Tuesday, December 2, 2008 13 comments ++[ CLICK TO COMMENT ]++

Why is the FedRes planning to buy govt bonds? Can someone explain?

Ben Bernanke has indicated that he may contemplate buying long term government bonds, now that the interest rate tool has run out of ammunition. IANAE (I Am Not An Economist) but I don't get it. Why are they trying to push yields even lower? Can someone explain the rationale for this?

Look at the historial 10 year and 30 year yield charts:



The yields are near multi-decade lows. I can see the bond purchase being considered if yields were abnormally high yet that is not the case. I don't see how a clear-thinking person would want to push yields down as low as possible. Yes, lower rates stimulate the economy but I would argue that we are already at levels that are low by historical standards (but not by Great Depression standards perhaps.) The long end of the bond market is set by the market, although one can argue that it isn't quite a free market given that the big players such as foreign central banks and Carribean sources (essentially hedge funds and anonymous foreign governments) primarily influence it. The central banks are most at comfortable controlling the short-term rate so it's not clear to me why the FedRes is trying to manipulate the long-term rate.

This seems especially dangerous if you consider the opinion of bears like me who think the bond market is in a bubble. To me, it seems like you are throwing gasoline onto the fire in order to heat yourself, while taking on the risk of the house burning down.

I have praised Ben Bernanke in the past, particularly when he injected liquidity into the system without increasing the money supply (this was done by selling Treasuries into the market, which the FedRes rarely ever does.) But this latest suggestion--thankfully it's only a suggestion so far--seems extremely risky.

(Note: I am assuming that this isn't some doublespeak where a political problem is being masked by a central banker. That is, I am not assuming that investors have lost faith in the US government and can't find buyers for its bonds, and hence the FedRes has to buy it. I don't believe that is the case at all so I am interpreting this solely as an economic policy.)

Tags:

13 Response to Why is the FedRes planning to buy govt bonds? Can someone explain?

contrariandutch
December 2, 2008 at 1:46 PM

Quantitative easing at work. Short term interest cannot go below 0 and effective Fed Funds is already there (not the target, at 1% but the effective rate, what bank really pay, is, currently .3% or so) so in order to ease monetary policy further the Fed must influence yield at longer maturities. The way to do it is to buy treasuries at the maturities to be influenced in sufficient quantity to drive down the yield to the desired (very low) level.

The fact that this increases money in circulation very fast and is thus highly inflationary is a feature not a bug. Uncle Ben wasn't kidding when he said a determined central banker can always reflate.

A nice side effect is that by monetizing government debt, bonds are removed from ciculation and replaced with freshly printed cash at no cost to the government, the effective indebtedness of the US government goes down. Not bad when the government has huge borrowing requirements.

Is this going to cause inflation down the line? You bet! Hence my expectation of rather high inflation several years from now.

December 2, 2008 at 2:19 PM

It never worked in Japan and it probably won't work now.

Wouldn't it be better to buy the bonds whose yields have gone up lately? Say some corporate bonds? Or do they need legal power from the President, Congress and Senate to start buying corporate bonds?



I don't have a strong opinion on inflation right now but I can see your case. But I can also see the opposite case. If we actually enter a deflationary period, inflation won't materialize. What I'm curious about is whether we will have a US$ trade-trade developing. Japan printed a lot of money and kept rates low but the cheap capital left the country.

contrariandutch
December 2, 2008 at 4:22 PM

It did work in Japan. The Japanese were just very late and timid in using it so the effect came late and in a small amount. Serious money printing only started in 2002 or so and still on far too small a scale to overwhelm risk-averse savers who mostly just invested in foreign bonds instead of domestic.

If the BOJ had gone nuclear right on the heels of the stock market and real estate collapse in 1989 Japan would have been shaken out of deflation.

The Fed has already started buying agency MBS and if current efforts are not enough, yes they will be buying corporate and structured bonds next. If that still isn't enough they will buy common equity. Eventually they win.

