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A Prediction

Within one year from this date, September 21, 2008, US 5 Year Treasury Bonds will be paying at least 6.5%. That is more than double today’s yield of 3.05%. This will place a huge burden on the Federal Treasury as it struggles to pay skyrocketing interest rate costs, and it will raise the borrowing cost for everyone else to crippling levels. All in all, by this time next year government officials will be wishing they had today’s problems.

I say that knowing that it is generally foolish to make predictions. But sometimes the future seems so obvious that it is hard not to. When you see dark clouds coming over the horizon, you feel safe predicting rain. When you see a match being put to dry grass, you feel safe predicting a fire. I feel a similar level of safety predicting that the US Government will soon have to offer an interest rate of at least 6.5% to attract bids on its bonds.

To understand why I feel so safe, you need to understand how marginal changes in supply or demand can produce huge swings in price in the short term. In other words, a 1% drop in supply can produce a 10% rise in prices. A 1% drop in demand can produce 10% drop in the price. To understand why this is so, let us conduct a little thought experiment.

Let us say that we have four different people buying apples from four different sellers for a dollar each. Let us say that each seller only has one apple to sell and each buyer only wants to buy one apple. Now let us imagine that one guy decides that he does not want to buy apples anymore. What is going to happen? Well, one apple seller is no longer going to make a sale. What determines who no longer makes a sale? The highest price at which one of the apple sellers is no longer willing to sell his apple.

Let us say that one apple seller is willing to sell his apple as low as 69 cents in order to make a sale, another 73 cents, another 84 cents, and another at 90 cents. The price that the remaining three apple buyers are going to pay for their apple is 89 cents. That is because three of the apple sellers are willing to sell for that price and one is not. Thus, even though the three remaining apple buyers are still willing pay a buck for an apple, they will only have to pay 89 cents for it (the two apple sellers who were willing to sell their apples for less will get still get 89 cents for them because why charge less if you don’t have to?)

(Edit: It was suggested that I make clear that I am assuming price discovery here. In other words, the apple sellers keep lowering their prices until one seller drops out. The buyers have no idea which seller was willing to sell for 69 cents if necessary. All they know is that at 89 cents there are only three apple sellers. Since each of the three buyers want an apple, that is all they need to know)

We can make this example even more extreme. Let us say that every apple seller has to sell their apple today or it will go bad. Since only three people are left who want to buy apples, one person is going to have to take a total loss. No apple seller is going to want to be the one who takes a total loss. So the price for apples will drop to almost nothing. The apple seller who is farthest away from giving his apple away will be the one who takes a total loss. The other three apple sellers will make something, but they also will take high losses. In order to not be the one who takes a total loss, they will have to sell their apple for far below cost.

The same thing works out in reverse if one of the apple sellers drops out and four people still want to buy apples. If one buyer is willing to pay $1.50 another is willing to pay $1.33, another $1.23, and another $1.10. The price that is going to be paid for the apples is $1.11 even though the three apple sellers were perfectly happy when they were just getting a buck.

(Edit: This one really confused some people. Again, I am assuming price discovery. The sellers keep raising their prices until one buyer drops out. Since all three remaining apple sellers want to sell their apple, that is all they want to know. They don’t know that they can raise the price all the way up to $1.23 and still all make a sale and they are not about to take the risk of raising prices even more and causing another buyer to drop out. After all, they were only getting a dollar an apple before. Some gain is better than running the risk of getting nothing.)

Again, we can make this example more extreme. Let us say that all the apple buyers are on the verge of collapsing from hunger. If they don’t get an apple, they are all going to die. What are these guys going to pay to insure that they are not the one without an apple? Let’s just say that it sucks be the guy with the smallest net worth.

One bad thing about the above thought experiment is that a 10% price swing as a result of 25% of the buyers or sellers dropping out of the market is not really a big swing. So it makes the non-extreme version of our thought experiment seem kind of silly. The important thing to realize is that it would not matter if there were 1000 sellers and 1000 buyers. One buyer dropping out could still cause 10% price swing even in a non-extreme scenario.

