Our Twin Financial Puzzles: The Long Run May Come Like a Thief in the Night

The fact that nobody inside the administration is paying attention to the current drift of the economic ship of state closer to the shoals is one big reason that we need a really strong Treasury Department and a really strong Federal Reserve:

Brad Setser http://www.roubiniglobal.com/setser/archives/2005/04/economy_strong.html: Economy strong (for now), fiscal deficit not falling (by much): I have always thought the argument that attributed the widening trade deficit to the absence of growth abroad was a bit deceptive... growth abroad has been quite strong.... Europe and Japan have lagged, but much of the rest of the world -- including China -- has been growing like gangbusters. The problem... is... the composition of the growth -- strongly driven by exports. This global growth has been strong enough... to generate extremely good times for any exporter of natural resources....

The same argument holds for the US fiscal deficit. The US economy continues to grow at a nice clip. A strong economy usually leads tax revenues to grow.... Revenues, according to the CBO, are up 10.3% y/y.... Spending, though, is also rising: it is up 6.7% y/y. The CBO estimates the six month fiscal deficit for FY 05 to be $291 billion, $10 billion below the FY 2004 deficit. Remember, we spend more than we collect in taxes, to tax revenues have to increase much more than spending (in percentage terms) to reduce the deficit....

The Bush Administration now likes to talk about its intention to reduce the budget deficit, particularly at international meetings. But I still don't see any evidence that they are willing to do more than talk about reducing the budget deficit. Expect more rhetorical commitments from the Bush Administration around this weekend's G-7 meetings, but no greater willingness to act.

The optimists--inside the administration and out--about the current financial situation have only one economic argument: long-term interest rates are relatively low, and are not pricing the dollar-collapse and the U.S.-interest-rates-spike scenarios as having any substantial probability at all.

The pessimists on Wall Street are puzzled at why this economic argument is supposed to have force. From their perspective, demand for long-duration dollar-denominated securities is high because the Asian central banks are buying as if there were no tomorrow in order to keep the value of their currencies down, the U.S. Treasury is borrowing short (it is not issuing that many long-duration securities), and U.S. companies are cautious and are not undertaking the kinds of investments that would lead them to issue lots of long-duration bonds.

We economists respond by saying that for every market mispricing there is an open profit opportunity: if long-term interest rates are indeed too low--if long-term bonds are indeed priced too high--there is money to be made by shorting long-term U.S. bonds, parking the money in some other investment vehicle that is not underpriced, waiting for bond prices to return to fundamentals, and then covering your short position. People will try to profit from trades like this, and in so doing they will push prices close to fundamentals today.

But the Wall Street types have a counterargument: For any one financial institution to make the international bet--to bet on the decline of the dollar against the yuan over the next five years in a very serious, leveraged way is to put its survival at risk should the trades somehow go wrong. And trades do go wrong: remember the collapse of LTCM. The riskiness of the bets is magnified by the existence of very large actors in the financial markets that are not in the business of maximizing their profits: if the Bank of China and the Federal Reserve decided that they wanted to teach speculators a lesson and push the value of the dollar relative to the yuan up for 20 percent for a month and see how many financial institutions with speculative positions that would bankrupt, they could do so. Similarly, for any one financial institution to make the domestic bet--to bet on a serious rise in long-term interest rates over the next five years in a very serious, leveraged way is also to put its survival at risk. For where do you park your money? Real estate rental yields and stock market payout yields are very low, and real estate and stock prices may well fall as much as or more than bond prices if interest rates spike. The only organizations that can make the domestic bet that interest rates will rise are businesses that can borrow long-term now, lock in a low real interest rate, and invest in expanding their capacity. But America's businesses see enough real risk in the future that they do not want to build up their capacity by any more than they are currently doing.

We economists believe that market forces drive prices to fundamentals. But we are not careful enough to distinguish situations in which equilibrium-restoring forces are strong from those in which equilibrium-restoring forces are weak. At the moment those forces are weak. And this adds an additional danger: at any moment those forces may become strong.

