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Thursday, August 27, 2009

Why the Growing Level of U.S. Debt May Not be Inflationary

History shows that high levels of government debt are frequently associated with inflation. The reason for this seems clear enough. At some point, maturing debt needs to paid back. At high enough levels of debt, rolling the debt over is no longer feasible. Cutting back government spending and raising taxes is politically difficult. The easy way out is simply to print new money. As the money supply expands, inflation resuts.

The rough logic described above would seem to fit the experience of many smaller economies that find themselves under fiscal pressure. But things may not work so simply for a select few dominant economies. Japan appears to be one example; and the U.S. another.

Let us consider the U.S. Unlike most other economies, there appears to be a huge worldwide demand for U.S. Treasuries and U.S. dollars (which can be thought of as zero-interest Treasuries). A large scale increase in the supply of these government debt instruments need not lead to a depreciate in their value if there is a correspondingly large scale increase in the worldwide demand for these objects. What is the evidence that this may be happening?

Foreigners Snap Up Treasuries Even as US Debt Keeps Rising

But why should this be so? What accounts for what appears to be an insatiable demand for US debt, especially in the wake of the recent financial crisis?

Ricardo Caballero of MIT offers some hints in a very interesting piece entitled: On the Macroeconomics of Asset Shortages. After reading this paper, I started thinking in the following way. Tell me what you think.

There is a high and growing demand for low-risk assets, both as a store of value, and as collateral objects in payment systems (e.g., repo and credit derivatives markets). This growth has exploded over the last 20 years or so; and stems from the demand from emerging economies and innovations in the financial sector. There is a worldwide "shortage" of good quality (low-risk) assets, like U.S. Treasuries (which explains their relatively low yield). Indeed, many of the innovations in the financial sector can be interpreted as the private sector's response to this shortage: the creation of "low-risk" tranches of MBSs allowing these objects to substitute for U.S. Treasuries as collateral in the rapidly expanding repo market.

The recent financial crisis was centered in the repo market. Very suddenly, agents in the repo market were no longer willing to accept MBS as collateral (or if they did, at very large "haircuts"). The demand for U.S. Treasuries exploded (I seem to recall a day when their yields actually went negative). At the same time, there was a worldwide "flight to quality;" which again, manifested itself as large increase in the demand for (relatively safe) U.S. Treasuries.

If this is more or less true, then the implication is this: The massive increase in the supply U.S. Treasury debt may very be "socially optimal" in the sense that the U.S. government is simply supplying the world with an asset that is in very high demand (which, in turn, means that the demanders obvious find some value in the existence of such an asset). To the extent that this "new demand regime" remains stable, the added supply of U.S. Treasuries will impose no financial burden on the U.S. (indeed, they make off like bandits, as the Treasuries are ultimately purchased by exporting goods and services to the U.S.).

The million dollar question, of course, is whether the high world demand for U.S. debt will persist long into the future (and whether the U.S. government will "overissue" debt beyond what is called for by this new high-demand regime). Who knows what will happen. But it appears to me that IF the U.S. government plays its cards right, it may very well enjoy its higher debt levels without the prospect of inflation. U.S. citizens will benefit (from the sales of Treasuries for goods) and the world will be grateful to hold a stable asset.

Well, maybe. But that was a big IF. What could possibly go wrong?


  1. Japan has a large trade surplus, much of their debt was purchased by the Japanese themselves with the proceeds of their exports, supporting the Yen. On the other hand, there is no fundamentally sound export economy supporting the US dollar. Unless I missed something, Japan without its debt sales would have had an even stronger currency; America without its debt sales would have a collapsing currency. These two cases appear to be exact opposites to me.

