The Truth About Deficits and Interest Rates
Jeff Nielsen is back with a defense of the idea that the Treasury market is witnessing the “ultimate financial contradiction: maximum supply and maximum prices.”
Nielsen believes that Treasury prices should be falling because the inventory of Treasury bonds has grown to historically unprecedented levels. But prices for Treasury bonds remain near record highs—and yields near record lows.
“The highest supply in history directly implies the lowest prices in history, for every market in the world — except U.S. Treasurys,” Nielsen writes.
How has the Treasury market accomplished this?
Nielsen says it is a “Ponzi-scheme” perpetrated by the Federal Reserve “fraudulently counterfeiting U.S. dollars.”
“I assert yet again that there is only one theoretically possible explanation as to why the U.S. Treasuries Ponzi-scheme has not already blown up like Bernie Madoff’s fraud: B.S. Bernanke is fraudulently counterfeiting U.S. dollars (by the $trillions) to prop-up this market,” Nielsen writes.
To be blunt: this is pretty much nonsense.
As I pointed out last month, the supply of assets considered “safe” has dramatically contracted over the past few years. The increase in the issuance of Treasurys that has accompanied deficit spending has not even kept up with the loss of top-rated sovereign debt, triple-A mortgage-related securities, and the contraction of agency-backed securities.
Let’s think about the market for potatoes. Imagine that a blight had wiped out potato crops everywhere—except for Idaho, which actually produces a bumper crop. Now Idaho is a very important supplier of potatoes. Someone like Nielsen, looking just at the supply of Idaho potatoes, might be shocked if the price of potatoes rose while Idaho churned out more and more spuds. But if he would look at the world-wide supply of potatoes, the mystery would be solved.
Writing about the growth of the outstanding stock of Treasury bonds without mentioning the contraction of safe assets is like saying that if Idaho grows more potatoes the price must fall. The rest of the market matters.
Joe Weisenthal at Business Insider pointed out that Nielsen also misses something important about Treasury bonds—they are issued to back government deficit spending. Each dollar of Treasury bond issuance by the U.S. Treasury implies a dollar of government spending in excess of government revenue. Which is to say, the larger the deficit, the greater the potential demand for Treasury bonds.
This confuses a lot of people, including Neilsen. So let’s try to break it down for a moment.
Our federal government spends money through the congressional authorization and presidential approval process set forth in the United States Constitution (more or less). It also collects tax revenues in ways approved by congress and the president. Spending injects money into the economy; taxes subtract money from the economy.
When the government’s budget is balanced, it is taxing the same amount as it is spending. The adding and subtracting cancel each other out, so spending just redirects the economy in directions the government favors.
When the government runs a budget surplus, it taxes more than it spends. The tax subtraction from the economy exceeds the spending addition. The government, in this case, is diminishing the amount of financial assets available to the economy.
When the government runs a budget deficit, it spends more than it taxes. The spending addition exceeds the taxing subtraction. The government is adding to the amount of financial assets available to the economy.
Our government issues debt to the public when it runs a budget deficit, issuing a dollar in bonds for every dollar it spends in excess of taxes collected. But because the bonds and the deficit spending are perfectly matched, there’s no net added demand on the economy’s financial resources.
(Side note: there is additional aggregate demand created by the spending—which could lead to inflation if the economy is near capacity or government spends on things in short supply—and political distortion as real resources get directed toward projects favored by politicians. But these are spending issues, not bond-market issues caused by debt issuance.)
It might help if we imagine a counter-factual. Imagine if the government were running a surplus and still decided to issue bonds. In this case, the government would be contracting the supply of dollars in the economy while attempting to convince people to swap more of their assets for Treasury bonds. In this case, it is easy to see how yields might need to go up: with dollars becoming scarcer, people would demand higher interest rates from the government in exchange for their dollars.
I realize that pretty much everyone thinks things work the opposite way. We think that surpluses drive down yields and deficits drive up yields. The mistake we’re making when we think this way is that we’re assuming supply and demand for Treasury bonds remains constant. A government running a surplus while enlarging the outstanding stock of its bonds through new issuance will drive up yields. A government running a budget deficit while shrinking the stock of its bonds will see yields fall.
What appears to be happening in the market for U.S. Treasury bonds right now is that the government is running a budget deficit while issuing bonds that are relatively small compared to the safe-asset supply contraction and demand for safe assets. In effect, we’re in the position of a deficit country with a shrinking stock of safe assets. So yields fall.
This is where Nielsen has gone wrong. He looks at just the rising supply of Treasury bonds and says that “history directly implies” prices should be falling. He doesn’t pay attention to either the contraction of other sources of safe bonds or the expansion of demand created by deficit spending.
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