A Socratic Dialogue: Fearing the Collapse of U.S. Treasury Bond Prices

Meno: I haven't seen you since spring classes ended.

Adeimantos: I have been away: Paris. London. Frankfurt.

Meno: Oh. Pleasant? Interesting?

Adeimantos: Not really interesting--too jet-lagged, so I sit in my hotel room in my underwear, read the Economist and Financial Times, and reflect on how if in my 20s I had been in a fancy hotel in central Paris with someone else paying I would have thought I was in heaven, but that now I am just tired. Thus not too pleasant either.

Meno: Middle age is a shipwreck?

Kephalos: It gets worse...

Adeimantos: However, it was somewhat lucrative: talking to European hedge funds.

Meno: And what do European hedge funds think?

Adeimantos: They look at things like this: ( See chart below )

Then they demand that I tell them why U.S. Treasury bond prices have not already collapsed (and Treasury interest rates risen) in anticipation of this forthcoming tsunami of bond issues. Given that Treasury bonds have not yet collapsed they are very very bearish about U.S. Treasury bond prices and interest rates. Supply and demand. The supply of U.S. Treasury bonds is about to become huge, and when supply goes up price should go down.

Socrates: But if that argument is correct, then rational profit-seeking traders should already have sold U.S. Treasury bonds and already have pushed their prices down in anticipation of the sudden increase in supply...

Meno: Are you Socrates or Milton Friedman?

Kephalos: There are two supply-and-demand arguments that can be made here. The first is that the supply of U.S. Treasury bonds is about to jump enormously -- and so by supply-and-demand the price will be low once the extra bond issues hit the market, and should be low now in anticipation of this low-price Treasury bond market equilibrium. The second is that the inverse of the price of U.S. Treasury bonds--the Treasury nominal interest rate--is the price of liquidity: the amount of interest income you forego by keeping your wealth in cash rather than in securities. According to this second argument, the supply-and-demand is the supply and demand for cash: when the supply of cash is high, the price of liquidity is low, and since the price of liquidity is the short-term Treasury interest rate the short-term Treasury interest rate should be very low.

Adeimantos: Which it is...

Kephalos: And the long-term Treasury interest rate is the average of expected short-term future Treasury interest rates. Since the Federal Reserve has flooded the economy with cash and will keep flooding it with cash for the foreseeable, Treasury interest rates should be low which means Treasury bond prices should be very high--which they are--and stay high.

Adeimantos: Loanable funds vs. liquidity preference.

Socrates: So, Kephalos, with your impeccable logic and deep wisdom derived from a long career financing expeditions to the shores of the Black Sea, you have presented us with two different supply-and-demand arguments, one saying that Treasury bond prices should be low and hence are about to collapse, and the other saying that Treasury bond prices should be high and are likely to stay more-or-less where they are for some time to come.

Meno: Which argument is right? Is the price of bonds the price that balances the supply and demand for bonds in the bond market? Or is the price of bonds the inverse of the interest rate which balances the supply and demand for cash in the money market? Both cannot be true, can they?

Adeimantos: Ah. But both arguments are true...

Meno: Why do I get the feeling that I am being cast as the dumb straight man in this dialogue?

Socrates: Because you are a sophist and we are philosophers. We write the dialogues, and we write them to make ourselves look good so that everyone thinks that philosophers are the roxxor and sophists are lame...

Meno: What have I ever done to you?

Glaucon: Tried to take our students and their fees, perhaps?

Socrates: And we have won. There are now departments of philosophy everywhere. But when was the last time you saw a department of sophistry?

Meno: OK. I will take up my role: Kephalos,: Can you explain to me how two perfectly-coherent supply-and-demand arguments lead to opposite conclusions? And if both arguments are coherent, why do European hedge funds all believe the first?

Kephalos: I can answer the second question but not the first: European hedge funds live in the bond market and they see the supply and demand of bonds all day, so that is the market they believe is most important...

Adeimantos: That is true about European hedge funds. But, Meno, the way you have posed the issue is somewhat misleading. It is not which supply-and-demand argument is correct--for both are: the price/interest rate on Treasury bonds clears both the bond and the money market, both loanable funds and liquidity preference. It is how does the economy adjust in order to make the Treasury bond price/interest rate clear both these markets.

Meno: And I have the feeling that you are about to tell me...

Adeimantos: Let's start with an economy in equilibrium--where Treasury bond prices are such as to satisfy both loanable funds and liquidity preference, so that everyone is happy to hold the bonds given their current price and everyone is happy to hold the economy's cash supply given the current interest rate. Now suppose the Treasury issues a huge honking tranche of bonds (and Obama spends the money hiring the unemployed to give people cholesterol screenings on the street and hand out statins). Now the supply of bonds is greater than demand at current bond prices. So what happens?

Kephalos: The prices of Treasury bonds fall--interest rates rise...

Adeimantos: And what happens in the money market as interest rates rise?

Kephalos: People are no longer happy holding the economy's cash--it's too expensive; it's burning a hole in their pocket. So they start spending it faster...

Adeimantos: And as they start spending it faster?

Kephalos: This puts upward pressure on prices and employment, as businesses find that they can charge more and make higher profits and so hire more people...

Adeimantos: Incomes rise, and as incomes rise savings rise because people don't spend all of their increased incomes, do they?

Socrates: Very true, Adeimantos.

Adeimantos: And what happens as savings rise?

Kephalos: People want to park those savings somewhere. They want to park those savings in Treasury bonds. And so demand for Treasury bonds rises...