    You say Americans are giving the world what they want, perhaps instead, the world is reluctantly giving America what it needs? It's almost like charity, or perhaps just another bubble mania. When the only reason you buy more of an asset is to prevent the stuff you already have from collapsing, does that sound like a recipe for long term stability? Is the solution to confuse that desperation for legitimate demand and create even more supply of that asset? Even if your lack of alternatives explanation is true, that implies (to me) that owners of treasuries are not investors, they are traders. When alternatives return (someday the recession with end) the likelihood they will hold the debt to maturity is low. And even if they did, they are unlikely to buy more debt with the proceeds... how will the government roll over all this debt? Raise taxes or higher interest rates? What happens to the US economy in either of those scenarios? I'm not sure if this sounds like de-coupling or 20 years of global anemic growth. Probably de-coupling, eventually.

    My question: how does this end without either the dollar losing value or some miracle invention that causes a new export revolution? Eventually when people realize the later is unlikely to occur, why would they continue to magnify their loses by acquiring more dollars? This doesn't pass the sniff test.

  2. Pointbite:

    I'm not sure why the world would "reluctantly" give the US government what it needs. Back in 1970, the world (predominantly Europe at the time) seemed quite willing to abandon the dollar (Re: breakdown of Bretton Woods).

    What has changed since then is that "the world" has expanded greatly along two important dimensions: [1] emerging markets in desperate need of a safe store of value (Caballero's argument); and [2] the rapid expansion of the shadow banking sector (e.g., repo market) with an enormous appetite for safe collateral assets.

    The U.S. appears to be the preferred source of these assets (e.g., I do not recall Japanese Treasuries, or any other government debt instrument being used as collateral in repo).

    To the extent that this is true and remains true, I find it unlikely that the recent increase in U.S. government debt will ultimately manifest itself as inflation (assuming they don't go overboard, of course). In fact, the massive increase in the demand for these objects is deflationary -- absent the growth in supply, we would likely be witnessing a worldwide deflation (not that this would be an inherently bad thing). That is, market forces would move to lower the price level in order to increase the real value of the outstanding level of nominal debt.

    I still have to think this through more carefully though. Thanks for your comment.

  3. David,

    The America of 40 years ago had the same name, but it was a completely different economy in a completely different world. But nevertheless your argument supports my point, ultimately Bretton Woods DID collapse. I'm sure it wasn't a spontaneous decision, the fact it didn't collapse the instant somebody first suggested it may collapse was not a reliable indicator of future outcomes. What is different about the world today that makes foreigners more willing to support the US dollar? Why do emerging markets have a need for a safe store of value in paper form? Maybe it's just me, but I have a hard time believing anybody NEEDS paper with fancy stamps and signatures. Wouldn't they be better off keeping the stuff they produce and sending the dollars back home, or trading with nations that actually pay their bills? That could be the source of inflation, foreigners have so many dollars it's almost as though there are two or more US central banks. Somebody should game theory a country with multiple central banks and a left-wing President.

    With regards to the shadow banking system, I see it as the same problem, confused billionaires with too much paper. Unless I misunderstood your argument, it sounds as though you're saying there is too much liquidity stuffed under Swiss ski chalet mattresses looking for a home. Eventually people will realize they can't eat dollars. There are actually many other "safer" places to put the money, assuming they're human.

    Here is my question: What is so safe about US debt anyway? Is it just residue from past glory, or is there something fundamental I can't see?

  4. Pointbite:

    You say that you have a hard time believing that anyone NEEDS paper with fancy stamps and signatures. Have you ever found yourself using currency; and if so, perhaps this will help you answer this question. You should also read the article by Caballero (it is quite readable).

    I am not claiming that US debt is safe; only that it appears to viewed as being relatively safe by agents who wish to save or have need of good collateral objects. My reading of Caballero is that he views this as an asset bubble; much in the same way that valued fiat currency is an asset bubble. The bubble may burst; but it need not as long as US debt is viewed as having value.

  5. This reminds me of the ways I could justify the housing boom in 2005: Low volatility; low yields on Treasuries; worldwide demand for safe paper (i.e. securitized mortgages); etc...

