Brad Setser

Brad Setser: Follow the Money

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The US government has already proved it can raise over $1.5 trillion in a year ..

by Brad Setser
January 12, 2009

The large deficit projected for fiscal 2009 stunned many. It is natural to wonder how such a huge deficit could be financed. But remember one thing: the US placed $1685 billion of Treasuries in the market in 2008 without pushing interest rates up.

Some facts.

In 2008, the stock of marketable public debt rose by $1257 billion.

The Fed’s holdings of Treasuries – counting the securities it has lent out to the market – fell by $427 billion.

That implies an absolutely huge increase in the stock of Treasury debt in the market. The outstanding stock of marketable Treasuries not held by the Fed rose from about $3795 billion to about $5480 billion.

All that debt had to be bought by the PBoC and other foreign central banks right?

Well, yes and no.

The Fed’s custodial holdings of Treasuries rose by $481 billion. That leaves $1.2 trillion of the $1.7 trillion increase in the stock of marketable Treasuries in the market in private hands. Foreign central banks don’t hold all their Treasuries at the Fed. Past data revisions – and a bit of extrapolation on my part – suggest that centrals bought $192 billion that doesn’t show up in the Fed’s custodial accounts. That implies a nearly $700 billion increase in central banks’ holdings of Treasuries.

That’s a record. And it is plausible in a world marked by record reserve growth (at least until the fourth quarter) and a flight to safety by central banks. It is way more than central banks bought in 2007. In 2007, the custodial holdings rose by $70 billion, with most of the rise in the official sector’s treasuries ($289 billion per my model which smooths the survey revisions over the course of the year AND tries to anticipate the impact of the June 2008 survey; $192.4 bilion in the Treasury data) came from central banks that weren’t using the Fed as custodian. Indeed, the 2007 increase in foreign central bank holdings ($289 billion) exceeded the increase in the stock of marketable Treasuries in the market ($247 billion).

But even if central banks bought about $700 billion of US treasuries in 2008, private investors also increased their holdings of Treasuries by over $1 trillion. In a year. That too is a record.

Some of those Treasuries were used to fund the Fed’s crisis lending, some funded the TARP and some funded the fiscal deficit. But in some sense it doesn’t matter. The market absorbed that huge increase in stock – and Treasuries even rallied in the process.

Facts are facts. The US has already proved it can raise over $1.5 trillion in a single year … without pushing yields up.

Of course, ability to the market to absorb this huge surge in outstanding Treasuries was a function of a crisis-induced panic and a scramble for liquidity and safety. And past performance is no guarantee of future results.

The financial crisis should subside this year. The US government isn’t going to let a big bank fail. But the financial crisis has turned into a severe economic crisis. Consumption is falling in the US and globally; investment is tumbling. That frees up funds for the Treasury market.

My guess is that central bank demand for US Treasuries will fall both absolutely and as a share of the US borrowing need. That is no bad thing. It is a byproduct of a smaller US current account deficit and a smaller current account surplus in much of the emerging world. Adjustment means things change, not that they stay as they were.

The United States past reliance on central banks for financing – and China’s central bank in particular – was a function of four things:

A) The emerging world’s current account surplus (and China’s surplus)
B) A lack of household savings in the US
C) A lack of private demand for US treasuries
D) Strong private capital inflows into the emerging world which pushed up the emerging world’s reserves growth.

All four look set to change.

The emerging world’s surplus should fall. The oil exporters’ surplus in particular. Some think China’s surplus will fall as well. I am not convinced. It rose rather substantially in the fourth quarter. But I doubt any rise in China’s surplus will offset the fall in the oil exporters’ surplus, the total surplus of the emerging world should still shrink.

Household savings in the US should rise. The “wealth” effect has gone into reverse; falling home values and the slide in the stock market imply that folks have to save more to rebuild their wealth. Read Merrill’s David Rosenberg. Or the forecasts of Goldman’s (crack) US economics team.* Private investment will fall.

Private demand for Treasuries has already increased. The Treasury at least gives your principle back on time. With others you cannot be sure.

And private capital is now fleeing the emerging world, pushing down the emerging world’s reserve growth.

To be clear, official demand for Treasuries surged in the fourth quarter even as reserve growth slowed – as central banks shunned Agencies and likely pulled big sums out of the hands of private fund managers and parked those funds at the Fed. But once that reallocation is finished, growth will be driven by the underlying growth in countries reserves. And that is slowing …

The widespread conception that a bigger deficit implies the need for more financing from China is almost certainly off.

China’s reserve growth is likely to slow, and over time so will its Treasury purchases – even if they haven’t yet. China isn’t going to add close to $70b to its short-term Treasury holdings forever; the pace of China’s purchases will slow.

That isn’t a major problem though, not so long as it happens gradually.** Not in a context when private demand for Treasuries has increased dramatically.

There is an enormous difference between running a huge deficit in normal times and running a huge deficit amid a huge contraction in private activity.

Data on the stock of marketable Treasuries comes from the monthly statement of the public debt; data on the Fed’s holdings of Treasuries and foreign custodial holdings comes from its balance sheet data; data on official holdings comes from the work I have done with Arpana Pandey.