The long run in which the dollar falls and U.S. long-term interest rates rise may come like a thief in the night as a very sudden shock. If it comes as a sudden shock rather than as a long, slow, gradual realization, it will come on that day when the gestalt of the players on Wall Street and elsewhere changes, and when they collectively regard holding dollars as the more risky rather than the less risky strategy in the short run, when they collectivley regard being long long-term U.S. Treasuries as the more risky rather than the less risky strategy in the short run. On that day the long run future will be, as football coach George Allen used to say, now.

When will that day come? Tomorrow? Next month? Next year? On January 21, 2009? A decade from now? We macroeconomists who believe in financial market equilibrium have, today, a certain similarity to Millenniarists: our models of when The Day will dawn are not much better than the models of those who base theirs on a rule that transforms HILLLARY RODHAM CLINTONN into the number 666.

Should that day come, keeping a financial crisis from becoming a major disaster may well require swift and rapid action by a Federal Reserve and a Treasury Department that have powerful and unconditional White House and Congressional support. Mexico in 1995 had a recession that only reduced Mexican GDP by six percent. That "only" is the result of Bill Clinton's backing his economic policy team when they said that supporting Mexico was the thing to do--even though others in the room were making sure that he was well aware that money loaned to Mexico in the crisis might well not come back. That "only" was a near-run thing: Senator Dole let Senator D'Amato slip his leash, and D'Amato came remarkably close to doing major damage both to Mexico in 1995-1996 and to East Asia in 1997-1998.

Remember that Alan Greenspan is supposed to retire next January. What is the scenario by which competent technocrats--in the Treasury or the Federal Reserve--manage to climb to a position in which this White House and this congressional leadership of Bush, Frist, Hastert, and Delay will give them the baton to handle as they think best whatever financial crisis may appear in the next several years?

Comments

[big al]

Sir Alan is a very old man, what would happen if he died in his sleep tonight?

[MBunge]

I don't have any answers, but I do have a good bet as to when things may come to a head. I'd say we've got until about 6 months after the 2006 elections. If by that time our government has not made any credible effort or attempt at addressing our problems, whether by the GOP or a newly elected Democratic Congress, I think the rest of the world is going to decide they can't wait yet another two years and hope that THEN some reasonable adults might take charge of U.S. fiscal and economic policy.

Mike

[Nathan Smith]

Your remarks remind me of those of Paul Volcker last weekend:

http://www.washingtonpost.com/wp-dyn/articles/A38725-2005Apr8.html

Volcker concludes with this advice:

"It's not that it is so difficult intellectually to set out a scenario for a "soft landing" and sustained growth. There is a wide area of agreement among establishment economists about a textbook pretty picture: China and other continental Asian economies should permit and encourage a substantial exchange rate appreciation against the dollar. Japan and Europe should work promptly and aggressively toward domestic stimulus and deal more effectively and speedily with structural obstacles to growth. And the United States, by some combination of measures, should forcibly increase its rate of internal saving, thereby reducing its import demand."

And how should the United States "forcibly increase its rate of internal saving?" Surely Social Security reform is part of the solution, right? A move from pay-as-you-go to prefunding, if carried out efficiently, would be a big boost to the savings rate.

I can't escape the impression that you've taken a position opposite to the direction in which your own arguments are pointing...

[spencer]

Is the Fed fighting the wrong war.

Greenspan has a long, long record of being too slow to recognize that the economy is slowing. Remember, it he had not been Fed Chairman he would have been remembered for his Whip Inflation Now (WIN) campaign just as the economy was collapsing in late 1974.

Cyclical stocks peaked several weeks ago and stable growth stocks like drugs are starting to lead the market.

Unfilled orders for metals, a great leading of commodity prices have clearly rolled over and oil
and some commodity prices like scrap steel are now
falling. We are seeing auto sales weakening and retail profit margins come under pressure. Harley Davidson just gave a big warnings that sales and shipments are weakening. Motorcycle and boat sales are the epitome of discretionary spending and both are weakening.

The impact of higher oil prices that we have all been watching for is here-- does the Fed recognize it?

[PrahaPartizan]

Spencer, are you arguing that the Fed should adopt a more relaxed posture in view of the putative slowing of the domestic US economy. If Greenspan does that, then Der Tag is likely to happen within weeks of his change of policy. Why should the Chinese and Japanese believe at that point that the US has any intention of cleaning up its fiscal mess, especially given today's permanent termination of the estate tax and its US$1 trillion per decade revenue stream? Like a photagraphic print in development, all of a sudden the picture will become clear for all.