The reason this is so is also the reason why this only holds true in the short term. You see, the cost of making something has no effect on its price in the short term if it is perishable. You have to sell an apple pretty soon after you produce it, otherwise it is worth nothing.

Thus, if even one person in a thousand stops buying an apple, there is going to be a huge price war amongst the 1000 sellers of apples (we are still assuming that all apple sellers only sell one apple). No one wants to be the fool who didn’t sell his apple. It is possible that the price of an apple will fall below the price of price of producing an apple just because that one person out of a thousand decided not to buy one. This is not likely in real life because lower price tends to create more demand, but it could happen if the conditions were right.

The same thing is true even of things that we don’t think of as being perishable such as cars or toilet paper. The longer a car sits around on a lot, the less it is going to be worth to your buyers, and the more expensive it become for you—you have the expense of storing the inventory.

It is easy to understand why sellers would have to drop prices sharply in the face of a small drop in demand due to the perishable nature of their product. But why would a seller have to bid a product up sky high just because of a small shortage?

One only needs to look at the recent run up in gas prices as a result of Hurricane Ike. The amount of refinery capacity lost in the storm is likely to be small and temporary. But who is going to cut back on their consumption of gas? Just as in our thought experiment, prices are rising quite a bit on a marginal reduction in supply.

Having said all that, it must be admitted that such price swings are quite rare even in the short term. This is because there is rarely one product that you need to buy, or only one way in which you can sell a product. You have to eat to live, but there is a wide variety of things to eat. If apple prices fall, you might eat more of them relative to other fruit. If apple prices rise, you might eat less of them relative to other fruit. These actions moderate the price swings.

The lessons from our thought experiment have greater applicability to things that have no good substitutes and yet people cannot easily do without them. As I noted before, gasoline would be one such example. You can’t put anything else in your car and yet you need to be able to drive your car. When the price of gasoline doubled in a short amount of time, people did not cut their driving in half. In fact, there was a relatively marginal drop in the amount of miles driven. At the same time, if you cut the price of gas in half, it is unlikely that people would drive twice as much as they do now. In other words, it takes very large price spikes to produce a small drop in the demand for gas in the short term. Conversely, it would take a large drop in gas prices to produce even a modest spike in demand.

But there is another thing that we all need that behaves a lot like the apples in our thought experiment, and that is the price of real money. Since real money is finite and there are no good substitutes, it can experience sharp short term swings for the same reasons that gasoline does.

To understand why this is so, we need to be clear on our definition of real money. When I say real money, I don’t mean gold, like certain people do. Rather, I am talking about the inflation-adjusted value of money. I use the term real money because the value of money comes from what it can buy, not what it is. It does not matter if you have a hundred dollars now or a thousand dollars later if they both buy the same thing (including opportunity cost and other such things, you would actually be better off with the 100 dollars, but those issues don’t really pertain to this essay).

Since the value of money comes from what it can buy, it stands to reason that you cannot define the cost of money without adjusting for inflation. For example, if inflation was running at 3% and you borrowed 100 dollars from Bob and paid it back a year later it would have cost Bob 3% of the purchasing power of those 100 dollars to let you have the money. On the other hand, if you had paid Bob back 106 dollars it would have cost you 3% of purchasing power of those 100 dollars for the privilege of borrowing the money. By extension we can say that when you have to borrow money at 6% when the inflation rate is only 3% you are paying a higher price for money than if you borrow money at 12% when inflation is running 11%. That is because you are giving up more purchasing power in former case than you are in the latter.

Once we understand that the value of real money comes from what it can buy, you can understand why it is a finite resource. There are only so many goods and services available to buy, hence there is only so much real money available.

Of course, it is not quite as simple as it appears. I have seen people use the principle outlined above to argue that real money growth can never exceed Gross Domestic Product. They look at whatever their preferred measure of money is (whither it is M1, M2 or whatever) and they say: “O my, money supply is growing faster than GDP. Inflation must be just around the corner because inflation is always a monetary phenomenon.”