*I am biased; a couple of friends work there.
** To be clear, there is enormous difference between a gradual fall in China’s purchases of Treasuries – one where China goes from buying $50b or more of Treasuries a month (its likely total in the fourth quarter; this is what I think Bradsher missed) to buying a more modest number – and a sudden stop to all Treasury purchases. China probably will buy between $300-400 billion of Treasuries in 2008. If that total falls to say $200-300 billion, the US market can adapt. If it goes to zero that would be a bigger problem (see what happened to the agency market). And net sales would be an even bigger problem.

Even here though there is one qualification. If say a surge in hot money outflows brings down China’s reserves but raises say Hong Kong and Taiwan’s reserves, as both intervene to keep hot money inflows from pushing their currencies up the overall effect is the same: Hong Kong and Taiwan end up financing the US instead of China.

49 Comments

  • Posted by Manc Trader

    I assume that those bar charts are for all treasuries. It would be interesting to see how private demand for 10 year notes and 30 year bonds has done.
    I also assume private investors thru funds like PIMCO were buying treasuries but are now moving away to other parts of the credit spectrum but no idea if that is significant in the scheme of things.

  • Posted by bryce

    This is especially interesting that the Fed has supplied so little of the borrowing in view of the simultaneous plummeting of interest rates. However, I imagine it wouldn’t have been thus in the absence of the Fed causing M1 to grow by ~$250 billion & M2 to grow by ~$300 billion in the last 12 months.

  • Posted by DJC

    The US government has already proved it can deficit spend over $1.5 trillion in a year ..

    What is really even more stunning is that Washington Consensus Economists still believe in the “free lunch theory” for government deficit spending. Somehow even more government deficits is suppose to fix the enormous problems caused by government deficits. It’s the theft by monetary inflation to finance government deficit spending that is the root cause of a shrinking US middle class today. If Obama listens to anything Neo-liberal pundit Thomas Friedman says, which now seems likely, it is going to be an even bigger financial disaster.

  • Posted by Manc Trader

    Sorry Brad for the off topic comment but DJC:

    No one reads or listens to Friedman anymore do they?

  • Posted by babar

    Where did the “other” money come from — from the equity or corporate credit markets?

    If so, then is financing the deficit dependent on another asset value crash?

  • Posted by exporter

    Summer 2009 headline from Brad:

    “The U.S. government has proved it defaulted on 1.5 Trillion dollars of debt”….

    China, Hong Kong and Taiwan will unpeg eventually. A little too optimistic to think Taiwan and Hong Kong will sponsor our standard of living.

  • Posted by frommarketticker

    “….. involved in producing your “American Recovery and Reinvestment Plan”.

    Why? In “Appendix 1″

    We considered multipliers for the case where the federal funds rate remains constant, rather than the usual case where the Federal Reserve raises the funds rate in response to fiscal expansion, on the grounds that the funds rate is likely to be at or near its lower bound of zero for the foreseeable future.

    Please tell me this is a joke. Obama really believes that The Fed can hold interest rates at zero for four years and they can spend without bound, while the bond market will blithely look on at $1-2 trillion deficits annually and the economy will begin to recover?

    You’re kidding, right?

    Unfortunately he’s not kidding, yet that premise forms the foundation of his plan.

    With it, the analysis his “team” performed gets a modest improvement.

    If he is unsuccessful in convincing people to lend the government money at zero interest so it can expand the federal debt by 70% in one year (the $7 trillion already committed) and an additional 10-20% annually for the foreseeable future thereafter, the plan fails and worse, the money that could be spent on direct assistance to Americans for food, shelter and clothing (as I have repeatedly urged be held back for this exact purpose) is gone.

    This plan is asinine in that if it “works” the flight out of Treasury debt that occurs with a recovering economy will guarantee rising rates (and thus torpedo the budget and government through radically increased borrowing costs) while if it fails we will have spent the money that is going to be necessary for that direct assistance to Americans.

    I’ve seen stupid come out of our government before, but this takes the cake; it is, in fact, a “can’t win” proposal.

    Everyone with their fingers in this needs to be fired and some adults (who actually look at history, along with the math) must be admitted to the room to have a rational discussion on the choices we have as Americans, the paths we can take forward, and their consequences.”

  • Posted by Bob_in_MA

    hmmmm…

    So, if we have another severe credit crunch in 2009, say 50% worse than 2008 to absorb 50% more in Treasury debt, the ensuing flight to safety will make everything work out fine?

    Of course, there could be a dollar crisis, and/or one or more of the BRICs could decide it doesn’t need all those T-bonds and/or investors just might get there fill of T-bonds, or any one of several dozen other scenarios could transpire that might derail this sanguine forecast.

    If you get away with something once, it does it really mean there are no consequences?

    This reminds me of the comment Cheney made about big fiscal deficits: Reagan proved they don’t matter!

    It’s the same thinking that most drunk drivers adhere to: well, I was even more $hitfaced yesterday and made it home OK!

    I sure hope Obama has a plastic statue of St. Christopher on the dash board…

  • Posted by Observer

    babar: If so, then is financing the deficit dependent on another asset value crash?

