This is the third and final part in a series of three posts on America’s debt story. A quick recap:
- In Part 1, I explained the events that made me question the collective concern with America’s debt;
- In Part 2, I wrote about the two main arguments that go against the traditional “America has too much debt” narrative; and
- And in this last part, I want to talk about low interest rates, QE, and how that has changed the world we live in. Also, I want someone to tell me the difference between long term debt and a wealth tax.
As I said at the end of Part 2, even if you’re going to be fine with the overall debt level per se, that’s not especially comforting when you start wondering whether the US can afford to pay the interest on its borrowings.
It’s all great now, after Quantitative Easing (QE), when interest rates are near zero. But what happens if those interest rates go up in the future? Won’t that mean that the US will struggle to repay its debt servicing costs?
And how do we deal with other facts like:
- Trump wants to implement tax cuts (which, by [literally] all accounts, will increase the borrowing requirement while decreasing the ability to pay the interest); or
- The fact that many of the welfare programs (like Social Security and Medicaid) are at risk of being underfunded.
So I’m going to start with this issue of higher interest rates in the future, and then talk about those second two.
The Low Interest Rate Era
Even if you think that current interest rates are as low as they are due to the great QE experiment. the yield rates on US treasuries were already in steady decline going back to the mid-1980s.
I’d suggest two related reasons for this.
Firstly (and least importantly), I want to suggest that investment returns have an underlying connection to economic growth. It’s not something that you hear said out loud very often, but I think that the economic growth level sets the baseline for investment returns, and then risk compensation levels adjust around it.
An example of this in practice: South Africa’s bond yields today are significantly lower than they were in the early 2000s (back when South Africa was being re-rated upwards out of junk status). But even though we have greater economic risk today, our bond yields remain lower than they were then. At the same time, our current (and forecasted) economic growth is also lower than it was in the early 2000s. For my money, those two are related.
And all that is my long-winded way of saying: US government yields are linked to US economic growth – and given that US economic growth has slowing for a while, yields have also been falling.
Secondly (and more importantly), I think that we can’t ignore the impact of financialisation. As the financial industry has grown, it has become much better at monetizing things. Let’s not forget that the first mortgage-backed security was created in the late 1980s! The ability to monetize traditional investments, alongside globalisation and the tech-communication evolution, has given us a world in which capital is incredibly mobile. It has also resulted in a lot of capital creation (at least in nominal terms). And this has created return squeeze, because there is a lot of capital out there searching for a home.
And this is a real problem.
Poor Richie Rich and his worsening Investment Constraint Crisis
Since even before QE began, I would hear a lot of rich people asking “Where should I put my money? Bond yields are negative. Stocks are too risky. Property is illiquid.” I realise that this is anecdotal – but I don’t think that it’s isolated. If you were asking for empirical support for it, I’d be pointing to Thomas Piketty’s work – because this looks to be the other side of the wealth inequality story. Piketty may complain about the problem from a tax evasion perspective – but this type of inequality is a problem for the wealthy as well.
Let me try to explain the thinking here:
What is wealth? It’s unspent disposable income (ie. savings).
Where do the savings go? Into investments to earn returns.
What drives those returns? Spent disposable income (ie. profits off that spent income).
What happens when unspent disposable income (wealth) starts to concentrate in the hands of the wealthy? Lower consumption.
So what happens to those investment returns as a result? They fall.
In my mind, this is the big capitalist/free-market problem that we’re currently facing. Wealth is a kind of blockage in the flow of money. If the wealthy could consume in proportion to their wealth, then perhaps we’d have less of an issue. But instead, as the rich grow richer, they reach a point where they can’t really consume any more. They have all the toys, holidays and expensive food that they want. And their spending ‘hobbies’ turn out to be investments in consumptive disguise (collecting cars, watches, holiday homes, contemporary art and wine). And so the game turns into one of trying to deploy wealth, rather than simply finding ways to consume it.
This reality also supports the Krugman idea that the asset-owners (or US bond-holders) do not want the bonds to be repaid – they need them to house the capital that they’ve accumulated.
If we accept that idea – that the rich have an investment constraint that works in the opposite direction to the budget constraint of the poor – then I’m not sure that we can expect the world to ‘naturally’ return to a state of higher interest rates. If anything, the natural state is one of very low base interest rates, because the rich will bid down returns by bidding up asset prices in their hunt for capital allocation. And that hunt has gone beyond national boundaries, and now works at a global level.
