Once there were three bubbles. The one that attracted everyone’s attention was the dotcom bubble, of which no more needs to be said. The second bubble, noted by plenty of economists was the glaring overvaluation of the bubble. Given chronic deficits in both the budget and current account, and the fact that the US dollar was trading at a value well above purchasing power parity, anyone who gave any credence to the view that markets eventually reach equilibrium could conclude that the US dollar was bound to fall, and it has duly done so. (this only leaves the question of why putatively rational investors did not sell earlier)
The third bubble seemed, until this year, like part of the second. Rates of interest on 10-year US government bonds are amazingly low, currently around 4.25 per cent (the price is inversely proportional to the interest rate, so low interest rates mean a bubble in bond prices). Most economists would, I think have assumed that, as the US dollar declined in value, long-term interest rates would go up. But, apart from a brief panic a few months ago, this hasn’t happened.
Why have long-term interest rates stayed so low? There are a bunch of factors that might be considered. First, as long as it maintains ‘credibility’, the US Federal Reserve can control short-term rates. The general assumption is that this control doesn’t extend to long-term rates, but the long run is just a sequence of short runs. If the Fed keeps the short rate at 1 per cent for years on end, the long rate must also be low (otherwise you could make as much money as you liked by borrowing short and lending long). I’m not convinced by this because, carried on indefinitely, such a policy would lead to resurgent inflation. So, to maintain credibility, it can only be maintained for a few years at most.
The second part of the story is that, while individuals are getting rid of US government bonds, Asian central banks are buying them. You can see this in the data supplied by the Bureau of Economic Analysis.
The third, and most interesting fact is that, even as it runs deficits, the US government is, in effect, buying its own debt. More precisely, it is not rolling over long-term debt as it expires but is, instead, issuing short-term debt. For example, even though rates on 30-year bonds look like an amazing bargain for a borrower, they are no longer being issued. Similarly, new issues of 10-year debt seem to be declining.
What all this means is that things are going to get very messy in a few years time, when the need to roll over increasing amounts of short term debt coincides with the payment of Social Security to the first of the baby boomers (in this purely actuarial context, generational terms like this are of some US).
As we have seen, no matter how solid they may seem, bubbles eventually burst, and the bond bubble will be no different.
{ 12 comments }
TomD 12.18.03 at 12:25 pm
“The second bubble, noted by plenty of economists was the glaring overvaluation of the bubble.”
What? You mean Americans are now paying for their groceries in bubbles?
Bubbles on the brain, more like.
Greg Hunter 12.18.03 at 1:35 pm
“You can see this in the data supplied by the Bureau of Economic Analysis.”
No, I cannot see where the data suggests that Asians are buying the bonds. I believe that the Asians are buying, but it is not presented in the data.
The Asians are buying because the U.K. and U.S. Corporations own sweat shops in Asia that need natural resources to operate. The US/UK governments have agreed to supply the resources as long as the Chinese supports the West in a life that it has become accustomed. They have to buy the bonds.
Matt Weiner 12.18.03 at 3:23 pm
this only leaves the question of why putatively rational investors did not sell earlier
Davies’ law, perhaps? (Per tomd, I assume you meant “overvaluation of the dollar.”)
jimbo 12.18.03 at 4:00 pm
“Credibility” has nothing to do with it; the fed can maintain short-term interest rates at any level it chooses, for as long as it wants to. Long term rates are determined by two things: what the fed is doiong right now, and what traders think the fed will od in the future. “Supply and demand” is inoperative in the case of financial instruments.
Inflation will only result if aggreagate demand exceeds aggregate supply, and we haven’t been anywhere near that since the late 60’s…
The Chinese and other trading partners are buying bonds because they are set on accumulating dollar assets by exporting to us more than they import from us, and the only alternative to buying bonds is to hold onto non-interest bearing reserves. (there’s no other place for the money to go) “Financing the trade deficit” is also a nonoperative concept in the case of a floating exchange rate regime.
russ e 12.18.03 at 5:38 pm
Whatever you call it, when us “whiny baby boomers” retire something’s going to go bust. Stop us before we bankrupt us all!
dsquared 12.18.03 at 6:12 pm
You know I love your stuff, jim, but why do you say:
Inflation will only result if aggreagate demand exceeds aggregate supply, and we haven’t been anywhere near that since the late 60’s…
Shurely with unemployment at amazingly low rates and consumer borrowing through the roof, it’s a bit hard to make the case that the USA has deficient aggregate demand?!?