    The asset value for corporate and agency debt have already crashed. The equity markets have been hit as well. As the economy recovers, one can hope that it will reverse.

  • Posted by Bob_in_MA

    One more point, with the references to a higher savings rate, I assume you mean to imply that that savings has to go into something, so may as well be Treasuries.

    But what appears as savings in the personal income/expenditure releases can all be debt retirement.

    The assets of U.S. households have fallen by several trillion $$, and will likely fall by several trillion more. Is it really reasonable to count on them to prop up massively increasing sales of T-bonds?

  • Posted by Observer

    The Fed has to be sensitive of the borrowing needs of other nations as well. According to David Goldman, south america and southern europe aren’t looking very good.

    There should be a rule that ties the amount of borrowing to credit conditions in a way that automatically decreases the borrowing needs of the Fed as corporate borrowing rates get tighter. The entire point of Fed’s borrowing is to ensure that it can be a lender of the last resort. If the credit market thaws, there should be a mechanism that automatically retires that obligation.

  • Posted by bsetser

    bar charts are for all treasuries. doing this at a more disaggregated level is a lot more work .. and even so there are limits unless you spend a lot of time figuring out what the fed holds and the current maturity distribution of the existing stock of notes.

  • Posted by DJC

    It’s the End of the World As We Know It

    What needs to take place is:

    1. Consumers need to cut back dramatically on consuming. Spending as a percentage of GDP needs to decline to 65%, or by $1 trillion. This would be approximately $3,000 less spending per household per year.

    2. Twenty years of consumer debt accumulation must be unwound. This required deleveraging needs to eliminate $2 trillion of household debt. The result will be thousands of retail store closings, mall closings, restaurant closings and auto dealership closings. The distinction between needs and wants will reveal itself like a sledgehammer.

    3. The consumer needs to increase their savings rate from 2% to 10%. This would provide more capital for investment.

    4. People who cannot afford the mortgage on their home need to sell or enter foreclosure. When home prices fall far enough, the market will clear the inventory. Lower prices are the only way to eliminate excess supply.

    5. Companies that have failed to prepare for this downturn by taking on excessive debt, allowing expenses to soar, and having no clear strategic plan should go bankrupt. Unemployment will reach 9%. New businesses will be created and Americans will be hired.

    6. The Government should make sure that no one starves to death or has to sleep on the streets. The safety net of food stamps and unemployment insurance should be strengthened.

    7. The Government’s purpose is to protect its citizens, enforce the laws and maintain the public infrastructure. Our roads are crumbling, we have 156,000 structurally deficient bridges, millions of miles of pipes under our streets are rusting away, and our power grid is antiquated. The job of Government was to maintain these things. It has failed miserably. Why does anyone think a new government infrastructure plan will work? Bridges to nowhere will be everywhere.

    8. Reducing spending dramatically on our military empire would provide funds to support the social safety net that is required during a depression. Congressmen in the pocket of the defense industry will never allow it to happen.

    http://www.prudentbear.com/index.php/commentary/guestcommentary?art_id=10175

  • Posted by Twofish

    People got into the mess by not looking at the lessons of the 1920′s. People will stay in this mess by looking at not the lessons of the 1930′s. It was precisely these policies that between 1929 to 1932 turned what could have been a recession into a full blown depression. We’ve been through this already……………

    DJC: Consumers need to cut back dramatically on consuming. Spending as a percentage of GDP needs to decline to 65%, or by $1 trillion. This would be approximately $3,000 less spending per household per year.

    DJC: Twenty years of consumer debt accumulation must be unwound. This required deleveraging needs to eliminate $2 trillion of household debt. The result will be thousands of retail store closings, mall closings, restaurant closings and auto dealership closings. The distinction between needs and wants will reveal itself like a sledgehammer.

    DJC: The consumer needs to increase their savings rate from 2% to 10%. This would provide more capital for investment.

    If 1+2 happen then three isn’t going to happen. When people start losing jobs, then spending rates tend to go way, way down since there is nothing to save. Once you have no savings, then there is no money for investment, which causes further job losses.

    DJC: When home prices fall far enough, the market will clear the inventory. Lower prices are the only way to eliminate excess supply.

    If the banks and real estate companies go bust then there is no market. The lesson of the Great Depression is that once you have no market, it’s pointless to talk about market mechanisms clearing the market.

    DJC: Companies that have failed to prepare for this downturn by taking on excessive debt, allowing expenses to soar, and having no clear strategic plan should go bankrupt. Unemployment will reach 9%. New businesses will be created and Americans will be hired.

    No they won’t. Once the banks are gone, and no one is spending, there is no money to start new businesses. Instead you have this massive downward spiral in which business after business closes.

    DJC: 6. The Government should make sure that no one starves to death or has to sleep on the streets. The safety net of food stamps and unemployment insurance should be strengthened.

    Once the economy starts falling apart, the government has no tax revenue to support this. It’s madness because you will have people sleeping on the streets while there are totally empty houses.

    My plan is that someone start a hoax that there are space aliens about to invade earth and that there needs to be a massive government plan to build rocket ships to attack those aliens on the planet Pluto.

    It’s more or less what got us out of the last depression.