[spencer]

I am suggesting that the Fed may quit tightening sooner then is generally expected.

Yes, it does raise serious problems about the value of the dollar. But would anyone be surprised that we are going to have to face a scenario where the Fed has to choose between the dollar and the economy?

[Hedley Lamarr]

Nathan, AG was sitting in Ayn Rand's lap in 1974, not
at the FED where I was.

[anne]

Brad is causing problems here with a set of stunning posts. Where to turn in thinking :) ? But, I too think the Federal Reserve should be cautious from here. The economy may be more fragile than the Fed governors suppose, and there can be no support expected from Europe or Japan.

Thanks, PrahaPartizan.

[P O'Neill]

One of the many puzzles is why the Treasury hasn't reissued the 30 year bond. France has already gone to 50 year. If somewhere deep down the Treasury knows that there's a lot of inflation coming down the road to deal with all the debt, why not maximize the future screwing by locking people into really long bonds at bubble prices?

[Auros]

"A move from pay-as-you-go to prefunding, if carried out efficiently, would be a big boost to the savings rate."

Not if the money for pre-funding is borrowed. That does not improve net savings. And some wealthier invesotrs might regard the private account as fungible with their current 401k/IRA options, and thus reduce inputs to those from their salaries, leading to a net decline in savings.

[Brad DeLong]

Nathan Smith wrote: 'And how should the United States "forcibly increase its rate of internal saving?" Surely Social Security reform is part of the solution, right? A move from pay-as-you-go to prefunding, if carried out efficiently, would be a big boost to the savings rate.'

But, alas! That's not the Bush plan, is it?

[Ken Houghton]

I'm still trying to figure out how Nathan Smith manged to convolute Forced savings increase with Social Security "reform" in any of its currently-proposed-but-not-really-versions.

Or maybe he's forgotten that we went from PAYGO to pre-funding in 1983, on the recommendation of Mr. G.

Raising interest rates significantly--I'm thinking 75bps at the next meeting, with a "we're not done" announcement (yes, it's a wet dream)--would encourage savings (or, at least, discourage spending). It would also cause a lot of portfolio rebalancing, which might unearth those few places that need capital right now.

The personal bankruptcies, housing foreclosures, etc. would be a collateral effect--serious, but it might keep from taking the global economy down with us and allow a recovery over a 2-4 year timeframe, as opposed to the pending Seven(ty?) Bad Years.

It would also give the Democrats the House and Senate in 2006, so it probably won't happen--though it would give Jeb/Frist/Liddy a "whipping boy" for the 2008 election--"Congress kept us from helping you"--so Mr. Rove might take the chance if he thought there was a significant chance of losing in 2008.

[Kosh]

Where your friend Ben Bernanke argues that deficits don't really matter that much:

Remarks by Governor Ben S. Bernanke
At the Sandridge Lecture, Virginia Association of Economics, Richmond, Virginia
March 10, 2005
The Global Saving Glut and the U.S. Current Account Deficit

http://www.federalreserve.gov/boarddocs/speeches/2005/200503102/default.htm

[camille roy]

Awesome series of posts, Prof. DeLong.

I recall reading a digest at the Global Economic Forum over the Xmas holiday, in which a bunch of fine Morgan Stanley economisties were peering into the foggy future (i.e. 2005). They thought - ha! ha! - that the Rethuglicans would get serious about the fiscal situation. Now that the Rethugs had won it all, their reasoning went, they could show their true colors: fiscal conservatives.

Har ha ha!!!

When I read that, I knew there was a level of fiscal prudence being assumed by markets and experts that was priced into stocks, bonds, etc -- that was totally undeserved.

We're being run by thugs and frauds, who happen also to be utterly incompetent. They have absolutely no concern for the country, they please their corporate masters and the Christian right (i.e. anti-abortionists who love the death penalty).

When the markets finally wake up to this reality, I think Der Tag will arrive.

