Q, of forced narrow banking, and of much higher reserve requirements. But this does mean that a lot of issues are not as clear as we would like them to be.
The economist in me believes that regulatory policies of financial repression to keep a lid on government borrowing costs cannot be wise. This is a relevantly heavy tax on a relatively narrow sector of the economy -- a tax on finance and on saving. Good taxes have broad bases and low rates. Bad taxes have narrow bases and high rates. But financial repression is what happened the last time the debt got as high as it is going to get in the future. It is the view of Reinhart and Sbrancia that, if given the choice between dealing with high debt either via inflation or default or through financial repression that imposes sneaky implicit taxes on the financial sector that people outside finance find confusing, the U.S. government will choose the last. It is very possible that that is what governments in the OECD are going to do after we get out of this current depressed-economy episode.
Another, and perhaps more important, factor keeping Treasury interest rates low from 1945-1970 is that everyone senior in insurance companies, pension funds, and banks back then had been scarred for life by the Great Depression. Their views about appropriate risks and appropriate portfolios were greatly shaped by the fear -- conscious and unconscious -- that perhaps 1933 might come again, and you had to be in shape to survive 1933 or you might find yourself out of the game and that you had forfeited what would have been a very good franchise if you could only have gotten past the crisis.
The second interesting period from the perspective of the debt-to-annual-GDP ratio is 1981-1993. When I went into the government at the start of 1993 we had had 13 years of a sharply rising peacetime debt-to-annual-GDP ratio. My faction of economists believed back then that this was a very dangerous risk for the American economy. We were, we knew, 60 years past the Great Depression. We couldn't count on seniors on Wall Street who had been shocked by the memory of that disaster to push their banks to hold lots of Treasury bonds. The 1970s should have convinced everybody that Treasury debt wasn't safe in real terms at all -- it is puzzling why you would think it was: holding Treasury debt is lending money to a very large entity that gets to decide via manipulating the price level just what real resources it needs to transfer back to you to square its debt. That is a strange investment to make. That is a very strange investment to call "safe". The ebbing of the memory of the Great Depression meant a decreased appetite for safety in portfolios. The memory of the 1970s meant that whatever appetite for safety there was should go somewhere other than Treasuries. Thus, I wrote back in 1993 in a bunch of internal memos, the fact that the U.S. government had been able to run a large debt-to-annual-GDP ratio in the late 1940s without seeing an explosive spike in the interest rate was cold comfort for the U.S. in the 1990s.
Usually since WWII, in the U.S., bad news about the deficit had been associated with a strengthening of the dollar. Bad news about the deficit meant that there was likely to be more Treasury debt out there in the future. More Treasury debt meant by supply and demand that it was likely to carry higher interest rates. Those higher yields meant that dollar-denominated assets would be more attractive. Hence bad news about the deficit had meant that the value of the dollar would jump up.
Over 1991-1993, however, it was starting to look to U.S. like that was beginning to reverse itself: bad news about the deficit seemed to be leading not to a higher but a lower value for the dollar. People thought that bad news about the deficit meant that some sort of political-economic instability was more likely -- and that is when you start dumping rather than grabbing dollar assets. We interpreted this shift in market sentiment as meaning that in 1993 we were approaching the limits of United States debt capacity. And this was one of the big factors that convinced Bill Clinton that he was going toy make reducing the debt to GDP ratio job #1 for his presidency, which he did, with great success.
Then George W Bush came in. He promptly took all of our Clinton administration work. He threw it on the floor and smashed it. And -- this is the third interesting period -- we Clinton administration types feared that this would be a disaster. We feared that interest rates were going to spike in the 2000s, as the George W. Bush administration demonstrated to markets that if ever the U.S. got its debt-to-GDP ratio on a downward trend Republicans would promptly set it on an upward trend again. But interest rates did not rise -- even though the debt-to-annual-GDP ratio resumed its upward Reagan-Bush trajectory. We were puzzled about this. We wrote papers about "global savings gluts". We wondered why the appetite both of China's public sector and of China’s rich for U.S. Treasury debt was so large, and whether it would be stable. For the Chinese government keeping the value of the renminbi down by purchasing Treasury debt was a way of ensuring full employment in Shanghai -- which the government very much wants. If you are a rich person in China, you’ve got to think there is a good chance your grandchildren will be living over here because it may well be the case that someday the balloon goes up and either your or your grandchildren have to flee in the Learjet, or in a rubber boat. But how large could these demands for U.S. Treasury debt possibly be? That is what we worried about before 2008.