  • Posted by Twofish

    from: Please tell me this is a joke. Obama really believes that The Fed can hold interest rates at zero for four years and they can spend without bound, while the bond market will blithely look on at $1-2 trillion deficits annually and the economy will begin to recover?

    Yes because the US debt/GDP ratio is lower than that of any other major industrialized nation. The US can increase its debt considerably before getting into payment problems.

    Massive borrowing is what got the US out of the 1930′s and the 1980′s. If you want to decrease debt ratios, you can do this by reducing debt or increasing income. If you massively increase debt and that gives you out of a economic problem, then you can pay off the debt later.

    This is basically what Reagan did in the 1980′s. Massive deficit spending.

    fromm: The money that could be spent on direct assistance to Americans for food, shelter and clothing (as I have repeatedly urged be held back for this exact purpose) is gone.

    If you have a stock of food, shelter, and clothing then you can just print money if you want it to be used.

    Anyway if you look at the numbers, there is very little reason that people won’t buy Treasuries because of too much debt. As a nation, the US really doesn’t have that much government debt, which is why it’s insane that we got into this mess in the first place.

    You save when times are good so that you can spend massively when times are bad.

    Times are bad…..

  • Posted by Howard Richman

    Brad,

    There’s a factor that you are missing. The European Central Bank appears to be buying dollars at a record pace right now. Check out the graph of their currency reserves on the European Central Bank website. You will see that it is spiking upwards.

    By the way, in my December 9 blog entry I predicted this. I wrote:

    “The dollar is falling vs. the euro and the yen, but not falling versus most of the world’s other currencies… However, I do not expect the fall in the dollar to continue. Foreign Central Banks will probably step up their dollar purchases. Japan and Europe will lose market share during the current depression unless their central banks intervene in world currency markets.

    “Unlike Americans, their economists are not ideological free traders. They understand mercantilism…. They have practiced mercantilism in the past, and are likely to beggar-the-United States again in the near future. If so, the fall of the dollar vs. the yen and euro will be temporary. The United States will continue to commit economic suicide without being joined by Japan and Europe.”

    Since then, the dollar has risen vis-a-vis the euro and yen, just as I predicted, and there is strong evidence that the European central bank is buying dollars.

    I also suspect that the Japanese central bank is buying dollars but I cannot find any evidence on the Japanese Central Bank website.

    Do you know where to look to find out about short-term changes in Japanese foreign currency reserves?

    Howard Richman
    http://www.tradeandtaxes.blogspot.com

  • Posted by wintermute

    The US has just had a “lost decade” like Japan. GDP grew at a fraction of national debt.
    Debt for consumption is slowly destructive – like drugs. Debt for production is the powerful part of what makes capitalism work! Government just can’t understand the difference and thinks that borrowing from future taxpayers can accelerate GDP growth. It is a disaster in the making and a disaster unfolding. The lessons from 1930′s and 1980′s were completely ignored – or we wouldn’t be in this mess now.
    The $1.2tn sale of Treasuries is a titanic monument to the failure of big government.

  • Posted by john

    hello all, new at commenting…nice blog btw

    though i agree with your global rebalancing theme(emerging markets turning inwards and us consumer stop leading global growth but i doubt big increase in savings(y cannot teach everyone new tricks)) and the stealth borrow and bailouts thus far by the FED, what is your view on the USD vs G10 currencies ( 3-6 months and 1 year ) to further ask you some questions ?

  • Posted by dyork

    But can the US government raise $3tr this year?

    Yes, it can raise $1.5tr in a year, especially when there is cash looking for a safe place to hide. But with a deficit of $1tr, a stimulus package/TARP II of say another $1tr and half the states looking for a bail-out of perhaps another $1tr, where will the cash come from?

    As far as I know, the world just doesn’t generate that much savings in a year, and the velocity of money is way down, so where do you find that sort of money?

    And that’s before even starting to think about borrowings by the UK, Europe, etc. This is something I could lose sleep over.

  • Posted by john

    @Twofish

    How can massively increasing debt can get you out of the deflation problem in the short term ?

  • Posted by Auskalo

    Italy is trading flat with Bank of America. It would seem odd that a bank (even a large bank) would trade flat with a reasonably productive state, but there is a double whammy working for B of A (and everyone like B of A) and against Italy (and everyone like Italy).

    First, the bottomless bailout has effectively made several, privileged entities in the US financial sector (including B of A) sovereigns by pulling them into the protective ring of the Treasury. Consequently, Italy isn’t really trading against B of A, it’s trading against the US Treasury.

    Second, the US Treasury keeps borrowing by the boatload, and the US Dollar remains the world’s reserve currency. That means that every borrowing sovereign finds itself in line behind the US at the door of every lender out there, and the US isn’t leaving much for everyone else.

    Which leads us to this: How long before sovereigns, or coalitions of sovereigns, start putting ring fences around their financial systems to restrict the flight of capital to the US? And when (not if) that happens, how will bailouts and stimulus packages be funded, and where will the credit loosening the MOAB was supposed to generate come from?

  • Posted by Twofish

    Q: How can massively increasing debt can get you out of the deflation problem in the short term ?

    You have a deflationary spiral. Job losses -> lower spending -> job losses -> lower spending. The trouble with this cycle is that it doesn’t stabilize until everyone has lost their jobs and no one is spending.