You might say that this could be disrupted by some kind of massive global financial shake-up – either through unexpected real economic growth or (more likely) through economic crisis – which may result in a temporary elevation in returns. But the crises that we’ve seen so far haven’t caused that (or haven’t been allowed to cause that).
Which brings us back to Quantitative Easing (QE).
The Artificially-Lower-Than-Low Interest Rate Era
So what did Quantitative Easing really do?
Well, QE just accelerated and exacerbated this capital allocation issue. With QE, the Federal Reserve acquired a big chunk of the US government bond market, and removed it from play. And the capital that was released from its holdings in US treasuries had to find alternative homes. So where did it go? Well, that’s the trillion dollar question, because the US treasuries market is one of the few markets that would have been large enough to have soaked up the extra liquidity floating around. Only, that market was already being disrupted by the buying activities of the Federal Reserve.
So the capital had to go elsewhere, and it flooded into other large markets, resulting in asset price inflation (in equity markets, emerging markets, bond markets etc). And because these things are inversely related, elevated asset prices drove down returns in those markets. And this hasn’t really changed yet.
Now we find ourselves in a situation where returns are low across the asset spectrum, historically speaking. And even though QE has notionally been over for a few years, not too much has changed.
And this is where the bubble-forecasters are going to town. They’re looking at historical relationships between earnings and asset prices, and shouting “WE MUST BE IN A BUBBLE!” But I’ve read their justifications, and they only talk about QE in the past tense. For them, it appears as though Quantitative Easing happened, tapered and ended – and now that the distortion is over, we can go back to looking at our neat historical relationships that we saw in the 1990s and 2000s.
The problem is: we live in a completely different world. And it’s a world that’s unlikely to change until the Fed starts to unwind its balance sheet.
Of course, the Fed’s balance sheet will be unwound eventually: whether it’s through the direct-selling of the Fed, or through the slow attrition of time as the US government repays those long-terms bonds. But that unwinding process is within the Fed’s control. Which means that the QE experiment isn’t really over – it’s still in progress.
Given the ongoing-impact of QE, as well as historical rates trends, I suspect that we’re in for low American interest rates for a while yet.
More importantly, they’re the rates that any new bond issues are getting. So when the US government releases new bonds in order to replace old bonds that are expiring, those low interest rates are locked in by the US government until the new bonds expire.
A different question: is debt a kind of indefinite wealth tax?
So I want to ask a different question about the sustainability of America’s debt: if a bond-owner does not want his bond to be returned to him in cash, and he is happy to accept yields that are near zero in order to keep it that way, are we even talking about debt anymore?
Let me re-frame that as a more domestic example. Let’s say that my parents give me $1,000 that they don’t need me to be repay. In return, they want me to pay them a notional annual interest payment of $20 per year. But I can also borrow back that $20 from them any time I like. And as time goes on, they keep giving me these $1,000 checks, with progressively lower notional annual interest payments. Would you call that unsustainable for me? And actually, would you even call that a loan – or is it more of a gift in disguise?
I know the question is controversial.
But the more I think about the circular flow of capital, the more sovereign debt just seems to be a kind of voluntary tax paid by asset-owners to the fiscus. They have the right to trade it between themselves, yes. And they have the right to add their return back to their original voluntary payment. But they’re also doing it with progressively less expectation that it will be re-paid. And they don’t seem to mind earning only a notional return.
As for those underfunded liabilities…
If there is concern about the welfare liabilities being underfunded, then the US government should be issuing more bonds today. Interest rates are low, the market is keen for assets to invest in, and there is a chance to lock in the funding of those liabilities at these historic lows.
And as for the tax cuts…
Won’t these tax cuts just free up more capital for the wealthy, which then needs to be homed somewhere?
And that somewhere will include the new US treasuries that are issued to cover the tax-cut shortfall?
And isn’t the difference between that and ‘tax’ just some wordplay and a slight yield?
Rolling Alpha posts about finance, economics, and sometimes stuff that is only quite loosely related. Follow me on Twitter @RollingAlpha, or like my page on Facebook at www.facebook.com/rollingalpha. Or both.