The idea seems logical. GDP represents all the goods and services produced in a country so it seems to stand to reason that the money supply cannot increase faster than GDP without losing purchasing power (i.e., create inflation). What people tend to forget is that GDP represents everything that is produced in a country. It does not tell what you can buy in a country. And it is what you can buy that sets the value of a dollar.

In other words, if you run a trade deficit, you have more goods and services in your country than you produced. This means that you can buy more things in your country than you could if you were not running a trade deficit. Since the value of money comes from what you can buy with it, we can say that you increase your supply of real money by running a trade deficit.

Counter intuitive as it may seem, how many goods you can make in your country has no effect on the amount of real money in a country. Rather, it is how many goods that people are able to purchase in a country that sets the value of money in a country. In practice, what a country can make and what it can buy are connected. But it is important to remember that it is not the whole story.

This is a concept that a lot of people don’t get. They think that when you pay for an import with dollars that the money is somehow leaving the country. But this is a totally backwards way of looking at a trade deficit. A country that runs a trade deficit is increasing the amount of real money in its country because more goods are entering the country than leaving. A country that runs a trade surplus is shrinking the amount of real money in its country because more goods are leaving a country than entering.

The ability of a country to increase its real money supply by running trade deficit is a key factor in keeping the price of money from making sudden changes. If there is a sudden spike in the demand for real money in one country, it can run a trade deficit with other countries. The trade deficit increases the supply of real money and keeps the spike in demand from driving up the price of money as dramatically as it would have otherwise.

For example, if the US had not been able to run a trade deficit during the Reagan defense buildup, interest rates for the average American would have gone through the roof. This is because Reagan’s defense buildup increased the demand for money. If there had been no increase in the supply of real money during Reagan’s defense buildup, the price of money would have gone up. But since the Japanese were willing to loan us huge amounts of money, the average American consumer was relatively unaffected.

I want to stress again that the only way Japan could get dollars to loan is if they first sold goods to the US for dollars. Only in this way could they create extra real money to loan to the US. That is why the Japanese ran a huge trade surplus with the US in the 80’s. Anywhere you see trade deficits created you will also see a sharp rise in the demand for money in the countries that created them. This is what keeps the price of money from making sharp swings.

Of course, this process does not always create stability. The currency crisis of the so-called Asian Tigers in the late 90s was caused in large part by reversal of this process. Investors suddenly got scared that the Asian Tigers would not be able to pay back all that they owed. As a result they stop exchanging goods for the currencies of the Asian Tigers. This forced the Asian Tigers to turn their trade deficits into trade surpluses. In other words, they went from growing their supply of real money through trade to shrinking their supply of real money through trade. This caused the interest rates (the price of money) in those countries to soar and threw the various economies of the Asian Tigers into severe recessions.

It has been argued that the same thing is unlikely to happen to the US. The Asian Tigers were small countries dependent on narrow selection of exports for their economic growth. The US is a big country that has a broad array of economic strengths. The Asian Tigers had fixed currency exchanges that depended on government support. When those governments ran out of money to support the currency, its value went into a free fall. The US has floating currency that does not depend on US government support for its value.

I am not inclined to argue with such a view although I do I take issue with the idea that US currency is a free floating currency. How can it be when four governments acquired close to a trillion dollars of reserves in one year? If that is not government intervention in support of a currency I don’t know what it would look like.

But when that support will stop, much less reverse, is anyone’s guess. Besides, the US is borrowing in its own currency from foreign political entities where as the Asian Tigers were borrowing in a foreign currency from commercial entities. So I think it is dangerous to try to draw too many parallels between the current account deficits that the Asian tigers ran and the current account deficit that the US has been running.

However, the speed at which interest rates changed during the Asian Currency crisis should alert us to the importance of trade deficits in setting the price of money. This is an important thing to keep in mind because we can confidently say that the US trade deficit will not increase beyond its current annual levels. And that has big implications for price of real money in America.