[chris]

This is one forum where I expected to see Greenspan is not thought to be able to walk on water. I am surprised to see comments complimenting on his stewardship of the value of the dollar. I think Greenspan let the internet bubble get out of control and the post bubble pop he has been trying to fight a fire by pouring gasoline on it. A better response is to start moaning and clutching your head when you hear Greenspan's name, and when you contemplate his replacement, perhaps Bernanke, start to groan louder. Greenspan is like Bush laying down the rules and then being willingly blind when your actions circumvent your own rules.

What we're seeing is central banking by people who aren't members of the reality based community.

[Fred]

Der Tag is coming. The Admin doesn't seem to know or care. Are we deer stuck in the headlights? For those of us trying to maintain some retirement savings - which way do we jump?

[knut wicksell]

It's an odd feeling to think your living near the tipping point. That's where we are. My economist side tells me to unload a hundred thousand dollars of stocks and retire the mortgage. Take the money and run. I am trying to figure out what side of me resists doing what seems rational. We call it inertia, but there is something psychological that lies behind it. A failure to emotionally admit that we are near catastrophe. To act in that belief is in some sense to seal it against hope. I feel like I'm in a car out of control that hasn't crashed into the light pole, but surely will.

I'm thinking (though not betting) that the crash will occur before the end of summer.

[Movie Guy]

Very good post and comments.

Let me ask the big question.

What's happens afterwards?

Once we crash into the wall or fall back into a severe recession, what will the plan of recovery?

In all likelihood, as we enter the recession or worse, we will be faced with inflation or deflation (don't know which at that time), flat or slowly growing wages, and a significant portion of consumer purchase performance built on previously low mortgage rates.

What do you do then?

[battlepanda]

A commenter on Brad Setser compared the situation with a fire in a crowded theatre. If you shout "fire" there's going to be a stampede. But if you don't, and nobody's putting out the fire, what's going to happen?

The mental image of a theatre full of bond traders tugging at their collars as the theater gets hotter and hotter is amusing. The real situation is not.

(Oh, say what you will of Alan G. Can you really imagine a BushCo appointee not being a train wreck? They're going to see this as a chance to get a federal reserve chairman in their pocket for the next 14 years.)

[Fred]

Reading the two brads and the other economic blogs is frustrating. I keep wanting to yell - "They aren't listening." I keep hoping some effort will go into deciphering what the world will look like on the other side. And, how do we prepare for it, if that's possible.

[kharris]

"We economists believe that market forces drive prices to fundamentals. But we are not careful enough to distinguish situations in which equilibrium-restoring forces are strong from those in which equilibrium-restoring forces are weak. At the moment those forces are weak. And this adds an additional danger: at any moment those forces may become strong."

Doesn't this fall into the "not very satisfying because not falsifiable" category? If we had some rules of thumb for knowing how to identify periods when equilibrium-restoring forces are strong or weak, that would clear things up a bit. As it is, this sounds like economist-talk for "things aren't prices like I think they should be."

By the way, Ip said "soft patch" today in the WSJ. My chatter-mates and I have been worried about a Q2/Q3 of this year since early autumn last year, and had been feeling a bit silly as Q4 GDP estimates got revised up. The trade and retail sales data this week have put a considerable dent in Q1 GDP estimates, already.

[p.lukasiak]

"If somewhere deep down the Treasury knows that there's a lot of inflation coming down the road to deal with all the debt, why not maximize the future screwing by locking people into really long bonds at bubble prices?"

my guess would be that the Treasury Department knows that everyone else knows the same thing (i.e. inflation is coming!) Thus, there would be precious little demand for long-term low interest bonds, and that trying to sell more of them at this point would let the genii out of the bottle --- and in fact bring on "The Day".

_______________

The day could be today, of course. All that has to happen is a successful major terrorist attack on the international oil infrastructure, and the whole house of cards comes tumbling down.

Hell, it doesn't even have to be a terrorist attack. If Chavez in Venezuela has any sense, he has already booby trapped his oil infrastructure. Given the nutballs in the White House, its not difficult to imagine the US attempting and succeeding in another coup in Venezuela, and Chavez loyalists setting off the bombs that would cripple Venezuelan oil exports for a couple of years....

[anne]

Brad DeLong and Brad Setser highlight well the problem of how cautious institutions and private investors must be in asset allocation.

