10/21/10 7:52 PMWhy I Am Not Surprised That U.S. Treasury Bond Yields Are Still Very Low Today - Grasping Reality with Both Hands

Page 1 of 10http://delong.typepad.com/sdj/2010/09/why-i-am-not-surprised-that-us-treasury-bond-yields-are-still-very-low-today.html

Grasping Reality with Both HandsThe Semi-Daily Journal of Economist J. Bradford DeLong: Fair, Balanced, Reality-Based, and Even-HandedDepartment of Economics, U.C. Berkeley #3880, Berkeley, CA 94720-3880; 925 7080467; delong@econ.berkeley.edu.

Economics 210aWeblog ArchivesDeLong Hot on GoogleDeLong Hot on Google BlogsearchSeptember 18, 2010

Why I Am Not Surprised That U.S. Treasury Bond Yields Are

Still Very Low Today

Hoisted from the Archives from June 13, 2009: what we Hicksians were thinking then,and why we have (so far) been right:

A Sokratic Dialogue: Liquidity Preference, Loanable Funds, and European HedgeFunds that Fear the Collapse of U.S. Treasury Bond Prices - Grasping Reality with BothHands:

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 myunderwear, read the Economist and Financial Times,, and reflect on how if in my 20s Ihad been in a fancy hotel in central Paris with someone else paying I would havethought 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:

Dashboard Blog Stats Edit Post

10/21/10 7:52 PMWhy I Am Not Surprised That U.S. Treasury Bond Yields Are Still Very Low Today - Grasping Reality with Both Hands

Page 2 of 10http://delong.typepad.com/sdj/2010/09/why-i-am-not-surprised-that-us-treasury-bond-yields-are-still-very-low-today.html

Then they demand that I tell them why U.S. Treasury bond prices have not alreadycollapsed (and Treasury interest rates risen) in anticipation of this forthcomingtsunami of bond issues. Given that Treasury bonds have not yet collapsed they are veryvery 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 upprice should go down.

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

Meno: Are you Sokrates or Milton Friedman?

Kephalos: There are two supply-and-demand arguments that can be made here. Thefirst is that the supply of U.S. Treasury bonds is about to jump enormously--and so bysupply-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 marketequilibrium. The second is that the inverse of the price of U.S. Treasury bonds--theTreasury nominal interest rate--is the price of liquidity: the amount of interest incomeyou forego by keeping your wealth in cash rather than in securities. According to thissecond argument, the supply-and-demand is the supply and demand for cash: whenthe supply of cash is high, the price of liquidity is low, and since the price of liquidity isthe short-term Treasury interest rate the short-term Treasury interest rate should bevery 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

10/21/10 7:52 PMWhy I Am Not Surprised That U.S. Treasury Bond Yields Are Still Very Low Today - Grasping Reality with Both Hands

Page 3 of 10http://delong.typepad.com/sdj/2010/09/why-i-am-not-surprised-that-us-treasury-bond-yields-are-still-very-low-today.html

with cash and will keep flooding it with cash for the foreseeable, Treasury interest ratesshould be low which means Treasury bond prices should be very high--which they are--and stay high.

Adeimantos: Loanable funds vs. liquidity preference.

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

Meno: Which argument is right? Is the price of bonds the price that balances thesupply and demand for bonds in the bond market? Or is the price of bonds the inverseof the interest rate which balances the supply and demand for cash in the moneymarket? 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 thisdialogue?

Sokrates: 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 thatphilosophers are the roxxor and sophists are lame...

Meno: What have I ever done to you?

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

Sokrates: And we have won. There are now departments of philosophy everywhere. Butwhen 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 botharguments are coherent, why do European hedge funds all believe the first?

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

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

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 pricesare such as to satisfy both loanable funds and liquidity preference, so that everyone ishappy to hold the bonds given their current price and everyone is happy to hold theeconomy's cash supply given the current interest rate. Now suppose the Treasuryissues a huge honking tranche of bonds (and Obama spends the money hiring theunemployed 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 whathappens?

10/21/10 7:52 PMWhy I Am Not Surprised That U.S. Treasury Bond Yields Are Still Very Low Today - Grasping Reality with Both Hands

Page 4 of 10http://delong.typepad.com/sdj/2010/09/why-i-am-not-surprised-that-us-treasury-bond-yields-are-still-very-low-today.html

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 findthat they can charge more and make hire profits and so hire more people...