We can be confident that the trade deficit will not increase beyond the current annualized level because it is hard to sell anything to a country in recession. In an economic downturn, people use less fossil fuels. They buy fewer toys from China. They don’t shop as much. For this reason the trade deficit has shrunk in most of America’s recessions. (I would say all, but there could be an exception I am unaware of.)

As a result, capital inflows into the US are unlikely to increase beyond their current levels unless the US economy has some strong growth. To put it crudely, the rest of the world can’t loan America more dollars if no one in the US buys their products. That means that real money growth in the US from the trade deficit is stuck at around 60 to 65 billion dollars (as they are currently valued, the nominal amount could increase) a month in the best case scenario. Annualized, that is 780 billion dollars of real money growth coming from overseas over the next year.

Of course that figure is wildly optimistic. The more likely scenario (and the one that is more consistent with the historical record) is that the trade deficit will shrink somewhat over the coming year. That means we would have less real money flowing in from the outside world then we have grown accustomed to receiving over the last couple of years. But I am trying to be as optimistic as possible here.

The only other way for the real money supply in the US to grow is for GDP to increase. At best, GDP growth is unlikely to increase faster than it did over the last year. So in the best imaginable scenario, GDP growth will contribute 200 billion dollars (at today’s value, not nominal) to real money growth over the next year.

Again, I doubt GDP will grow at the same rate it did over the last year. In fact, I think we will be lucky to grow GDP at half the rate it grew last year. But again, I am trying to be as optimistic as possible.

If we add up all of our wildly optimistic figures, we get 980 billion dollars. That is a big increase in real money. In fact, I can’t bring myself believe that figure is in any way realistic. But let us try real hard to pretend that it is. Let us say that we will have an increase in the supply of real money to the tune of 980 billion dollars. What will the increase in the demand for real money be like?

If you want to get technical, growth in the demand for real money cannot exceed 980 billion dollars. Supply and demand must always balance out. But we can forecast what the demand for money would be like if the current price of money stayed the same. That would tell us if the price of money needs to rise to balance out supply and demand.

Since we only figured the optimistic projections for an increase in supply of real money, it is only fair that we only figure optimistic projections for demand of real money. Therefore, we have to figure all projected government borrowing or increases in taxes as increased demand for real money. We also have to figure on whatever money is needed to deal with the current financial crisis as being increase in demand.

All new government borrowing (as opposed to rolling over existing debt) must be counted as increased demand because over the last year the private sector (households and private enterprise) spent almost as much as it saved. This means that government borrowing has to be funded by flows of capital from overseas or the increase brought about by GDP growth.

We say this even though it is likely that the private sector will cut down spending and investment in order to save more. This would cut down on demand for real money and enable the private sector to fund some government borrowing. However, this would also cut down on the trade deficit (since people have to spend money to buy things from overseas) and GDP growth (since you have to invest to get growth). In other words, any cut back on spending or investment by the private sector will shrink the supply of real money as well as demand. Thus, the fact that it is likely to happen does not affect my overall point.

Increase in taxes should also be figured in as demand for real money because they must take away money from current economic activity or they will be funded by an increase in real money supply. If they take away from current economic activity they will reduce GDP growth and thus reduce the supply of real money. Since we are thinking happy thoughts and pretending that GDP growth will not go down, we will figure an increase in taxes as an increase in demand for real money, not a reduction in supply. But in practical terms it makes no difference which way we choose to look at an increase in taxes.

The money needed to deal with the current financial crisis needs to be counted as an increase in demand for the same reasons that an increase in taxes is counted as an increase in demand. The money to recapitalize banks, insurance companies, and the Agencies has to come from somewhere. It will either take money away from current economic activity or it will increase demand for the money.

I figure the money needed to take care of the financial crisis separately from government borrowing because I don’t want to presume on how the recapitalization is going to occur. Besides, I want to breakdown all my assumptions as far as possible so that other people can judge for themselves how wildly optimistic I am being.

