Is Government Making it Worse? The Evidence Says No
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I appreciate Ewan’s response to my last post on how recessions are like fires that must be put out. But his post has left me confused, and—I’m sorry to say—more convinced that ideological opponents to fiscal stimulus are economic nihilists. Maybe ‘nihilists’ is too strong a word. Let’s go with fatalists.
I call this anti-stimulus position economic fatalism because it holds that the government is incapable of mitigating the length and severity of recessions. Ewan seems to support this view. In fact, he states that government actions only exacerbate recessions, and that it should get out of the way by cutting spending. Essentially he is saying that government should shrink itself, and we’ll just cross our fingers that the private markets will pick themselves up again.
As I understand it, Ewan points to two ways that increased government spending hurts the recovery: rising interest rates and higher inflation. Let’s tackle them one at a time.
Interest rates
Ewan says that with government borrowing, “inevitably the rest of the private economy is starved of the funds it needs to grow.” This assumes the economy is fully utilizing every available dollar of capital out there. But consider the following: Recessions cause an underutilization of labor markets--unemployment is at 10 percent right now--so why can’t they cause an underutilization of capital markets?
The question is then why are interest rates high for businesses? Ewan’s hypothesis is that government borrowing is raising the demand of capital, which raises the price and makes it more expensive for businesses to borrow money (think of interest rates as the price of capital). If that were true, we’d see high interest rates for both private AND public borrowing because demand is growing while the supply of capital is fixed.
So what is the private market charging for loans to the government? Nearly nothing. For example, the yield on a 10-year loan to the U.S. Treasury is a measly 3.4 percent. To put that in perspective, the average between the years of 1958 and 2008 was 6.7 percent, nearly twice what it is now. And only for a single month in those 50 years did it fall to 3.4 percent or lower (April 2003).
But then why is there a shortage of capital available to private businesses? It’s because we’re in a recession! Private capital markets see a lot of risk out there, so they charge businesses a risk premium to compensate. This happens in every recession, and has nothing to do with public debt levels. In fact, the widening spread between interest rates for businesses and those for the government (which started growing when the recession hit, and long before the stimulus was passed) proves that capital markets have become more risk averse. This is why they’re flocking to the ultra-secure U.S. securities.
Inflation
Data on Treasury yields also proves that inflation isn’t a concern. We can compare the price of inflation-indexed securities—which the U.S. Treasury started selling in 2003—to regular securities to determine how concerned the markets are about inflation. Turns out, the spread is actually about seven percent lower than the pre-recession average. In other words, market expectations on inflation for the next 10 years based on recent public borrowing is no higher than it was back in the early part of the decade.
I hate to pick on Ewan here, but the nice story he presented just isn't supported by the hard data.
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Comments
In reply to Ethan Pollack
Mr. Pollack has penned an interesting reply to Ewan Watt's provocative article which, unfortunately, is a bit muddled in its composition. I must say that I am not entirely convinced that Ewan is correct in his assumption that public borrowing will "force out" private sector obligors; it never has but then again,it has always been impossible to calculate the increased cost of borrowing to either party in the face of high demand. There is a cost, however, and that is a certainty. Oh, by the by Mr. Pollack, debt and capital are different things with different costs...but that is merely an aside.
But where is the muddle? There is no shortage of debt funding to the private sector Mr. Pollack, there is a shortage of demand. If there were, Double AA corporate debt would be yielding far above the 40 basis point spread through Treasuries as it presently shows. The economy stinks; corporates don't borrow. Forget about small businesses that seek support through private sources; they don't count for the purposes of this discussion. As for the historically low yield for the 10 year Note, Mr. Pollack seems to give no credit whatsoever to the quite unbelievable liquidity surge created by the Federal reserve and the fact that the Fed, while it has greatly reduced this activity, was the sole provider of short term corporate financing yet still continues to fund, to the extent of at least a trillion dollars, the mortgage market. With no demand and a trillion or so sloshing about every day it is no wonder that interest rates are low.
Will the Fed tighten and reduce this activity? Sure, when is the question. But I would also point out that this mob in Washington has created a deficit that at best count will approach 2 Trillion dollars that will have to be financed. That sort of government competition in the capital markets has never been experienced and should the economy recover (and that is a interpretive phrase) bringing with it a new financing demand, I suspect that we may well see Ewan's prediction--and I consider it to be thus at this stage--come true. And then of course looms the specter of our dear friends the Chinese. Some feel they are in a dollar trap (see: Brainard, L.); I wonder. Treasuries may be ultra-secure, Mr. Pollack, but what good is repayment in the reserve currency that isn't worth anything? The French have always moaned (among everything else) that we have the printing press for the world's medium of exchange. And if some time in the not-too-distant future it isn't? What then, Mr. Pollack?
A final point. You speak of market expectation. The Chinese portfolio of Treasuries (not Agency debt) now has an average maturity of approximately 360 days. And no one is worried about inflation? Think again. Or to put it another way, if the holder of the mortgage on your house had it in the form of a demand note, would you worry? Sleep well.