Monday, 9 February 2009

Why all stimulus packages fail

Here lies the fatal flaw of all fiscal stimulus packages - the long run interest rate.

Since it became clear that Obama wanted to pump up the US fiscal deficit to unprecedented levels, the yield on long term US government paper began to rise. Since late December, the 20 year, the constant maturity T-bill rate has increased 81 basis points. That is the equivalent of three rate hikes. However, Obama hasn't even begun to ratchet up the deficit. Imagine what will happen to rates when the Federal Reserve tries to shift $100 billion of debt every month.

What happens if the Fed holds a T-bill auction and no one turns up? Actually, the Fed has an answer to that question. The Fed will buy the debt directly and print lots of crisp dollar notes to cover the cost. Existing US government debt holders will recoil in horror as their investments are destroyed by a huge wave of newly printed cash.

Forward looking investors, ie the Chinese government, will move long before the Fed gets a chance to monetize the deficit. The Chinese will start selling their US treasury bills, pushing up long term yields and killing off any hope of an early US economic recovery.

And if you are thinking that none of this has anything to do with the UK, think again. Brown and Darling's plans for a fiscal stimulus are just as large and equally ill conceived.

The relationship between long term government yields and fiscal deficits is well understood. When government borrows and spends,it raises interest rates and kills off private sector investment. This is called crowding out.

The bond market is about to teach everyone that governments can not spend their way out of trouble. The question is whether Obama and Brown are sitting at their desks and paying attention to the teacher.

16 comments:

Anonymous said...

1) Evidence on crowding out is mixed.
2) "They will start selling their US treasury bills, pushing up long term yields" --- it's not a given that a sell-off in the short-end would affect the long-end.
3) China has c. $1tn of reserves, of which c. 600-700bn are in Treasuries. Not an easy position to get out of in a hurry. And please explain what they'll do with their reserves. Buy EURUSD? Buy GBPUSD? Buy AUDUSD?

Bad boy said...

Anon 14:48

That chart doesn't suggest a good start. In real terms, long term rates are going to tighten, especially if, in the short run, the US starts to deflate.

Mark Wadsworth said...

What first Anon says, point 3.

Good chart, a couple of months ago, the bubble du jour was in US or UK government bonds, they look to be something worth getting out of, or short selling if can be bothered.

Mark Wadsworth said...

What first Anon says, point 3.

Good chart, a couple of months ago, the bubble du jour was in US or UK government bonds, they look to be something worth getting out of, or short selling if can be bothered.

Nick von Mises said...

Broadly agree. I've been banging on for a year that it's the bond vigilantes that'll put a crimp of Darling's stimulus madness long before the electorate or EU do. During the Treasury bubble I started to wonder.

China is the epitome of an idiot investor, not a smart one BTW.

The main problem is this is still all very deflationary due to the much larger destruction of commercial money.

Mitch said...

For a student of history gordon seems very ignorant,perhaps he thinks like everyone before him that this time will be different.

Rick said...

I wonder what will happen if the Fed became the sole purchaser of new and existing treasuries, surely yields would fall in this unprecedented move.

powerman said...

"I wonder what will happen if the Fed became the sole purchaser of new and existing treasuries, surely yields would fall in this unprecedented move."

They would have to just print money to buy all the bonds, so either the government would have to massively reduce it's borrowing or inflation would increase.

Anonymous said...

Remember when James Carville (advisor to Bill Clinton) said he wanted to come back as the bond market?

Well for years the bond market has been complicit in this mess, accepting low yields (mainly foreign central banks like China's buying US debt).

In my mind, the trillion dollar question has always been when would central banks stop purchasing US govt/agency paper.

Much to my surprise, this recycling of $'s by central banks has gone on much longer than I thought possible.

But you are correct, that someday, and that day may be perilously close for the US, central banks will stop funding US deficits and then look out...

When that happens it will be very, very messy indeed!

AntiCitizenOne said...

Anonymous @ 00:12

Here's my take on that.

http://anti-citizen-one.blogspot.com/2009/02/telegraph-bond-market-calls-feds-bluff.html

Anonymous said...

AntiCitizenOne,

It is true that the bond market yields have started to back up. Still, I would contend that if the FED and US gov't continue to forge ahead in the reckless path they currently are on (and there is no reason to expect their approach to change until forced to by the markets-- either currency or bond), then the correction will be orders of magnitude greater than what we are currently seeing on the mid to long end of the curve.

Of course, I have been taking this position for a long time and the bond/currency markets have not agreed substantially with me... YET!

K T Cat said...

China will continue to buy Treasuries so long as the RMB is pegged to the dollar. They have to in order to protect their own currency.

Conjecture: When it becomes impossible for them to pour enough money into Treasuries to protect the dollar, they will peg the RMB to gold or something similar and flee the Treasuries. According to Brad Setser's Follow the Money blog, the Chinese are selling off their long-term Treasuries and are buying short-term ones. In other words, they're moving closer to the door.

Anonymous said...

Please bear with an ignoramus.

When you write that "yields are starting to rise" do you mean that the traded values of (say) a hundred dollars worth of 3% long term US treasury bills is starting to fall, as investors factor in inflationary expectations ?

If so

a) aren't those who are currently holding the bills (if they bought at face value) sitting on a large potential loss ?

b) won't any further issues of long-term 3% Treasury bills fail to find buyers at face value ?

Man in a Shed said...

This isn't my area of expertise, but aren't there anumber of Asian governments involved here. The temptation for some of them to run for the hills is going to be strong isn't it.

The situation looks inherently unstable the way you describe it.

Anonymous said...

Anon 10 February 2009 14:59,

If/when interest rates increase, you are correct in concluding there will be massive losses.

Many beleive, I among them, the credit bubble migrated from tech stocks to real estate to find its finally home in the US treasury market.

At some point holders of longer term maturities are going to head for the exits (unless you beleive we are going to experience deflation for as far as the eye can see). When the inevitable exodus happens, the losses will be huge for everyone, but the lucky first out.

As an aside, it always amazes me the number of people who think they will be the lucky few (of course the vast majority will not be so lucky).

Once again, however, the trillion dollar question is when the unravelling will occur., keeping in mind the markets can stay irrational longer than you can stay solvent betting against them (to paraphrase Keynes).

Orlando said...

Unfortunately gents there is $500 billion in Option ARM’s that will be resetting interest rates and/or reached 125% cap on loan to value ratio very soon.
I believe that we will see some severe declines in housing values in next 12 months. This industry is getting the hose....