Interesting article at Barron’s online, commenting on the continuing decline in 10 year Treasury yields*. Is it a bubble, as we have opined? Or is it an indication of a long term decline in U.S. economic growth, combined with expectations of tame inflation or outright deflation? They quote Societe Generale’s Albert Edwards in support of the latter hypothesis.
We’ve been skeptical of this school of thought, primarily because we believe that over the long run, the U.S. Federal Reserve will inevitably manage monetary policy based on slowing (or contracting) domestic growth, which, in combination with higher rates of growth in developing regions of the world, will produce some degree of inflation in internationally tradeable goods. As a result, there will be inflationary forces at work, even if asset values and economic activity contract.
However, looking at national balance sheets, it’s difficult to be optimistic about the long term level of asset values and economic growth in mature economies, including the U.S. In the 20th century, the ratios between household liabilities and assets, and household debt and income, rose steadily from the 1950s and into this decade. There has been a concomitant decline in household savings rates since the 1980s, and in the net national savings rate since the 1960s. There’s a rule of thumb that consumption is roughly 70% of U.S. GDP. If that’s true, and if saving will preempt consumption for a time, then you have to consider that economic output in coming years might be 25-50% of the rate we’ve become accustomed to over the last fifty years. Certainly, the rate of growth in consumption that has been enabled by rising household leverage cannot be sustained indefinitely. For an interesting take on this line of thought, see Tom Osenton’s book The Death of Demand.
Add in the current and expected expansion of public debt, on top of massive entitlements owed to future pensioners and retirees, and it appears that the federal government is following U.S. households down a similar path into "full extension". The Federal Reserve could always inflate some portion of those debts away (in fact, we should all get accustomed to hearing the term "quantitative easing", as nominal interest rate targeting is not relevant in a contracting economy), but that’s taboo to central bankers — or at least inflating it away at a rate above 2-3% per year is taboo. Add it all up, and the Japan / JGB case is certainly on the table for the U.S.
However, there’s a critical aspect of this puzzle that deserves attention, and that’s the difference in savings behavior between U.S. and Japanese households. Perhaps that’s changing in the U.S., but the net savings rate is still very low by historical standards. So while Japan’s national government has had a ready supply of domestic savings to absorb its debt, the U.S. will still be forced to rely heavily on foreign savings, which are generated in large part by exports to mature economies, which is quickly turning into a dry well. When the supply of Treasury debt exceeds demand, its value falls, which causes its yield (its effective interest rate) to rise. And given the historically wide spreads between treasury yields and the yields on other types of debt, there’s a trillion dollar question at hand — when spreads normalize, will it be due to Treasury yields rising, other yields falling, or both? That will depend very much on the quality of U.S. policy responses. For example, in Japan, the policy responses have been lousy overall, and JGB yields have stayed low. Should that happen in the U.S., yields will stay low — but only as long as foreign savers are willing to absorb and hold U.S. debt.
Obviously, the structural challenges facing the global economy are daunting. Martin Wolf of the FT penned an interesting piece on this issue two days ago, and it’s definitely worth a read (there are some eye candy graphics too):
This then is the endgame for the global imbalances. On the one hand are the surplus countries. On the other are these huge fiscal deficits. So deficits aimed at sustaining demand will be piled on top of the fiscal costs of rescuing banking systems bankrupted in the rush to finance excess spending by uncreditworthy households via securitised lending against overpriced houses.
This is not a durable solution to the challenge of sustaining global demand. Sooner or later – sooner in the case of the UK, later in the case of the US – willingness to absorb government paper and the liabilities of central banks will reach a limit. At that point crisis will come…
In normal times, current account surpluses of countries that are either structurally mercantilist – that is, have a chronic excess of output over spending, like Germany and Japan – or follow mercantilist policies – that is, keep exchange rates down through huge foreign currency intervention, like China – are even useful. In a crisis of deficient demand, however, they are dangerously contractionary…
In short, if the world economy is to get through this crisis in reasonable shape, creditworthy surplus countries must expand domestic demand relative to potential output.
These challenges clearly require some out of the box thinking, and we’ll throw in our two cents again:
- The U.S. should cut or eliminate all taxes on saving, productive activity, and investment, including (but not limited to) policies which lower the financial and other burdens associated with hiring people in the above board economy. A consumption tax with some degree of progressivity would be optimal.
- The Federal Reserve should pursue policies that make it worthwhile to save, rather than saving being motivated only by dire financial circumstances.
- Some of the comprehensive immigration reforms considered in recent years might be helpful, whereas the ‘fence building’ approach is undeniably a net economic cost. However, those reforms would have to encourage domestic savings by immigrant income earners, as opposed to the usual expatriation of their earnings abroad (sorry, Western Union shareholders).
- And although policy engineering is often risky business, it might make sense to encourage greater consumption and lower saving in countries that currently hold large financial claims to U.S. goods, services, and assets; in fact, it might be helpful for those countries to enact policies that incentivize greater domestic consumption, much as the U.S. has done for decades (see the Wolf article quoted above).
These measures could make a long hard slog shorter and easier. A status quo approach will probably not. And a poorly designed approach will only make it worse.
* When the yield on a debt instrument falls, it signifies that its price has risen. For example, assume that you draw up a note with a lender to borrow $100, and you agree to pay $5 per year for the privilege, for an annual yield of $5 / $100 = 5%. If the lender later sells that note to someone else for $200, the yield to the new holder is now $5 / $200 = 2.5%. Thus, the steady fall in Treasury yields over recent mon
ths and weeks tells us that there is rising demand for U.S. Treasury debt.
URLs:
http://online.barrons.com/article/SB122826163410573995.html?mod=djemBF
http://www.stlouisfed.org/publications/re/2006/c/pdf/household_assets.pdf
http://research.stlouisfed.org/publications/regional/05/07/saving_crisis.pdf
http://www.assoc-amazon.com/e/ir?t=symmetrycapit-20&l=as2&o=1&a=0131423312
http://www.ft.com/cms/s/0/027b1efc-c0a4-11dd-b0a8-000077b07658.html?nclick_check=1
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Uncategorized | art December 5, 2008 | 
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