With that being said, let us look at projected demand for money.

The federal government is going to borrow at least $600 billion dollars next year to finance its operations. That figure is higher than the $546 billion figure that the Congressional Budget Office is projecting, but they had to smoke a lot of crack to get that number. Besides, they are basing their projections on current law. Both presidential candidates have already promised new stimulus packages and Obama has promised he won’t repeal Bush’s tax cuts until the troubles are over. So I think that even the $600 billion figure is wildly optimistic.

The State governments are going to need about 50 billion dollars in additional borrowing or higher taxes. Again, this is slightly higher than projections, but it is also wildly optimistic.

The cities, counties, school districts, and other forms of local government are also going to need money. I don’t have any figures on what they are going to need all told, but I think 25 billon dollars sounds about right. After all, it is only half the figure that the states are going to need. And the very idea that local governments will only need half of what the states need sounds wildly optimistic to me. It seems to me that local governments are in worse shape then state governments.

Next comes the money needed to bail out the Agencies (I should put this figure in with the total federal budget deficit, but they are not budgeting for it. They just said they would do it.) I figure the Agencies will cost the feds at least 60 billion dollars next year. I have seen all sorts of projections for what bailing out the agencies will cost in total, but no one wants to break it down by year. Since one of the lowest total figures that I have seen was 300 billion dollars I think that figuring the Agencies will cost feds 60 billion next year is a properly wildly optimistic guess.

And last but not least comes the money necessary to plug the holes in the financial system. This is the money that will be needed to cover any additional sub primes losses (figured at 100 billion for next year). This is the money that will be necessary if one (or all) of the big three auto makers go bankrupt. This is the money that will be necessary for any FDIC action in response to a failed bank (when FDIC sells off the bonds in its reserves to finance a takeover someone has to buy them). This is the money necessary to cover all the credit card debt that is going to go bad. Given the fact that Feds are trying to come up with 75 billion just to rescue one company, I think that 300 billion is a wildly optimistic figure. (Edit: I wrote the above before Paulson came out with his plan to bail out the banking industry to the tune of 700 billion dollars. As I said, I was being wildly optimistic.)

If you add this all up you get 1.03 trillion dollars of additional demand for real money. That is 50 billion dollars more than our additional supply figure. Of course, this unbalance cannot actually exist. Price has to balance out supply and demand. So the price of money is going to go up for everyone until 50 billon dollars worth of demand drops out.

We can be fairly certain the Federal Government will not be the one priced out of the market. What is more, the Federal Government seems determined to stand behind many of the weak players in the market.

So it will not be the agencies that reduce demand. Nor is the banking system as a whole likely to reduce demand by much. The Fed seems determined to prop up the banking system as a whole.

Granted, the Fed has let a few of the players go bust. But even when institutions in the financial sector go bust, demand for real money is not reduced by much. Part of the reason for this is that those institutions that have deposits insured by FDIC actually increase demand for real money when they go bust. This is because the FDIC has to raise money to cover the losses that would impact the insured funds. (The FDIC has a trust fund that it has yet to exhaust. But all that trust fund has in it is treasury bonds that they have to sell in order to raise money. This is the same as new government borrowing hitting the market). Even in busts where there are no insured deposits (such as in the case of Lehman’s) the government has given out huge amounts of money to make sure losses did not spread to counter parties.

The Federal Government is also likely to backstop the states in a pinch. How can they say that AIG is too big to fail and turn around and let the State of California go under? If one state fails, it is likely to snow ball as financing costs for all other states soar. The Federal Government is likely to do whatever it takes to prevent this.

So the only ones left to be priced out of the market for money are the healthy parts of the US economy. And though it may be hard to believe, there are still plenty of healthy companies with strong balance sheets in the US. No one will understand the cause and effect if they don’t expand as much as they otherwise might have. Thus, pricing the healthy parts of the US economy out of the capital markets will be the least bad choice, politically speaking.