    There is a serious risk of inflation. We have large deficits and a Federal Reserve that has lost some credibility as a-political.

    Suppose the inflation rate picks up to 3% or 4% and unemployment is at 9%. No way the Fed raises rates. Congress will raise hell and Economists will talk about the dangers of raising rates in the context of the so-called "lost decade of Japan."

    Glad you are writing. About time.

    Morris Davis.

  6. David,

    Are you suggesting my local grocer will accept barter in exchange for food? I use dollars because I'm not a farmer and I need to eat. I use them because they work, not because I need them. So I guess US treasuries will maintain their value so long as foreigners continue to accept US dollars in exchange for their production. If that logic is correct, strangly, a reduced trade deficit could actually be an ominous sign...

  7. Hey Mo: Welcome aboard!

    You say "Suppose inflation picks up?" I am saying that this may not happen. If it does, then it will likely be the consequence of agents desiring to "dump" US dollars and Treasuries (in exchange for what, I wonder?). And if this does happen, for whatever reason, then I agree with you: we are in trouble.

    Pointbite: There is a sense in which a high trade deficit is a signal of (relative) strength. Creditors are only willing to lend to those who they believe are in a strongest position to repay. Of course, this does not mean that creditors won't be disappointed ex post.

  8. I do not have any evidence to support this but I think that the demand for dollars and dollar denominated assets like the US treasury bonds from emerging economies is partly because of payment required for oil imports. So then the question is would the US debt continue to be non inflationary if the oil starts being priced in Euros?

  9. Excellent post. Caballero is confirming many of my priors.

    Question: If the US suffers a so-called "currency crisis" what will happen to China? Will such a currency crisis lead to a series of competitive devaluations world-wide?

    I tend to think the US dollar will soften slowly going forward. For their many sins, American citizens will gradually see their purchasing power reduced.

  10. westlope, I think that's what many American leaders want, but there's no way to plan it. Why would someone hold an asset that's declining, simply because it's declining in an orderly way? Once you recognize it's a bad investment over your desired time period, you will stop accumulating it and try to get rid of anything you own. When the major purchasers become major sellers, why would minor purchasers continue to buy? Markets can drop in sudden and unexpected ways due to psychology, we all witnessed proof of that, again, just recently. This is all speculation, but to me it looks as though US dollars will continue to be sound until the day they're not. And then it's over. For a long time.

  11. If I'm interpreting correctly what you say, the U.S. has a monopoly producing this kind of low-risk asset? Maybe monopoly is too strong a word, but one might ask what are the barriers to entry for potential competitors? If some other party could provide a "better product", that could affect demand. But I have no idea what that would be. Very interesting post, and thanks again for the great links!

  12. Pani Pani:

    Read the Cabellero piece. Sure, financial market innovations could lead to a decline in the demand for US Treasuries. Arguably, this was what the emergence of MBS was (didn't work out so well). And if developing economies allow their financial sectors to develop, then they would presumably produce substitute assets that would drive down the world demand for US debt.

  13. pointbite,

    Yes, currency markets often sharply correct as opposed to gradually adjusting.

    Last I looked, China was still adding 7 million people net a year. The job creation imperative must be overwhelming. If China stops buying US debt, it may unhinge the renminbi, jeopardize net exports and threaten job creation.

  14. I find apparent policy asymmetries an interesting generator of questions. For example, everybody seems feel comfortable with low, stable rates of inflation but uncomfortable with low, stable rates of deflation.

    The same goes for the attitudes towards asset bubbles in the world of monetary policy. The rule of thumb is that monetary authorities ignore asset prices in favour of focusing on the prices of goods and services.

    Yet, central banks are quick to react when asset bubbles burst.

    If US debt and the current massive monetary stimulus are not inflationary, then it is reasonable to expect asset bubbles. Will these new asset bubbles threaten longer-term growth?

    Or are some asset bubbles dangerous and others inconsequential?