TOm 12.18.03 at 7:50 pm
“The Chinese and other trading partners are buying bonds because they are set on accumulating dollar assets by exporting to us more than they import from us, and the only alternative to buying bonds is to hold onto non-interest bearing reserves.”
I wouldn’t say that’s the ONLY thing they could do. They could also buy US real estate or stock. Or they could exchange the dollars for, say, euros, and invest in something over there. Or import something from over there.
nnyhav 12.18.03 at 10:41 pm
More like a bubble of bubble theories. Mere misvaluation does not a bubble blow. But I shan’t further interrupt your buying into a self-sustaining frenzy.
jimbo 12.19.03 at 12:52 am
Tom –
You don’t get it – they can do all of those things, but the that just moves the dollars around. The only way that the dollars are “removed” from the system is to exchange them for U.S. bonds. Remember – dollars never “leave” the U.S. – their only existance is as accounting data in U.S. banks. They are created when the Fed writes a check, and only destroyed when the Fed cashes one (or acts as intermediary for the Treasury doing it, which is the same thing).
The Chinese are attempting to maintain a peg of their currency against the dollar. In order to do that, they must be willing to continously sell dollars on the open market at their peg price. (In the same way the U.S. treasury used to sell gold at $35 an ounce to anyone who showed up in order to maintain the gold standard) Accordingly, they have to obtain those dollars to have on reserve. Fortunately for them, they don’t have to dig them up somewhere – we are willing to give them all the dollars they need, in exchange for stuff they send us.
What this means is that the more demand there is for their currency, the more dollars they need to maintain the peg. In real terms, they are giving us boatload after boatload of stuff, and in return we are incrementing the numbers on their central bank’s account at the Fed. (we don’t even have the decency to send them fancy bits of paper, anymore) Can this go on forever? Probably not – but it is their problem, not ours. We are getting $100B dollars a year in free stuff that we don’t have to work for. It’s not like they can come over here and take it back when they realize they’ve been had. So our currency drops – who cares? Income is transfered from the import sector to the export sector. The level of a currency has nothing to do the real wealth of a nation. If statemen would only realize that, a lot of bad policy would go away…
jimbo 12.19.03 at 1:23 am
Sorry – I mispoke. (I have trouble keeping it stright in my head, myself) What the Chinese are doing is buying dollars to maintain the peg at a artificailly low level.
Long and short – Chinese industry sells to U.S. for dollars, turns in dollars to Chinese CB for Yuan. Chinese CB keeps buying them by issueing Yuan, keeps building up reserves in order to keep Yuan low. Since Yuan is so low, Chinese can’t afford to buy U.S. products, so export surplus is maintained. The net effect is to impoverish your native population in order to build up financial claims that are of uncertain value (since the U.S. dollar is not pegged to anything and freely floats)
China is doing this because it is undergoing a wrenching transition, unemployment is high, and it believes it cannot afford the disruption that a strong yuan would cause (specifically in it’s ailing agricultural sector). But like I said – it’s their problem, not ours, and we benefit from it in real terms…
jimbo 12.19.03 at 1:35 pm
D^2:
Surely, with all the talk about a “jobless recovery”, “2 million jobs lost”, etc., you of all people would not want to argue that we are at full employment! I define “full employment” as being a situation where anyone who is willing and able to work can find a job with some minimum of effort. By that measure, yes, I would say that we have not been at “full employment” for quite some time. And the last time we had true “demand pull” inflation was during the “guns and butter” days of the Vietnam war.
rapier 12.21.03 at 12:04 pm
links
First the slightly influential among bears, non political, Doug Noland and his weekly Credit Bubble Bulletin
http://www.prudentbear.com/archive_home_com.asp?category=18
For a totally off center peek at some of these issues here is an article to ponder.
http://www.atimes.com/atimes/Global_Economy/EH14Dj02.html
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