Also note that banks can now borrow unlimited quantities of cash at near-zero interest putting up as collateral anyting including Lehman's dead guard dog, suitably cut into BBB and B- tranches of course. The Fed does not sterilize this cash-creation anymore by having T-bills issued so in a sense the Fed is buying all types of fixed-income instrument, except that they formally don't take ownership. The ECB is doing the same and is even more liberal in permitted collateral, the dog's droppings are good too.

So in my opinion inflation is a given down the road. But short to medium term deflation looks to be the order of the day due to the massive credit destruction going on.

December 2, 2008 at 4:51 PM

I think we agree that Japan didn't do enough early. But the verdict is still out on what actually worked. Part of the problem is that you may stabilize the financial markets, while the economy deteriorates:

"Bank of Japan Governor Masaaki Shirakawa said in May that while the strategy [Japan's] “was very effective in stabilizing financial markets,” it had “limited impact” in remedying Japan’s economic stagnation because banks wouldn’t lend and companies wouldn’t borrow. "

It remains to be seen what comes of any of this, given that money can flow out via a US$ carry-trade.

contrariandutch
December 2, 2008 at 6:01 PM

Measured in GDP per capita Japan's economy did not do so poorly over the past twenty years. Many people look at total GDP growth but the real measure of improvement in the economy is imo growth in GDP per capita. One of the problems with the US is that GDP growth looks good but it is largely a function of population growth so real incomes are stagnating. Debt was used to camouflage that ugly fact and look how that worked out.

With a slowly falling population like Japan the total GDP number looks bad but growth in GDP per capita can be fine. Also, the persistent high savings rate and thus low domestic consumption of Japan have probably held back total growth. The Japanese stagnation is really a bit of a myth if you ask me, just as the supposed slow growth of Europe compared to the US is a bit of a myth fueled by misleading GDP growth rates.

Still, you are correct that monetary policy can only do so much and may not keep the real economy going. That is why fiscal stimulus is called for, and lot's of it because that will push the economy forward. Monetary policy can support this by making government borrowing ridiculously cheap.

A USD carry trade has been going on for some time and it;s unwinding has apparently been a major reason for the sharp fall of EU/USD. It may be resumed, but given the cultural difference between the US and Japan I really don't expect a Japan redux. Americans just will not save, especially with interest near zero.

December 3, 2008 at 10:35 AM

At this rate we may see Ben in a literal helicopter dumping literal cash across Manhattan before long! :)

I agree the US / Japan comparison can be pushed too far.

As I understand it, the Japanese had a cushion of savings to fall back on even after their bubble peaked. The US consumer is going to *need* credit just to buy stuff.

There will be some doing without / a drop in standard of living (or growth - i.e. the recession we're in) but I don't think US consumers will prolong the agony by fulfilling the paradox of thrift with any great relish.

December 3, 2008 at 2:09 PM

Monevator: "At this rate we may see Ben in a literal helicopter dumping literal cash across Manhattan before long! :)"

Now... only if I could find someone in America to stand under the helicopters and catch some of those dollar bills ;)... hmm...


"As I understand it, the Japanese had a cushion of savings to fall back on even after their bubble peaked. The US consumer is going to *need* credit just to buy stuff."

But the thing is, the vast majority of people do not live off savings. Rather, most people live off their jobs. I would argue things like unemployment rate, income, and so forth, matter more. Furthermore, I personally don't care about savings if the government can finance debt cheaply, which the US can.

December 3, 2008 at 2:27 PM

ContrarianDutch: "Measured in GDP per capita Japan's economy did not do so poorly over the past twenty years. Many people look at total GDP growth but the real measure of improvement in the economy is imo growth in GDP per capita. One of the problems with the US is that GDP growth looks good but it is largely a function of population growth so real incomes are stagnating. Debt was used to camouflage that ugly fact and look how that worked out. "


The way I look at it...

Total GDP is what matters if you are looking at economic power. For instance, the first country or civilization that will build a spaceship to the next star system will probably be the one that has the largest total GDP.

However, if one looks at quality of life, then GDP per capita matters more so than GDP. You as an individual would be better off living in a country that raises GDP per capita rather than total GDP alone.