Adeimantos: And the economy settles back at its new equilibrium, with (a) somewhat higher interest rates and (b) higher spending and income so that (c) people are happy holding the economy's cash at the current interest rates and rate of spending, and (d) people are happy holding the bonds at the current bond prices and level of income.

Kephalos: So both supply-and-demand arguments are true...

Meno: And the way that they can both be true is that there isn't just one quantity--the bond price--that adjusts to match supply and demand in the bond and the money markets...

Socrates: But there are two quantities that adjust: the bond price and the level of spending...

Adeimantos: Yes. You have just derived things that were well-known 72 years ago. See John Hicks (1937), "Mr. Keynes and the 'Classics': A Suggested Interpretation."

Meno: So when European hedge funds predict the collapse of U.S. Treasury bond prices as the new issues hit the market and ask where is the extra demand to hold all these new bonds come from, the answer is...?

Adeimantos: That even as the government issues the bonds it is also spending the money, and as the money it spends is parked in the bank accounts of the businesses the government is buying things from, the banks in which the money is parked take it and use it to buy Treasury bonds.

Meno: That sounds like sophistry...

Socrates: You should talk...

Glaucon: Actually, it's just general equilibrium...

Meno: But is this doctrine--that the government's issuance of a fortune in bonds and spending of a fortune in money will show up primarily not as a collapse in bond prices and a spike in interest rates but as an expansion of spending--true?

Socrates: We will see. Keynesian--or maybe I should say Hicksian--economists would say that bond prices/interest rates and spending/income levels are the two quantities that together adjust to jointly clear the bond and the money markets, to satisfy both loanable funds and liquidity preference equilibrium; that sometimes the principal movement is in interest rates; that sometimes the principal movement is in spending levels; and that right now it is likely that spending will adjust by much more than interest rates.

Adeimantos: And there is a little bit of empirical evidence that the Hicksian economists are right. Tim Fernholz sends us to Nelson Schwartz, who writes:

Europe Lags as U.S. Economy Shows Signs of Recovery - NYTimes.com: There was more evidence Thursday that the United States economy might be stabilizing, if not rebounding, even as economic reports in Europe remained gloomy. The American news — showing slight growth in retail sales and a dip in first-time jobless claims, as well as rising stocks — was not enough to end the disagreement between bulls and bears over how soon the economy would improve. But the apparent divergence of fortunes between America and Europe highlighted the different approaches to solving the financial crisis, and why some economists say the more aggressive American strategy may be working better, at least for now. It is a debate that is likely to be one of the issues dominating discussions when finance ministers from the eight largest economies meet in Italy this weekend.

Some private economists are even predicting that the American economy will resume growth in the fourth quarter, while Europe’s economy is expected to remain in recession well into 2010, after contracting an estimated 4.2 percent this year compared with an expected 2.8 percent decline in the United States. “The shock originated in the U.S., but Europe is paying a higher price,” said Jean Pisani-Ferry, a former top financial adviser to the French government who is now director of Bruegel, a research center in Brussels. Almost from the beginning of the crisis, the United States and Europe chose largely different paths to aiding their economies. The most stark was Washington’s willingness to commit hundreds of billions of dollars to stimulus spending — in addition to moving aggressively to shore up banks and keep credit flowing — versus Europe’s worry that similar spending would increase inflation in the future. Just as the policies pursued during the Great Depression have been dissected ever since by economists, the fate of the United States and Europe as the two regions emerge from the global crisis will be analyzed for decades to come.....

One crucial concern about America’s increased deficit spending — that it would lead investors to demand higher interest rates on United States debt, making it far more expensive to borrow and slowing the economy — has been allayed, for now. An auction on Thursday of $11 billion in 30-year Treasury bonds found enthusiastic buyers, helping to push the Standard & Poor’s 500-stock index to a seven-month high...

Meno: And the Chicago School economists who say that government borrow-and-spend logically cannot increase overall spending? The Robert Lucases who say: "[W]ould a fiscal stimulus somehow get us out of this bind...? I just don't see this at all. If the government builds a bridge... by taking tax money away from somebody else, and using that to pay the bridge builder... then it's just a wash.... [T]here's nothing to apply a multiplier to. (Laughs.)... [And] taxing them later isn't going to help, we know that..."? And the John Cochranes who said: "[W]hile Tobin made contributions to investing theory, the idea that spending can spur the economy was discredited decades ago. 'It’s not part of what anybody has taught graduate students since the 1960s. They are fairy tales that have been proved false. It is very comforting in times of stress to go back to the fairy tales we heard as children but it doesn’t make them less false.'" To borrow money to pay for the spending, the government will issue bonds, which means investors will be buying U.S. Treasuries instead of investing in equities or products, negating the stimulative effect, Cochrane said. It also will do nothing to unlock frozen credit..."?

Socrates: I, at least, find myself unable to understand them. They say they believe in the quantity theory of money -- that spending is equal to the economy's cash times its velocity. And they say that they believe that velocity is interest elastic -- that people respond to incentives and spend the cash in their pockets more rapidly when nominal interest rates are high. They say that they believe that bond prices/interest rates are such as to balance saving and investment and make people willing to hold the stock of bonds. That's all you need to be a Hicksian. Yet they also claim that Hicks is wrong, somehow -- without giving arguments. I can trip up and make foolish anybody who makes an argument, but if they don't make an argument I cannot make them look any more foolish...

(C)2009, Brad DeLong