[anne]

The sense I had was that the slow growth patch begins about now. The Fed will hopefully be cautious about raising short term interest rates.

[Ken Houghton]

Paul L. - There already was a "successful major terrorist attack on the international oil infrastructure." It's called the Iraq war and its aftermath.

[John Stein]

Am I correct in inferring from part of this post that the presence of the Fed and BOC as big players, and the uncertainty of their motivations, are actually preventing market actions that might promote a soft landing? This reminds me of the engineering situation where one linearizes a basically nonlinear device with some additional circuitry -- it works fine as long as the signals stay within an acceptable range, but when the signal amplitude is too large, the resulting distortion is far, far worse than it would have been.

[p.lukasiak]

Ken....

actually, the Iraq war has had little impact on Iraq oil exports to the US.

[Kevin]

Fred:
>And, how do we prepare for it, if that's possible.

I think it would be extremely interesting to see a survey of where economists are parking their investments these days, as compared to the population as a whole.

My guess is we'd find lots of short term bonds, perhaps in non-US currencies.

[Fred]

Kevin - My guess is that economists also suffer from the disease identified by Knut -"To act in that belief [of a coming catastrophe] is in some sense to seal it against hope."

[lise]

There is money flowing to defensive stocks, as large drug companies here and in Europe, also consumer staples and especially utilities. There is a lot of use of GNMA bond funds which have nice yields and low durations.

[anne]

GNMA funds, by the way, are not filled with Fannie Mae or Freddie Mac securities, but only government insured mortgages. There is no credit risk involved, and the Vanguard GNMA fund has a duration of 3.3 years and a yield of 4.7%.

[lise]

http://flagship2.vanguard.com/VGApp/hnw/FundsVIPERByName

Sector Indexes
12/31/04 - 4/14/05

Energy 12.7
Financials -7.9
Health Care 1.4
Info Tech -10.9
Materials -5.2
REITs -6.1
Telecoms -6.6
Utilities 5.3

[lise]

http://flagship5.vanguard.com/VGApp/hnw/FundsByName

Vanguard Returns
12/31/04 to 4/14/05

S&P Index is -3.7
Large Cap Growth Index is -5.1
Large Cap Value Index is -1.9

Mid Cap Index is -3.1

Small Cap Index is -6.8
Small Cap Value Index is -6.1

Europe Index is 0.1
Pacific Index is -3.6

Energy is 10.8
Health Care is 1.7
REIT Index is -6.2

High Yield Corporate Bond Fund is -1.6
Long Term Corporate Bond Fund is 1.3

[Bill]

Nathan:
How does the Fed govt borrowing $X so that it can establish private accounts with balances of $X (less transaction costs) increase savings? Brad's not inconsistent here.

P.O'Neill:
I agree. 30 or 50 year bonds make a lot of sense now.

[simon]

Interesting post ... the question I have is with one of the first assumptions made.

Namely, "We economists respond by saying that for every market mispricing there is an open profit opportunity: if long-term interest rates are indeed too low--if long-term bonds are indeed priced too high--there is money to be made by shorting long-term U.S. bonds, parking the money in some other investment vehicle that is not underpriced, waiting for bond prices to return to fundamentals, and then covering your short position. People will try to profit from trades like this, and in so doing they will push prices close to fundamentals today."

Specifically, I have two questions with this statement. The first is that in the current market the short-term rate appears too low, but the long rate does not appear too high. One could easily argue it to is too low given the risk that Brad and other rightly suggest exists. Consequently, I do not see a trade opportunity other than in an abstract sense. The second question is around finding assets that would not be correlated to permit parking. Again, I do not know of any in the market.

In summary, while I understand the point that Brad is making (and also beleive that it is logical), I do not think that it is empirically based or justifiable (it is merely a theoretical conjecture. Subsequently, I remain convinced that the problem revolves around three factors: easy money policy in the US, Asian economies betting on export driven growth, and general incompentance of US executives to manage manufacturing ventures (GM, Ford, Motorola, HP, etc.).

I do not see Bush as a major problem source (other than reckless spending). He is impotent in a market economy where all of us Americans are are free to make our own econoic choices. Thus, I think Brad is far too harsh as well as unjystified in his criticisms of Bush. I would direct towards Fed.