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

Sokrates: Very true, Adeimantos.

Adeimantos: And what happens as savings rise?

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

Adeimantos: And the economy settles back at its new equilibrium, with (a) somewhathigher interest rates and (b) higher spending and income so that (c) people are happyholding 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--thebond price--that adjusts to match supply and demand in the bond and the moneymarkets...

Sokrates: But there are two quantities that adjust: the bond price and the level ofspending...

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

Sokrates: But which adjusts more?

Adeimantos: Once again back to Hicks (1937). When the unemployment rate is highand the nominal interest rate on Treasury bonds is very very slow, adjustment comesin the form mostly of changes in spending and only slightly in changes in interestrates--the world is then "Keynesian." But when the unemployment rate is normal orlow and the nominal interest rate on Treasury bonds is near its normal levels,adjustment comes in the form mostly of changes in interest rates and only slightly inchanges in spending--the world is than "Classical." That's why the title of the article is"Mr. Keynes and the 'Classics'."

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

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

Meno: That sounds like sophistry...

Sokrates: You should talk...

10/21/10 7:52 PMWhy I Am Not Surprised That U.S. Treasury Bond Yields Are Still Very Low Today - Grasping Reality with Both Hands

Page 5 of 10http://delong.typepad.com/sdj/2010/09/why-i-am-not-surprised-that-us-treasury-bond-yields-are-still-very-low-today.html

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

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

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

Adeimantos: And there is a little bit of empirical evidence that the Hicksian economistsare right. Tim Fernholz http://www.prospect.org/csnc/blogs/tapped_archive?month=06&year=2009&base_name=compare_and_contrast_economic sends us toNelson Schwartz, who writes:

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

Some private economists are even predicting that the American economy willresume growth in the fourth quarter, while Europe’s economy is expected toremain in recession well into 2010, after contracting an estimated 4.2 percent thisyear compared with an expected 2.8 percent decline in the United States. “Theshock originated in the U.S., but Europe is paying a higher price,” said JeanPisani-Ferry, a former top financial adviser to the French government who is nowdirector of Bruegel, a research center in Brussels. Almost from the beginning of thecrisis, the United States and Europe chose largely different paths to aiding theireconomies. The most stark was Washington’s willingness to commit hundreds ofbillions of dollars to stimulus spending — in addition to moving aggressively toshore up banks and keep credit flowing — versus Europe’s worry that similarspending would increase inflation in the future. Just as the policies pursued duringthe Great Depression have been dissected ever since by economists, the fate of theUnited States and Europe as the two regions emerge from the global crisis will beanalyzed for decades to come.....

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

Meno: And the Chicago School economists who say that government borrow-and-

10/21/10 7:52 PMWhy I Am Not Surprised That U.S. Treasury Bond Yields Are Still Very Low Today - Grasping Reality with Both Hands

Page 6 of 10http://delong.typepad.com/sdj/2010/09/why-i-am-not-surprised-that-us-treasury-bond-yields-are-still-very-low-today.html

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 thisat all. If the government builds a bridge... by taking tax money away fromsomebody 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'tgoing to help, we know that..."

What about them?

And the John Cochranes who said:

[W]hile Tobin made contributions to investing theory, the idea that spending canspur the economy was discredited decades ago. 'It’s not part of what anybody hastaught graduate students since the 1960s. They are fairy tales that have beenproved false. It is very comforting in times of stress to go back to the fairy tales weheard as children but it doesn’t make them less false.'" To borrow money to payfor the spending, the government will issue bonds, which means investors will bebuying U.S. Treasuries instead of investing in equities or products, negating thestimulative effect, Cochrane said. It also will do nothing to unlock frozen credit...

What about them?

Sokrates: I, at least, find myself unable to understand them. They say they believe inthe quantity theory of money--that spending is equal to the economy's cash times itsvelocity. And they say that they believe that velocity is interest elastic--that peoplerespond to incentives and spend the cash in their pockets more rapidly when nominalinterest rates are high. They say that they believe that bond prices/interest rates aresuch as to balance saving and investment and make people willing to hold the stock ofbonds.

That's all you need to be a Hicksian.

Yet they also claim that Hicks is wrong, somehow--without giving arguments. I cantrip up and make foolish anybody who makes an argument, but if they don't make anargument I cannot make them look any more foolish...

