Perpetuities, Debt Crises, And Inflation - Barokong

My brief exchange with Markus Brunnermeier at the end of a Covid-19 talk  attracted some attention, and merits a more detailed intervention.Gavin Davies at FT made some comments (more later) as did the Economist. My anjuran to fund the US with perpetuities comes from a paper, here. (Sorry regular readers for the repeated plug.)  The rest is standard fiscal theory of the price level, spread over too many papers to give one more plug. There are three main points.  First, inflation is not about money anymore -- the choice of money vs. bonds. Money -- reserves -- pay interest, so reserves are just very short-term government bonds. Inflation is about the the overall demand for government debt. That demand comes from the likelihood of the debt  being repaid, and the rate of return people require to hold debt. Second, if we have inflation, the mechanism will be very much like a run or debt crisis. Our government rolls over very short term debt. Roughly every two years on average, the government must find new lenders to pay off the old lenders. If new lenders sniff trouble they refuse to roll over the debt and we're suddenly in big trouble. This is what happened to Greece. It's what happened to Lehman Bros. In our case, our government can redeem debt with non-interest-paying reserves, resulting in a large inflation rather than an explicit default. 2a, a run is always unpredictable. If you knew there would be a roll-over crisis next year, you would dump your government bonds this year, and the run would be on. There is a whiff of multiple equilibrium too. Our debt is nicely sustainable at 1% interest. If interest rates go up to 5%, we suddenly have north of $1 trillion additional deficits, which are not sustainable. The government  is like a family who, buying a home, got the 0.1% adjustable rate mortgage rather than the 1% (government debt prices) fixed rate mortgage because it seemed cheaper. Then rates go up. A lot. Sure demand is high for US government debt, rates are low, and there is no inflation. But don't count on trends to continue just because they are trends. How long does high demand last? Ask Greece. Ask an airline. Third, for this reason, I argue the US should quickly move its debt to extremely long maturities. The best are perpetuities -- bonds that pay a fixed coupon forever, and have no principal payment. When the day of surpluses arrives, the government repurchases them at market prices. By replacing 300 ore more separate government bonds with three (fixed rate, floating rate, and indexed perpetuities), treasury markets would be much more liquid. Perpetuities never need to be rolled over. As you can imagine the big dealer banks hate the idea, and then wander off to reasons that make MMT sound like bells of clarity. That they would lose the opportunity to earn the bid/ask spread off the entire stock of US treasury debt as it is rolled over might just contribute. But we don't have to wait for perpetuities. 30 year bonds would be a good start. 50 year bonds better. The treasury could tomorrow swap floating for fixed payments. Then we would be like the family that got the 30 year fixed mortgage. Rates go up? We don't care. By funding long, the US could eliminate the possibility of a debt crisis, a rollover crisis, a sharp inflation for a generation. Gavin Davies shows the following graph, congratulating the Treasury for going longer after 2008. But weighted average maturity is a terrible statistic, and substantially overstates the maturity. It weights only the maturity of the principal, ignoring the coupons. If the Treasury introduced perpetuities, the weighted average maturity would instantly be infinity, which is obvious nonsense. We know how to calculate better numbers -- start with duration, which includes the maturity of the coupons. The Treasury's antiquated accounting is an obstacle to reform. Well, a rise in rates is  hardly likely, you say. Indeed in the same volume as my perpetuities anjuran, Robin Greenwood, Sam Hanson, Joshua Rudolph, and Larry Summers advocated an even shorter maturity structure. The ARM is cheaper, and they ran some situations that a rise in interest rates was unlikely given the statistical patterns of recent history. But past history does not always continue. I buy earthquake insurance in California even though there hasn't been a really big one since 1906. The same statistical approach to risk management blows up regularly. Economists working on climate change often make the insurance argument -- sure, the conditional mean is not a catastrophic impact, but we should take out insurance that it's not much worse than we think. A debt crisis is like the Spanish Inquisition. Nobody expects it. Alan Blinder, for example, writing in WSJ echoes this conventional wisdom, First, at least for now, the Fed is buying as many debt securities as the Treasury is selling. On net, the investing public doesn’t have to buy any. Wait a minute, Alan, the public does have to hold the reserves, which are just another form of government debt! Second, the U.S. borrows in its own currency. Sovereign debt crises almost never arise in such cases. True, but inflations do. Riots, civil wars, pandemics and coups "almost" never arise either, yet we are well advised to pay some attention. And the US has had one big debt crisis in 1972, though we borrow in our own currency and under Bretton Woods the dollar was the reserve currency. Foreigners distrusted the dollar and demanded payment in gold, which we ran out of.  (Short version). The UK had several debt/currency/inflation crises. Third, if the U.S. Treasury starts to supply more bonds than the world’s investors demand, the markets will warn us with higher interest rates and a sagging dollar. No such yellow lights are flashing. Did I mention that nobody expects a run? Flashing yellow lights did not warn Greece, Lehman Bros., or the US. Here are 10 year rates and inflation through the 1970s and 1980s. 10 year rates never saw inflation ahead of time. They didn't see the decline in inflation even after it happened. Fourth, interest rates on government debt in several advanced countries—notably but not only Japan—are superlow today even though their national debts are far higher, relative to gross domestic product, than seemed prudent a decade or two ago. So AIG was in worse shape than Lehman. Fifth, the U.S. public debt topped 100% of GDP at the end of World War II with no adverse consequences. After that peak, we managed to whittle the debt down to only 22% of GDP over the next 28 years or so. To accomplish that feat, we didn’t need to run anggaran surpluses year after year. We just kept deficits small enough that the debt grew slower than GDP. Which is not that hard if the interest rate remains below the economy’s growth rate—as has been true for years. Actually, post WWII, after a quick bout of inflation that wiped out some of the real value of debt, the US ran steady primary surpluses until 1975. And had strong supply-side growth in a much less regulated economy. Let's be nice -- "keep deficits small enough" is wisdom widely overlooked around Washington. "if the if the interest rate remains below the economy’s growth rate—as has been true for years" sounds  a lot to me like "if the stock market keeps going up at 7% per year -- as has been true for years." Yes, I was worried in 2008, and the crisis hasn't happened yet. But the logic of it does not suggest  a classic near-term forecast. It could wait 10 or 20 years. We could escape with strong supply side growth, and "deficits small enough" by sensible reforms. But if it came -- doubtless in a deep recession, social unrest, perhaps war, just the sort of times that people doubt America's ability to reform itself and pay off its debt -- it would be an immense disaster. Locking in 1% interest rates for a generation seems like a no-brainer. While markets are willing to sell us insurance at this rate, take it. Updates: 1) A colleague writes, Might the short term debt issuance be a way the government is implicitly committing to not inflate the debt away. Such inflation would be much more painful than say deciding to inflate away debt with a long maturity structure? This is a good point. The short maturity structure is much harder to inflate away. The long maturity structure means in the event of inflation, default, widening credit spreads for the US, etc., the government comes out ahead, and is thus less likely to avoid the event. Seeing the US in effect take a big bet on inflation might also scare markets a bit. It's sort of like showing up at the insurance office with a can of gasoline under one arm. Like swaps, it also raises the counterparty question. If the US issues 30 year bonds, interest rates rise, the bondholders take a huge hit. Will the US really allow that to happen? If the bondholders are big banks, pension funds, and so forth? I think Merton Miller once suggested that Hong Kong defend a currency peg by writing a huge number of options against it, which would profit if the peg did not fall apart and ruin the country if it did. 2) In my memory of history, I can think of only one and a half times that debt to GDP greater than 100% has ended well for bondholders in the last 1000 years. The UK following the napoleonic wars is the first (funded by perpetuities, by the way). The US after WWII is the half - the inflation of 1945-46, the collapse of Bretton Woods and inflation of the early 1970s also contributed a bit. The UK following WWII was not a success. The UK grew out of the debt -- it started the industrial revolution. So both US and UK successes trace to a surge of supply-side growth, with sober fiscal management -- at least primary surpluses, as above.  We have neither going forward.  I asked some assembled economic historians for other examples. The US after the civil war came up. That's about it. I welcome other antecedents, especially ones with sclerotic growth and ever expanding deficits.