    Having the government spend massive amounts of money breaks this cycle. One other way of thinking about it is that printing money and going into debt is inflationary, and when you are in a deflationary spiral, you need to reverse it with inflationary action.

    Off hand, I can’t think of a single situation in which a deflationary spiral was cured by reducing debt. I can think of about six or seven cases, where it made things worse. The problem with trying to fix the problem by reducing debt is that your GDP contracts faster than your debt reductions which leaves you in an even worse position.

    Also, I don’t think that the financial crisis was caused by too much credit. It was a problem of misallocation and not total amount. People that argue that the US hit its credit limit have to explain the topic of this article which is that the government has no problem raising large amounts of money at 0% interest.

  • Posted by bsetser

    Auskalo — you know, nothing forces most countries to hold most of their reserves in $. at some point, if the dollar rises (b/c everyone wants $) and spreads for non-dollar borrowers widen v fundamentals, then it would be attractive to shift away from dollar reserves.

    agree tho that BoA is backed by the US gov. you could argue that the challenge italy faces is that there isn’t a comparable euro area backstop for its weakest members. there isn’t incidentally, any shortage of central bank holdings of euros. but i guess CBs right now aren’t in the mood to take risks so they presumably aren’t flocking to BTPs (Italian gov bonds). and while the fed is buying the bonds that CBs don’t want (agencies), there doesn’t seem to be a comparable ECB policy to try to bring down the spreads among eurozone countries.

    Institutions matter. and here the fact that eurozone currency area isn’t a political union seems to be part of the explanation.

  • Posted by Ang70

    Brad, great blog!

    Despite dire predictions I have been long treasuries (and other soverign bonds) over the past year because of what happened in Japan.

    During the 1990s Japanese bond issuance increased massively and yields dropped. At the time the short JGB trade was a favourite trade with pundits but it was a disaster.

    The main reason for this was that in the face of negative loan growth banks bought JGBs. It was a great trade for everyone. Banks made carry and rolldowdown to repair their balance sheets and the government could raise the sums required to finance fiscal stimulus.

    If the US can allow banks to lever their balance sheets with zero-risk rated treasuires then the new bond issuance will be a wash.

    If a US Bank was to borrow USD from the Fed at Zero and buy 10 yr notes yielding 2.5% they would get carry and roll of around 3.2% unleveraged annual return. Not bad given the alternatives.

  • Posted by Exporter to GANT

    I am sure you all realize that…US needs to keep other asian countries in a bit terrified state to finance deficits.

    IF everything is fine.. i dont think they will keep adding..right now they are adding reserves fearing an armageddon.

    Fear of armageddon will have to be sustained…few banks failing here and there…retailers closing..car companies going bust..some weird M&A all has to happen to keep asian countries bewildered thru most of 2009. Oh I forgot the wild swings in EQ, FX and FID markets are a prerequisite

  • Posted by geert

    @ John
    “How can massively increasing debt can get you out of the deflation problem in the short term ?”

    It cannot get you out of deflation !
    It’ll take longer than assumed. The best governement can and must do, is to combat the deflationary spiral and soften the worst consequences.
    Though I have good hopes because the US government is acting swiftly (Europe is still in denial)

    @2Fish
    “Also, I don’t think that the financial crisis was caused by too much credit. It was a problem of misallocation and not total amount.”

    Yes and no. There is too much credit (because of speculation) and on top a big part is misallocated as the middle class kept its standard of living thanks to credit expansion.

    The US government has no problem raising money at 0 %, because of the exceptional situation this market is in. I wouldn’t take it as a reference. Wait until the rest of the world joins the spending party! Here too you have the advantage of acting first and swiftly.

    Debt vs GDP: a good portion of the misallocated debt must be destroyed while the government must sustain GDP. You need to go both ways or better you won’t have the choice.
    My thoughts on this (briefly)
    - overconsumption must disappear (consume to consume and shop as a passtime), the process of deflation will take care of this;
    - a lot of debt must be destroyed, something the process of deflation will take care of;
    - government spending must sustain basic consumption for as many people as possible;
    - government spending must aim at the expansion of usuful common goods (mainly in the future useful because we will shift the burden largely to the next generations too);
    - the purpose of government spending is redistribution of wealth (wide variety of investments for as many participants as possible, no lobbying, labour intensive);
    - protectionism must come back or the mercantilists will profit from the spending programm of the West
    - a far more progressive tax system; you cannot put the burden of all our spending on the next generations and as the rich don’t have to invest anymore in the expansion of production, they can as well contribute a little to the common well-being of our society;
    ……

    BTW 2Fish: the comment counter on your blog doesn’t show that a comment is given on the end of monetarism and mathematical economics.

  • Posted by geert

    The first sentece had to be
    “It can not get you out of deflation in the short term”

  • Posted by CGT

    An excellent post. I am fully in agreement that sovereign debt markets are getting into rising yield territory from here on. The dynamics in the sovereign debt auctions as well as yields globally (see http://trueeconomics.blogspot.com/2009/01/near-sovereign-bonds-next-frontier.html) suggest we are facing a bubble in higher grade sovereign debt. The above link discusses the room for further yield compression in US Treasuries (none) and the new areas for investment inflows (munis and state debt).