Brad DeLong on September 18, 2010 at 09:51 AM in Economics, Economics: FederalReserve, Economics: Finance, Economics: Fiscal Policy, Economics: Macro, ObamaAdministration | Permalink

Reblog (0) |

Favorite

| Digg This | Save todel.icio.us | Tweet This!

TrackBack

TrackBack URL for this entry:http://www.typepad.com/services/trackback/6a00e551f0800388340133f459513b970bListed below are links to weblogs that reference Why I Am Not Surprised That U.S. TreasuryBond Yields Are Still Very Low Today:

10/21/10 7:52 PMWhy I Am Not Surprised That U.S. Treasury Bond Yields Are Still Very Low Today - Grasping Reality with Both Hands

Page 7 of 10http://delong.typepad.com/sdj/2010/09/why-i-am-not-surprised-that-us-treasury-bond-yields-are-still-very-low-today.html

Comments

Robert Waldmann said...

Fine on Hicks and boy you made Meno look like a sophist. However, I don'tunderstand your statement about Lucas and Cochrane. Cochrane made an argument --the Tresury view. You had no trouble tripping him up and making him look like a fool.Lucas made a more foolish argument. It's right there in the quoted passage

"there's nothing for the multiplier to multiply" the word "multiplier" is clearly areference to Hicks. Lucas asserts that, according to the IS-LM model (the multiplier) abalanced budget increase in spending has no effect on output. This is a very gross andvery elementary error. A student who made that error would not pass my introductoryMacro course (and I am a very notorious softy -- very notorious indeed and that byItalian standards).

Even if "the multiplier" is not an appeal to IS_LM models, his claim is false for allknown economic models. As you have repeatedly noted, if there is Ricardianequivalence and public goods and private goods are not perfect substitutes, thenbalanced budget spending increases cause increased aggregate demand. Lucas knowshe can't argue that output is at the maximum possible given tastes and technologywithout making people laugh at him not with him. He therefore said something whichhe must know is false.

He has a Nobel memorial prize.

Are you really sure the Sophists lost ?

Reply September 18, 2010 at 01:40 PMOmega Centauri said...Brad, I think you have a PR problem. Your equilibrium model requires the solution ofsimultaneous equations (two in your example), so the equations are implicit. Yetrhetorical argument only is effective with simple explicit relationships (A causes B),and thats it folks. Also, it has to compete with the morality play. The vast majority ofbrains are Amygdala dominated, and the morality play trumps logic, especially logicthat requires the solution of non-intuitive (and hence distrusted) math. When the latercontradicts the simple morality play result, the more emotionally satisying result wins.

Reply September 18, 2010 at 07:37 PMComments on this post are closed.

10/21/10 7:52 PMWhy I Am Not Surprised That U.S. Treasury Bond Yields Are Still Very Low Today - Grasping Reality with Both Hands

Page 8 of 10http://delong.typepad.com/sdj/2010/09/why-i-am-not-surprised-that-us-treasury-bond-yields-are-still-very-low-today.html

Me: Economists:

PaulKrugmanMark ThomaCowen andTabarrokChinn andHamiltonBrad Setser

Juicebox

Mafia:

Ezra KleinMatthewYglesiasSpencerAckermanDanaGoldsteinDanFroomkin

Moral

Philosophers:

Hilzoy andFriendsCrookedTimber ofHumanityMarkKleiman andFriendsEricRauchwayand FriendsJohn Holboand Friends

First, Kill all the PensionsThe Atlantic (blog) - Oct 19, 2010She may or may not have been the first major economics blogger, depending onwhether we are allowed to throw outlying variables such as Brad Delong out of ...Related Articles » « Previous Next »

economics DeLong

10/21/10 7:52 PMWhy I Am Not Surprised That U.S. Treasury Bond Yields Are Still Very Low Today - Grasping Reality with Both Hands

Page 9 of 10http://delong.typepad.com/sdj/2010/09/why-i-am-not-surprised-that-us-treasury-bond-yields-are-still-very-low-today.html

10/21/10 7:52 PMWhy I Am Not Surprised That U.S. Treasury Bond Yields Are Still Very Low Today - Grasping Reality with Both Hands

Page 10 of 10http://delong.typepad.com/sdj/2010/09/why-i-am-not-surprised-that-us-treasury-bond-yields-are-still-very-low-today.html