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Bailouts V Bankruptcy - Barokong

Bailouts are back. It's all 2008 all over again. Bankruptcy of a large corporation does not leave a crater behind. Bankruptcy is reorganization and protection, not liquidation. The point of bankruptcy is precisely to keep the business going. When a corporation files for bankruptcy, the stockholders are wiped out, bondholders lose a lot and become the new stockholders. The company rewrites a lot of contracts -- union contracts requiring a plane to fly even with empty seats, contracts to buy fuel at high prices, gate leases, and so forth. Bailouts are bailouts to stockholders, bondholders, creditors, unions. The first three all basically signed up to write insurance, and got a fee for doing so. Bailouts are not bailouts to "the corporation" which isn't a thing.  Maybe maybe there was a case in 2008 that big banks were "systemic" and their creditors could not take the losses that they had signed up to take. Not so industrial companies. Airlines and similar companies are in this mess because they took on way too much debt. If the government does bail out their stockholders and creditors, it makes a lot of sense not to let them take on  so much debt again. Repurchases per se are not the villain, as companies can borrow and pay big dividends. We might also start by finally, finally, removing the huge subsidies  to debt. If you're not persuaded, Veronique de Rugy and Gary Leff have an excellent and exhaustive article on this The Case Against Bailing out the Airline Industry.
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New Virus Podcast - Barokong

A grumpy economist podcast on virus economics so far.
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Low Bond Yields - Barokong

Why are interest rates so low? Here is the 10 year bond yield, by itself and subtracting the previous year's inflation (CPI less food and energy). The 10 year yield has basically been on a downward demam isu since 1987.  One should subtract expected 10 year future inflation, not past inflation, and you can see the tambahanvolatility that past inflation induces. But you can also see that real yields have fallen with the same pattern. There is lots of discussion. A falling marginal product of capital, due to falling innovation, less need for new capital, a "savings glut," and so forth are common ideas. The use of government bonds in finance, the money-like nature of government debt among other institutional investors and liquidity stories are strong too. And most of the press is consumed with QE and central bank purchases holding down long term rates. I hope the steadiness of the demam isu cures that promptly. Along the way in another project, though, I made the following graph: The blue line is 10 times the growth rate of nondurable + services per capita (quarterly data, growth from a year ago). The red line is the negative of an approximate measure of the real return on 10 year government bonds. I took 10 x (yield - yield a year ago), and subtracted off the CPI. Look at the last recession. Consumption fell like a rock, while the real return on long-term bonds was great. That real return came from a double whammy: long term bonds had great nominal returns as interest rates fell, and there was a big decline in inflation.  No shock, there is a "flight to quality" in recessions, along with a sharp decline in nominal rates. From a foreign perspective, the rise in the dollar added to the return of long-term bonds. The graph suggests this is a regular pattern going back to the almost-recession of 1987. In every recession, consumption falls, interest rates fall, inflation falls, so the real ex post return on government bonds rises. Government bonds are negative beta securities.  At least measured by consumption or recession betas.  Negative beta securities should have low expected returns. They should be less even than real risk free rates. I haven't seen that simple thought anywhere in the discussion of low long-term interest rates. Making the graph, I noticed it was not always thus. 1975, 1980, and 1982 have precisely the opposite sign. These were stagflations, times when bad economic times coincided with higher inflation and higher interest rates. Likewise, countries such as Argentina which go through periodic currency crises, devaluations, and inflations, flights to the dollar, all associated with bad economic times, should have the opposite sign. There is a hint that 1970 was of the current variety. One could easily make a story for the sign flip, involving recessions caused by monetary policy and attempts to control inflation, vs. recessions involving financial problems in which people run to, rather than from, money in the recession. In any case, the period of high yields was associated with government bonds that do worse in recessions, and the period of low yields is associated with government bonds that do better in recessions and have a negative beta. I haven't really seen that point made, though I am not fully up on the literature on time-varying betas in bond markets. In any case, if we want to understand risk premiums in bond markets, this sort of simple macro story might be a good starting point before layering on institutional complexities.