  • Posted by Twofish

    geert: Yes and no. There is too much credit (because of speculation) and on top a big part is misallocated as the middle class kept its standard of living thanks to credit expansion.

    I don’t think that is true at all. If it were true then the crisis would have come when middle class people stopped being able to pay for their credit cards, mortgages, and auto loans. This is happening now, but it is the consequence of people losing their jobs rather than the initial cause of the problem.

    If the credit expansion had been limited to middle class people with good credit, I’d argue that we wouldn’t have had problems at all, since people with good credit will tend not to overspend even if you give them the ability to overspend.

    The problem was that credit was extended to people that had no chance of repaying their loans in the first place, with no deep thought given to what happens if they didn’t repay.

    geert: The US government has no problem raising money at 0 %, because of the exceptional situation this market is in. I wouldn’t take it as a reference.

    Except that if the problem was overconsumption and overexpansion of credit rather than misallocation of credit, then we wouldn’t have zero percent interest loans. Zero percent loans just don’t happen in emerging market crises.

    Emerging markets with financial crises don’t have the option of massive government spending to generate demand because the money disappears and no one will give them credit except for the loan sharks from the IMF who then demand structural adjustment that makes the situation worse.

    geert: Wait until the rest of the world joins the spending party!

    OK, what happens?

    geert: overconsumption must disappear (consume to consume and shop as a passtime), the process of deflation will take care of this;

    I don’t think there was overconsumption. If you have idle factories and unemployed people, then by definition there is under-demand.

    Overconsumption will get you in trouble if you keep borrowing for debts that you have no chance of repaying, but at a national level, this didn’t happen and it frankly isn’t happening even with $1 trillion deficits.

    geert: BTW 2Fish: the comment counter on your blog doesn’t show that a comment is given on the end of monetarism and mathematical economics.

    Fixed.

  • Posted by Hilario

    Surely the US can finance these high deficits for a year or three, but once the economy bounces back a rigorous programme to curb (cut?) government spending and increase taxes – 50-50 mix, like Sweden in 1994 – to to get government finances back on a sustainable path.
    Hilario

  • Posted by Archeo

    USD demand by ECB spiked in October and has been moderating since, see http://www.ecb.int/stats/external/reserves/html/assets_U2_2008.en.html but
    (1) Gold – systemic rise, albeit modest in last few months, and
    (2) National CBs deposits – reflective of savings build-up on banks deposits side with national banks
    drive the official reserve assets.

    See http://trueeconomics.blogspot.com/2009/01/near-sovereign-bonds-next-frontier.html for European and global demand fundamentals in the US Treasuries market…

  • Posted by john

    @Twofish
    yes i agree, i meant more regarding the difference of only stealth “borrowing”(which is neutral in the short term) as opposed to monetization(immediate inflation)
    -too much can only lead to higher yields, currency fall, or rise in inflation.

    @bsetser
    there cannot be too much domestic private investment in Ts to offset fiscal expansion because of the “crowding out effect” which accompanies the Gov actions.

    Furthermore the funding of the expansion can be ‘easier’ if an economy is self-funding (i.e. jpy), or the economy has existing excess capital (shown through a current
    account surplus, i.e. CHF). The important here is the starting position of each participant.

    Also the resulting decline in the net income position will likely weigh on the current account position. This may negate some of the benefits of lower consumer demand in the trade account as an economy slows. It may also detract from the imbalance adjustment being seen through currency weakness. finally there is a risk premium increase on increased gov debt.

  • Posted by Albion

    Comparison is not reason
    No Japan macroeconomics in 1987 and USA today are not the same. Japan debt is and was domestic in 1987 and did not require the support of the international community, as the Postal saving Bank was the main provider of funds.
    When purchasing as an individual, a bond you may have to hold it to maturity as of today bonds are above par, maturity 10 years (that requires a prescient knowledge of the inflation even when factoring the philosophical vocabulary of inflation expectation)
    When taking into account the extensive competition among governments on the debt markets ( they are now running increasing budget/ current accounts deficits). One may wonder if and where the money will come from (in USA money market funds are 3.8 TN USD) International reserves assets are 6.7 TN USD and more likely to be depleted for domestic purposes than replenished.
    Inflation in the 1930 was hovering around 4 Pct (see Mr P kasriel ) » the worst recession since the great depression perhaps but « 
    http://www.ntrs.com/pws/jsp/display2.jsp?XML=pages/nt/0601/1138283684288_6.xml&TYPE=interior

    And last before purchasing any assets wherever, study their prices mechanisms (TIC TARP Derivatives, Primary dealers, comptroller of currency),if one does not belong to this syndicate , one may not be foretold.

  • Posted by Kafka

    I know I am a dope but didn’t much of the Treasuries in private hands result from the Fed giveaways? In fact, for sure yields have actually declined but hasn’t the Fed’s balance sheet containing assets of dubious value massively increased which effectively results in a massive yield increase. If the Fed takes an asset worth 50 but pays 100 for it, why is any explicit yield even necessary? Just asking some dopey questions.