Carmen Reinhart of Harvard has a very good line: that the assembled central banks and superrich of the world are the equivalent for the U.S. of Japan's inertial postal savers. But how much Treasury debt can in steady state be held by those who are using it as a form of political risk insurance? And do those using U.S. Treasury debt as a form of political risk insurance care at all what its yield is? Those were the big questions, pre-2007.
Does that mean U.S. debt capacity is much larger than at least Clinton administration Treasury staffers like me had thought back at the start in the 1990s? The answer appears to be: Yes -- at least as long as the economy is depressed. In 2008-9 we blew through all the limits of what we had thought might be the debt capacity of the United States. We do face an uncertain fiscal future We really don't know what Medicare and Medicaid and the exchange subsidies will look like in the 21st century. We don't know whether voters will be willing to raise taxes or cut benefits. We do know our doctors are going to find a way to charge U.S. lots of money for whatever they do. Yet in spite of all of this, demand for Treasury securities first before and now after 2008 has turned out to be much, much larger than I at least thought plausible back in 1993.
So what will happen in the future, whenever we exit from our current depressed-economy condition? We know that as long as the economy remains depressed -- as long as unemployment remains high and inflation remains subdued, the Fed will keep interest rates low. And we know that long-term rates are a weighted average of expected future short-term rates. So we expect low interest rates until recovery happens. But what happens after the recovery is well-established, and once the Federal Reserve is no longer keeping interest rates at their zero nominal lower bound?
The first scenario is that we have an exit from the zero nominal lower bound even before we have labor force recovery and profit share normalization. There is already a faction at the Federal Reserve -- a remarkably strong faction, now that Esther George at the Kansas City Fed has been joined by brand-new Governor Jeremy Stein -- saying that the fed needs an exit from its zero lower bound policy as quickly as possible, before labor market recovery. The argument is that your average bank needs to make 3% on assets to cover its costs. Your average bank president can’t go to the directors and the shareholders and say: "We lost a ton of money last year, but we have this very valuable commercial banking franchise for the long run, and we have to stay the course. I am sorry, but we will be reporting losses for the next five years until the economy normalizes." That's the right thing for them to say. That's the honest thing to say. That's a thing to say that gets them fired.
They don't want to be fired. They want, instead, to be able to report profits. So all over the country commercial banks are reaching for yield one way or the other -- which means that they are effectively selling unhedged-out of-the-money puts and hoping those puts expire before the come into-the-money. They are doing this in all kinds of ways, says Jeremy Stein, that we don’t understand, that they don't understand, and that the regulators can’t monitor. This has the possibility of blowing the banking system. And this time the political situation is such that the Federal Reserve will not be there to fulfill its standard role as lender at last resort. From Jeremy Stein and Esther George's point of view, this is the big risk facing the U.S. economy right now. It is necessary to guard against it -- even though guarding against it comes at the price of further delaying our exit from our current state with a depressed economy and a super-normal unemployment rate. At the moment, out of the 19 participants in FOMC meetings, perhaps 4 hold this view -- the other 3 back Bernanke. But the fact that one of those 4, Jeremy Stein, is probably the smartest one on the committee will have influence over the next several years.
I put what I regard as premature exit from the zero lower bound policy as a 5% scenario, but it is a 5% scenario. In this case short-term rates rise, the economy weakens, and long-term rates stay low and stay low for quite a while -- we are talking not just "lost decade" but "lost generation" here.
The fact that I give this only a 5% chance should not reassure you. Seven years ago, I would have put the chances that we would be here, now, in this situation at only 0.1%. The past five years have taught me that my probability estimates are surely wrong, if they have taught me anything. Right now, from my perspective of seven years ago, we are unbelievably far out in the lower tail.