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Why Stop At 100? The Case For Perpetuities - Barokong

Issue 100-year Treasurys,advocates the Wall Street Journal.  It mentions a short notedeep on the Treasury situs web that Treasury’s Office of Debt Management is conducting broad outreach to refresh its understanding of market appetite for a potential Treasury ultra-long bond (50- or 100-year bonds). My 2 cents: Why stop at 100? Issue perpetuities! (I wrotea whole paper on this a while ago, if you want lots of detail and answers to practical questions. Unfortunately the Treasury situs web does not say how to send in suggestions, and nobody outreached to me, so this blog post is it.) Perpetuities are bonds with no principal payment. Each perpetuity pays $1 forever.  If interest rates are 3%, to borrow $100, the government would sell three perpetuities, and then pay investors $3 each year. When the government wants to pay back the debt, it simply buys back the perpetuities on the open market. A 100 year bond is almost a perpetuity. If the government issues a $100 100 year bond at 3%, only 100/(1.03)^100 = $5.20 of that value comes from the $100 principal payment. 95% of the value of a 100 year bond is already in the stream of coupons. For the penanam modal, they are practically the same security. In particular they have nearly the same sensitivity to interest rate changes. But perpetuities are better. Most of all: Perpetuities would be much more liquid -- easy to buy, sell, and use as collateral.   The reason is simple. Once 100 year bonds get going, there would be 100 separate and distinct issues outstanding. The 2123 2.6% 100 year bond is a different bond from the 2124 2.7% 100 year bond. If a dealer has an order for the first and an offer for the second, he or she cannot make the trade. If you borrow and sell short the first, you cannot deliver the second in return. This segmentation would make the markets for each bond thinner, and the bid ask spread larger. It would keep a lot of dealers and traders and market makers needlessly in business, which may  be one good reason the financial industry seems largely against the idea. Perpetuities, by contrast, are a single security. When the government borrows more next year, it is borrowing more of the same  security.  There is one, thick, transparent, low-spread market. A more liquid market would pay lower rates .  Much of the point is for the government to borrow at low rates. Much of the reason government debt has such low interest rates is that it is very liquid -- easy to buy and sell, the "safe haven" in bad  times and so forth. Government debt is somewhat like money, and like money pays less interest in return for its liquidity. Well, then, the more liquid the better! A 100 year bond would make sense if there were a group of investors sitting around who really wanted to have $3 coupons for 100 years, and then $100 exactly in 100 years, not 101 years, and they were not planning to buy or sell in the meantime. That is not remotely the case. Long term bonds are actively traded. Perpetuities match the varied investment horizons of ultimate investors, and by being more liquid are more flexible. There is plenty of historical precedent. Perpetuities actually came before long-term bonds. They were the cornerstone of UK finance for the entire 19th century. One can raise a bunch of practical objections, and if you have them go check out thepaper. Lower costs?  The WSJ only advocates 100 year debt on the notion it would give the Treasury a lower borrowing cost when yield curves are inverted. This is a good argument, but more difficult and subtle than the WSJ lets on. The current yield is not the lifetime cost.  The 100 year cost of borrowing with short term bonds depends on what short term interest rates do in the future. If rates go up, it costs eventually more to borrow short. If rates go down it costs less, even if the current yield curve is inverted. In the benchmark "expectations model" yields have already adjusted so the expected cost is the same. The issue is the same to a household deciding between an ARM and a fixed rate mortgage. Even if the current ARM rate is higher than the fixed, if ARM rates go down in the future, the ARM could end up being better. My paper was part of a conference at Treasury,published by Brookings.  I had a good debate with Robin Greenwood, Sam Hanson, Joshua Rudolph, and Larry Summers who wrote The Optimal Maturity of Government Debt (availablehere). They argued for borrowing short, not long. A the time the yield curve was steeply upward sloping, and in their simulations they opined that the chance of short rates rising and long rates declining to the point that the cost advantage would invert was small. The current reality has changed that conclusion as now it is the short rates that are higher. Still, I think this is the wrong way to look at it. The Treasury is not in a great position to play bond trader and figure out where small variations in the yield curve reflect profitable opportunities. Risk management.  