Japanese performance in the last two decades is still poor but there are a lot of issues that make it seem worse than it is, as well as making it seem better. Key items to note include the following:

Japan's demographics is poor, and I don't know exactly when you had large retirees compared to young workers but the total GDP would have likely shrunk (or not grown much) even if it didn't face a huge boom and bust. So you are right in being skeptical of the numbers.

The other thing to note is that--I remember Marc Faber making this point which I found insightful--although GDP growth has been poor, the mild deflation has meant that living standards for the average person has kept up or even gone up! For instance, cost of rent (urban rents were insane in Japan,) or food has gone down for the majority of the population.

Overall, though, I still think the Japanese situation is bad. The reason is that the Japanese government has run up so much debt--almost 200% of GDP--that it is masking the actual damage. You may correctly elicit concern about the debt of Americans (British, Canadians, and others) but America, even if you assume some big fiscal spending, does not have debt anywhere near 200% of GDP. The corporate sector in America is also clean (outside financials) whereas Japanese firms of all stripes had poor balance sheets in the 90's (you had manufacturing firms gambling on real estate for example.)

contrariandutch
December 3, 2008 at 4:42 PM

Sivaram said:

"Total GDP is what matters if you are looking at economic power. For instance, the first country or civilization that will build a spaceship to the next star system will probably be the one that has the largest total GDP."

I regard this as incorrect. In 1600 the GDP of India or China was far larger then that of any European country and in 1800 this was no different, yet it was European countries that went on to conquer India and relegate China to the position of minor power. The Netherlands in this period conquered the Indonesian archipelago, with perhaps 10x the population and 5x the GDP. And in between European countries explored the world, saw massive technological deverlopment and got the inustrial revolution on the runway. The Europeans did have superior GDP per capita.

More recently Russia could not by itself defeat Germany, with smaller GDP, in war on two occasions as the Germans had higher GDP per capita and thus could achieve a higher level of mobilization. Compare also Israel and the Arab states. The Arabs collectively have much bigger population and GDP then Israel but get their asses handed to them every time they are stupid enough to fight a direct war. In terms of technological achievement it's even less of a contest.

The point is that a huge mass of peasants living at barely subsistence level can create a big GDP but there is little available for purposes other then keeping that mass of population barely alive, so no budget for research, exploration and industrial investmen. High GDP per capita means after the populatin is taken care off there are significant resources left. This matters, along with the will to mobilize these resources for national purposes rather then private consumption.

In my opinion the first country to colonize another planet will be one with high GDP per capita and a strong will to mobilize available resources. Such a country will also enjoy a persistent military edge over rivals with bigger GDP but less potential for mobilization. Japan actually scores well on both counts.

sc
December 3, 2008 at 9:58 PM

Excellent exposition cd. Thank you.

December 5, 2008 at 11:39 AM

ContrarianDutch,

Good counter-arguments but I'm still not sure I buy the GDP per capita argument. If I get some time, I'll try to dig up some historical evidence to support my argument. I would argue that your examples capture superior technology, knowledge, etc but not the economic power. In other words, the examples you cite capture the situations at a point in time and doesn't account of countries/civilizations that are rising or falling.

Based on what you are saying, one would conclude that Japan will build a spaceship to Alpha Centauri before China will. That would certainly be the case if we look at a slice in time: say over the next 5 years. But how about the next 50? I would argue that China would have an easier time.

contrariandutch
December 5, 2008 at 12:18 PM

Higher GDP per capita is a necessary consequence of superior technology, knowledge etc.

If, and only if, China gains superior GDP per capita over the next fifty years, yes they may be the first to colonize space. I think it will be one of three, the Germans, the Japanese or the Russians. The first two have superior technical skill (and the GDP per capita to show for it :-)) as well as proven ability to mobilize massive resources and proven imperialistic ambition, the Russians have just imperialistic ambition but a look at a world map will tell you that has always been enough for them.

Look forward to the findings of your historical research!

December 5, 2008 at 12:54 PM

Looking at GDP per capita seems akin to looking in the rearview mirror. Perhaps what matters is growth in GDP per capita.

I did a quick Google search but can't find much info on GDP per capita a few hundread years ago. Easy to find raw GDP but the per capita info seems harder to locate.

Post a Comment