If in fact we do get some kind of labor-market normalization -- if the extraordinary simulative monetary policies that are now being pursued continue until the economy recovers from more less normal employment-to-adult population ratio -- I see three scenarios.
The first scenario is what we economists call fiscal dominance. The interest rate on government debt will normalize to something. The something will probably be bigger than what we used to think as normal, because our views of what a normal government debt interest rate is corresponds to a 40% net debt to annual GDP ratio, and we will have an 80% one. When interest rates are normal, the government has to run a primary surplus to amortize the debt. And if the political system does not allow the government to run a large enough primary surplus, you get inflation until inflation has eaten away enough of the debt that the politically-feasible primary surplus does amortize it.
This was a point first made by John Maynard Keynes in the 1920s, when he told the Bank of France that it could not and should not try to halt the then-ongoing French inflation because France was then under this régime of fiscal dominance, and attempts to stop or delay the inflation would only make matters worse. That is definitely one of our scenarios: interest rates will normalize, the technocrats will say "we have to raise taxes in order to amortize our debt", the politicians will say "nope", and inflation will take off.
The second scenario is that the U.S. government, unable to raise broad-based taxes to properly amortize the debt and unwilling to suffer inflation, will impose "macro prudential" regulations that have the effect of creating a large, captive demand for U.S. Treasury debt and thus keep interest rates artificially low: financial repression, as after 1945. Require banks to hold huge reserves. Require direct lending to the government by captive domestic institutions, such as pension fund -- the French are already requiring people to do. Explicit or implicit caps on interest rates. Public ownership of banks. Having the Federal Reserve talk to banks, saying: "You aren’t holding enough Treasuries. We will remember this when you need something from us.” The dividing line between macroprudential regulation requiring large holdings of safe assets on the one hand on the one hand and financial repression to make it easier for the government to borrow on the other hand is a very thin line indeed.
This is what Carmen Reinhart and Ken Rogoff think is most likely to happen, by far.
Then, in this second scenario, there is the question of how harmful to growth and profits such policies would be. They impose a heavy, narrow-based implicit tax on finance. They get in the way of capital markets' ability to push financing where it’s productive. Reinhart-Reinhart-Rogoff say that if you raise your debt-to-GDP ratio from 50% to 150% your growth rate is likely to slow by 1% point per year. Some of that is reverse causation. Some of that comes when inflation deranges the price system or high interest rats depress the economy. How much of that is left as a damaging effect on growth of financial repression? That is the Reinhart-Rogoff debate we should be having. That is not the Reinhart-Rogoff debate we are or have been having.
The third possibility is that the economy recovers, the labor market normalizes, but interest rate normalization simply never comes. The 2001 and 2009 collapses of the equity market and the 2007-2009 collapse of the housing market means that for the next 50 years or so everyone is going to be back in their 1950s mode of believing that equities and housing are too risky, and that with a Federal Reserve that hits its inflation target you really want to have your money in safe nominal debt. And especially now the government is the only organization that can issue safe nominal debt -- nobody is going to trust any securitizer at any rating agency to produce anything that’s really AAA for a long time to come. The US, the German, the British and the Japanese governments are thus the only places that can originate AAA assets. And in a world of a global savings glut, demand for their liabilities will be enormous. This is a point that Ricardo Cabellero at MIT makes.
The very high equity premium we have right now is a powerful argument that this scenario is the correct one.
In this scenario, we may well find ourselves in a situation in which the U.S; government can simply borrow and borrow and never have to pay it back because the economy grows faster than interest accrues. In which case the U.S. government looks much more like the Renaissance Medici Bank -- an organization you are happy to pay to keep your money safe, rather than a debtor from whom you demand a healthy return. The treasury becomes a profit center for the government rather than a cost. We will know if this scenario is true when the labor market normalizes: do we then find the interest rates environment we have had in the past five years persisting, a new normal for the long term?
Those, as I see it, are the four options for normalization.