Like all investors, though, the Treasury's first question should be risk management, not profit. And there is a great risk facing the US Treasury. We are clearly going to run up a lot more debt before sanity sets in. Go look at the just released CBO Long Term Debt Outlook. Net interest is already large. What happens if interest rates go up? Yes, they are unbelievably low now. But nobody really knows why. Between "secular stagnation" and "r* has declined" and "savings glut" you can see economists making things up right and left. So, you should not have huge confidence that we will not  return to historically normal interest rates of the last few centuries, or moreover that we will never suffer the kinds of interest rate spikes that happen to highly indebted countries trying to roll over 100% of  GDP  or so debt in a recession,  financial crisis, or war. If interest rates rise sharply, the US Treasury, having borrowed  short, is screwed.  We bought the ARM at a teaser rate. This,  to me, is the real argument that  the  government should issue lots more long-term debt; 100 years if needed (but please, only every 10 years or so!) or, much better, perpetuities. Buy the fixed rate mortgage, and you keep the house no matter what happens to rates. Let's keep the house. In this discussion with Greenwood et al, they argued that the chance of such an interest rate spike is low. Perhaps, but the insurance is cheap -- and with a flat or inverted yield  curve it's even cheaper. Borrow long to buy insurance, not just for a good deal. Update: In response to a few comments. In thepaper I proposed that the Treasury issue 1)  fixed-rate perpetuities -- a security that pays one  dollar forever -- 2) floating-rate perpetuities -- just like Fed reserves, the interest rate adjusts  daily  and the price is always exactly $1.00 3) indexed perpetuities  -- it pays one dollar adjusted for  the CPI (or one of its improved versions) forever. The first eventually replaces all long  term debt, the second eventually replaces all short term debt, and the third replaces TIPS. The second is really more  important, and I'll do a separate post eventually. If the treasury offered a fixed-value floating-rate instantly transferrable security just like reserves, it would do wonders for the  financial system.
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Lend The Shutdown? - Barokong

The Federal Government seems to be obeying with rather remarkable accuracy the constitutional mandate that the government may not spend money that has not been appropriated by Congress. I would be curious to hear from legal experts, however, what stops the government from lending  money to federal employees, or just guaranteeing loans. After all the government lends money all over the place, and credit guarantees are even larger. Is the Treasury no longer operating small business loan programs? (Honest question.) Is the Fed no longer lending money to banks, if they want it? Are Fannie and Freddy refusing to buy home mortgages because the funds to guarantee home mortgages (which it does) are not appropriated? No. As far as I can tell, Federal lending and loan guarantee programs are up and running. If so, what stops the Treasury, from either lending money directly to Federal employees, or guaranteeing private lending. After all, the Treasury will write their back paychecks when the time comes, so these are potentially risk free loans. What stops the Treasury from just writing on a federal employees' paycheck "this is a loan against your back pay?" Or... Social security and Medicare are still running. Can they write advances against social security payments that will be deducted from future federal paychecks? I presume there is something stopping this -- that it is a step too clever, like the trillion dollar coin solution to the debt limit. But I would be curious to hear what the limitation is. (HTMarginal Revolution on federal employees' other sources of financing, at pretty high interest rates.)
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Volatility - Barokong

An essay at The Hill on what to make of market volatility: What’s causing the big drop in the stock market, and the bout of enormous volatility we’re seeing at the end of the year? The biggest worry is that this is The Beginning of The End — a recession is on its way, with a consequent big stock market rout. Is this early 2008 all over again, a signal of the big drop to come? Maybe. But maybe not. Maybe it’s 2010, 2011, 2016, or the greatest of all, 1987. “The stock market forecast 9 of the last 5 recessions,” Paul Samuelson once said, and rightly. The stock market does fall in recessions, but it also corrects occasionally during expansions. Each of these drops was accompanied by similar bouts of volatility.  Each is likely a period in which people worried about a recession or crash to come, but in the end it did not come. Still, is this at last the time? A few guideposts are handy. There is no momentum in index returns. None. A few bad months, or days, of stock returns are exactly as likely to be continued as to be reversed. The fact is well established, and the reason is simple: If one could tell reliably that stocks would fall next month, we would all try to sell, and the market would fall instantly to that level. Twenty percent volatility is wajar . Twenty percent volatility on top of a 5 percent average return, means that every other year is likely to see a 15 percent drop. Big market declines come with a recession, as in 2008. But recessions are almost as hard to forecast as stock prices, and for much the same reason. ... They asked me to hold off a few weeks before posting the whole thing. So either wait two weeks or head over to The Hill. I also wrote here "The Jitters" related thoughts about the spring 2018 bout of volatility.
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