  • Posted by jimbo

    Amazing. I was looking in vain in this posting and all the comments for the slightest sign that anyone has a basic understanding about how the U.S. monetary system works, and didn’t find one. Most of what all of you people are talking about is simply inapplicable in a floating exchange rate fiat money regime.

    In such a system, there are only two ways for excess reserve balances to be removed from the system – through taxation or through the substitution of interest bearing securities. There is no, repeat no, other way to drain reserves. When the U.S. gov spends money, it increases reserve balances that must in turn be drained so long as there is a target FF rate.

    Thus, there are no financial limits on the U.S. gov’s ability to finance any amount of debt, at any interest rate it chooses to pay. It is not “competing” in the market for dollars – it creates the dollars, and only THEN does it “borrow” (really, offer interest bearing alternatives in order to support non-zero dollar interest rates) what it does not tax. There is no “funding constraint”, the U.S. gov does not depend on foreigners to buy the debt. There is no pile of dollars out there that the U.S. has to beg for – dollars are a creature of the Fed, and have no existence outside of it’s spreadsheets.

    Really, this should be covered in the first week of any undergrad money and banking class. The fact that people here don’t understand it is really disturbing.

  • Posted by geert

    2Fish

    “If it were true then the crisis would have come when middle class people stopped being able to pay for their credit cards, mortgages, and auto loans.”

    Why so? I differ between the trigger mechanism and the structural imbalances present. It is not because the crisis started with subprimes that it is the main cause of the crisis.
    If this will be a short lived crisis then I’ll agree with you, but if we need to struggle thru a severe recession I would be looking at the real consumer class.

    I didn’t write that the credit has been limited to middle class with good credit. Maybe we should first define what we both understand by middle class.
    Around here I even dare to write that the majority of the people that belong to the middle class, judging on their standard of living and jobs, have none to little savings.
    If that middle class is that good and not overborrowed, then why do they get in trouble? Unemployment? So fast? Odd to say the least.

    “OK, what happens?”

    I refer to the eighties. Competition on the international credit markets took interest rates sky high. True that this time private borrowers will probably not participate so intense but I see deficit spending by all countries exceed by far the funding needs of the countries in the eighties (relatively).

    Whether we have overconsumption is also a subject in need for a definition. I stick to the overconsumption theory for the West which doesn’t imply that on a global aggregate level there’s overconsumption.
    That’s why we see an under-demand that is not really relevant for determining whether the west has overconsumption.

  • Posted by Howard Richman

    Correction to what I posted here Jan 12 at 7:19pm:

    Although the dollar has indeed been going up in currency markets ever since I predicted that it would turn around. There is not sufficient evidence in the chart that I pointed to that the European Central Bank is buying dollars. There are at least three possible explanations for why the dollar turned around:

    1. The extensive borrowing by the United States government could be causing the dollar to rise. Whenever we borrow from abroad, we are essentially bidding to buy dollars in currency markets so that we can borrow them.

    2. Foreign central banks may be increasing their reserves. Whenever foreign central banks increase their dollar reserves they bid up dollars in order to place their countries’ savings into American assets, usually US Treasury bonds.

    3. A random change in dollar value.

    While it seems likely that government actions by the US government and by foreign governments are causing the dollar to strengthen, the evidence is not clear.

  • Posted by john

    i do not know if you listened to Bernanke at LSE. For those who did, why do you think he insisted on :
    1. admitting the way to affect markets is though communication or jawboning or bluffing, and gave examples
    2. that really the crisis is(or should be or make certain that it’s) a global confidence crisis

  • Posted by Albion

    Jimbo

    There are few caveats in a central bank balance sheet expansion, the main one is when to wipe out the targeted liquidity excess and how to quantify this excess ?
    So far Central banks are far from proving their nano science.

  • Posted by Kafka

    Jimbo, perhaps, you can educate me. You wanna call it credits or printing money fine. If the Fed, credits Treasury for the issuance of Treasuries without taking the Treasuries to market and the Treasury spends the dough, that my friend is effectively printing money not a financing transaction. If private parties or central banks buy the Treasuries from the Fed that is not printing money assuming the Fed reduces its liabilities by a corresponding amount. If the Fed takes the Treasuries and swaps them for assets worth 50 cents on the dollar, that is effectively printing money (not to mention theft) not a financing transaction as result of the apparent differences in FMV. Where has my remedial banking analysis gone wrong? I would also submit to you that excess reserves can be removed via the swap lines and exchange rate fluctuations though the transparency of these transactions is dubious.

  • Posted by jimbo

    Kafka,

    “if the Fed, credits Treasury for the issuance of Treasuries without taking the Treasuries to market and the Treasury spends the dough, that my friend is effectively printing money not a financing transaction.”

    What would happen in that case? The FF rate would immediately drop to 0 (it doesn’t have far to go, true, but they still nominally set a rate). If they do offer the Treasuries, banks, private parties and the like would have to prefer to hold non-interest bearing liabilities (reserves) rather than interest bearing ones (Treasuries) for the them to fail to sell. Again, there is no other place for them to go. Sure, they can buy something else – say a corporate bond. All that does is move the reserves from one account to another. Only by someone buying the bond from the fed or the Treasury can the reserves be drained.

