Friday, February 12, 2010

Whither US interest rates?

Is there a global bond bubble or are we blinded by old habits?

The author of "The Black Swam" recently said on TV that it was "100%" certain bond prices would collapse. Interesting statement from someone whose punch line in that famous book was about the unpredictability of the future. The book was published before the Wall Street bailout and the author became famous precisely he was warning about the uncertain future in the middle of a huge bubble no one saw bursting.

The case for a bubble is straightforward: just look at all the money printed by the major economies, including China, to save the world from Great Depression 2.0.

Yet, interest rates are close to zero. Long bonds have barely moved.

Paul Krugman argues strenously that those, like me, are blinded by simplistic quantity theory of money: more money printed, all others being equal, results in higher inflation.

Krugman believes we are more like Japan in the "lost decade" of the eighties where zero cost money didn't do much, if anything. Economy was stagnant because Japan found itself in a liquidity trap where easy money was irrelevant, What the world needed then and now is more stimulus, forcibly pulling the world economy out of a deep ditch.

To support his argument, there is indeed excess capacity all over the major economies. Stories of mega ultra modern factories in China abound. Savings rates in the US have been moving up, meaning folks are not spending. No wonders. A large number of Americans, save a handful on Wall Street, are flat broke.

Feeble private demand and excess capacity do not an inflation make. Hence, there is no bond bubble, if you follow this logic.

So, what gives?

Niall Ferguson, a fabulous English writer, a celebrity multi-millionaire talking-head on TV and a respectable historian, now a professor at Harvard B School, is not an economist. In fact, definitely he is not one of my favorite economists either.

However, sometimes it pays to listen to someone with a historical perspective even though Krugman, the Nobel winner and august professor at Princeton, has only contempt for Ferguson, the "fake" economist properly schooled only in historiography.

Trained as an economist myself, I am among the first to admit economists do not always have the correct answers on economic issues even if they speak with the air of authority honed by years of precision, mathematical logic.

This is why I want you to think about this particular excerpt by Ferguson here:

..."For the world’s biggest economy, the US, the day of reckoning still seems reassuringly remote. The worse things get in the eurozone, the more the US dollar rallies as nervous investors park their cash in the “safe haven” of American government debt. This effect may persist for some months, just as the dollar and Treasuries rallied in the depths of the banking panic in late 2008.

Yet even a casual look at the fiscal position of the federal government (not to mention the states) makes a nonsense of the phrase “safe haven”. US government debt is a safe haven the way Pearl Harbor was a safe haven in 1941.

Even according to the White House’s new budget projections, the gross federal debt in public hands will exceed 100 per cent of GDP in just two years’ time. This year, like last year, the federal deficit will be around 10 per cent of GDP. The long-run projections of the Congressional Budget Office suggest that the US will never again run a balanced budget. That’s right, never.

Read the entire article here. It provokes thought, if nothing else.


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