Right now, the healthy parts of the US economy and the Federal government do not compete with each other for funds. The healthy parts of US economy draws there funds from people and institutions who invest their money with the intention of making more money. The Federal government borrows money primarily from central bankers who invest based on political needs. It is as if the Feds and private sector exist in two different capital markets.

But when the Federal government exceeds the ability of Central Banks to finance its wants, it will have to directly compete with the healthy parts of the private sector for financing (the healthy parts being any sector of the economy that the government is not bailing out). The question is, what will the Feds have to pay to drive 50 billion dollars worth of demand out of the private market?

Since the US economy has a historical real growth rate of around 3%, I think that it is reasonable to think that the healthy parts of the US economy will be able to offer up a risk adjusted real return of 3%. In other words, if you spread your money out amongst the various healthy parts of the US economy you would make 3% real return. This is because some people will go broke even in the healthy parts of the US economy where as others will pay out a greater than 3% return.

Thus, I think that that the Federal Government is going to have to pay a 3% real rate of return in order to price out significant parts of the healthy economy. If you figure a 3.5% inflation rate (which below our current CPI rate, which is currently trending at about 4%) you get a figure 6.5%. That is the yield that Fed is going to have to offer.

Keep in mind the fact that most federal debt is short term. So soon all federal debt will be paying 6%+ for the same reason that one apple seller dropping out caused the price of all apples to rise. This rise in the federal interest rate will cripple federal finances and destroy its ability to do anything useful.

A lot of very smart people are trying to fool themselves into thinking otherwise. They look at the very low interest rates that the Fed currently has to pay on its bonds and they look at the sharply increasing rates the corporations have to pay on their bonds and they see an opportunity for arbitrage. They think that if they use the low interest rates that the treasury has to pay to bring down the rates that the corporations have to pay, then everything will fix itself.

But arbitrage always has one result. It causes the prices of two separate financial instruments to act as if they were one. How will it help the underlying problems that America faces if the interest bill for the federal government goes up even as the interest bill for the private sector holds steady? How will it help the underlying problems in America if the Federal government takes capital away from healthy companies and gives it to failing companies?

In reality, it is not as simple as I have made it sound. For one thing, just because the historical rate of return for the US economy is 3% does not mean that a business can make a real return of 3% today. On the other hand, the healthy parts of the US economy have long had a rate of return that was far better than 3%. The average rate of return comes from adding in wasteful government spending and failing industries to the mix. Since the US government seems bent on propping up the borrowing of the unhealthy parts of the US economy, it seems reasonable to imagine that it is going to have to price out the healthy parts of the US economy.

The long and the short of it is that I could write another essay defending the idea that the Feds are going to have to pay at least a 3% real return. But one should not get too hung up on the absurdly precise figures that I have been using. I use them only to discipline the mind.

I use to get frustrated back in the 90’s when I use to argue with people about whether the stock market was overvalued. I never could get the people I was arguing with to put numbers to the assumptions they were making to justify the then current stock prices. They would use words like “revolutionary change” and “ground breaking technologies” but they would never put numbers on what they thought those words meant. To do so would have been to paint a picture of the future that was so absurd even they could not believe it.

I have put real numbers on an optimistic view of the future to demonstrate that real interest rates are going to rise over the next year no matter what. There is no way to prevent this from happening. Many households, local governments, and private business have so much short term debt that they will not be able to stay solvent as real interest rates rise. There is nothing anyone can do to stop this from happening. It does not matter if they inflate the money supply. It does not matter if they cut taxes. It does not matter if they bail out select banks. People are going to go broke in large numbers.

Therefore, the focus should be not on prevention but on preparing the road for recovery. We should not look at a sharp contraction in US GDP as being the worst of all possible fates. It would be better if GDP shrank by 20% next year and then increased at 3% compounded over the next 10 years then it would be for the US economy to shrink by 3% for the next 10 years. Yet the best policy makers can hope to achieve with their current policy of robbing Peter to pay Paul is the latter scenario.

2 Responses to “A Prediction”

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