    Operationally, the Treasury spends money prior to taxing it or “borrowing” it. Neither is a “financing” operation.

  • Posted by David Heigham

    Th US Treasury was able to raise that much ready. Whether it will be able to do so in 2009/10 is a different question. My best guess is it can; but the financing process won’t look very similar.

  • Posted by Greg

    China bought Treasuries with money raised from selling agencies, not with new money

    They sold the agencies (indirectly) to the Fed, which paid for them with printed money

    History shows this exercise is not sustainable

  • Posted by Emmanuel

    Dr. Setser, can you quickly walk us through the arithmetic here as I cannot duplicate this figure:

    The Fed’s holdings of Treasuries – counting the securities it has lent out to the market – fell by $427 billion.

  • Posted by bsetser

    emmanuel — am a bit pressed for time but it is the fall in the treasuries the fed holds (down from $741b to 476…) and the increase the securities the fed has lent to the market (reported a memo item under the custodial holdings) which rose from $18b to $181b.

  • Posted by Twofish

    geert: Why so? I differ between the trigger mechanism and the structural imbalances present.

    And I’m arguing that there structural imbalances weren’t very important in the crisis, which is to say that even if you had no imbalances, the crisis would have still happened.

    geert: It is not because the crisis started with sub-primes that it is the main cause of the crisis.

    What I argue is that no subprime -> no crisis. Subprime + structural balance -> crisis. So even if you had high savings rates and a very low GDP, with so much bad lending, you’d still have a crisis.

    geert: If this will be a short lived crisis then I’ll agree with you, but if we need to struggle thru a severe recession I would be looking at the real consumer class.

    Even if we do have a severe recession, then it doesn’t mean that there was a major structural problem to begin with.

    geert: If that middle class is that good and not overborrowed, then why do they get in trouble? Unemployment? So fast? Odd to say the least.

    Yes. Most middle class families will run out of liquid current assets if they are without work for six months. You can start dipping into IRA’s and 401(k)’s but that tends to be a bad idea especially if everyone does it at the same time.

    The moment you have any chance of unemployment, people just suddenly stop spending. If you look at what happened between August and October, it wasn’t that people hit their credit card limits, it’s that point that everyone suddenly said “oh my goodness, I might lose my job” at which point spending stops cold.

    The number of non-retired people that could financially survive extended unemployment is very small. If most people didn’t have to work, they wouldn’t.

  • Posted by gw

    Brad would you dare to comment at what price the market is willing to accept those treasuries?

    Your idea that private retail(?) investors will absorb the addtional load implies that they are setting the prices. And those folks tend to be more fickle than the institutional central banks and they do have more alternatives. As prices are set at the margin…

  • Posted by Lou Thomas

    An analysis that is purely focused upon the monetary concerns of stimulus and borrowing misses the fundamental economic factors underlying the present crisis. And we are nearing that moment of truth when fundamentals once again start to matter.

    We need to recognize that:

    * The export of heavy industry from the U.S. to other nations is a key factor in the present trade imbalance, and in the terminal dependency upon monetary manipulation and, more benignly, the service economy, which are dysfunctional and unsustainable, respectively.

    * A large part of what remains of U.S. industry is dedicated to military production, which is a net negative for the real economy, and that dependence upon the external projection of power has destroyed the integrity of the U.S. economy, while building a fifth column in the form of a military-industrial complex that tends to lock the U.S. in to this destabilizing policy.

    * Other centers of power have emerged as the internal decay of the U.S. through militarism and other corruption has undermined U.S. economic power and military alliances.

    We need some truly creative ways of addressing these problems, such as:

    * Making deals with nations with net surplus reserves that have grown tired of financing U.S. overspending, to obtain additional investment in exchange for the U.S. (and its clients) drawing back from present aggressive policies, and also by using these funds for a massive conversion of the military industry to civilian productive purposes (e.g., green technology) that the world needs and that can therefore ultimately correct the trade imbalance.

    * Cutting the military budget and using the proceeds for part of the required stimulus.

    * Including as part of the stimulus package Federal grants for worker-run cooperatives to take over idled manufacturing facilities, as happened during the recent Argentine crisis.

    * Putting zombie banks out of their misery and dealing with the chain reaction of failures by replacing these failed institutions with direct public investment, instead of pouring TARP funds down a bottomless pit of financial chicanery.

    * Tight regulation of what remains of the financial sector.

    Can we do it? It comes down to whether we have the will to survive.

  • Posted by Itrac Rougese

    Does any one want to give MORE of our current jobs and childrens future to other countries? The below comment says YES to me and many other citizens.

    Geithner’s comments in the United Arab Emirates capital Abu Dhabi came on the second leg of a two-day trip to the Middle East, where he is seeking to convince Arab leaders on the Obama administration’s efforts to fix the U.S. economy.

    “We want to rebuild a stronger foundation for more balanced growth globally,” Geithner said after a closed-door meeting about education and economic development with UAE Foreign Trade Minister Sheikha Lubna al-Qasimi and other officials. “We need to make sure as we emerge from this crisis we’re not sowing the seeds of imbalances that will lead to future crises.”

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