This is a random idea that is almost surely wrong. And if it is wrong, it will be wrong in a way that seems obviously stupid. So don’t expect me to stick with it.
Without blaming Nick Rowe, I started thinking about this when he wrote,
By “secular stagnation” I mean “declining equilibrium real interest rates”.
Most explanations of secular stagnation say it is caused by a rising desire to save and/or a falling investment demand. Call this the “Saving/Investment Hypothesis”.
But there are lots of different real interest rates. For example, the real interest rate on Bank of Canada currency is around minus 2%. (That currency pays 0% nominal interest, and the Bank of Canada targets 2% inflation). But people are willing to hold currency, despite that, because it is very liquid. But all assets differ in their liquidity. More liquid assets will have a lower real yield than less liquid assets. And if an asset becomes more liquid over time, its real yield will fall over time.
What if there is a sharp rise in the supply of government debt? The standard view is that this tends to raise interest rates, as debt absorbs more savings.
The alternative view I am putting out there is that government debt offers liquidity (in the limiting case, think of it as a very close substitute for money). If the supply of liquidity goes up, then there is less demand for banks to manufacture liquidity out of risky assets. The public wants fewer deposits backed by loans on fruit trees and instead is happy to hold mutual funds containing government bonds.
The result is fewer fruit trees planted. We would observe a decline in interest rates on low-risk assets and an increase in interest rates (or a loss of credit availability altogether) for risky investment projects.
Think of this as government debt crowding out private investment, even though the interest rate on safe assets, particularly government debt itself, can remain low and perhaps even fall as the crowding out gets larger. Again, this is probably wrong.
First, we aren’t at equilibrium so more government debt at this stage won’t increase rates. Second, more government debt now could reduce real risk rates by increasing growth expectations. Third, even if we were or when we will be, increases in government debt less than the economic growth rate are fiscally contractive. Fourth, it is the difference between the increase in government debt and the increase in desire for liquid assets. There is no sign this desire is lessening and there are reasons to believe it will increase, demographics among them. Fifth, risk rates are mainly about risk, so unless and until government rates increase, risk rates won’t either. The tradeoff is between money and government debt rather than riskless and risk investments until then.
Yup. This is another way of looking at why net debt issuance (i.e. fiscal policy) doesn’t crowd out private spending in a liquidity trap.
A related citation is Woodford AER (1990), “Public Debt as Private Liquidity”.
I think the standard view comes from increasing government consumption absorbing more savings.
What we are seeing is that a post bubble more risk-averse economy results in large decreases in private consumption and business consumption/investment that results in decreasing real interest rates.
The post bubble environment also causes decreasing asset prices and bank panics.
This leads to large reductions in tax receipts and increased government purchases of bank assets. Both of these increase the supply of government debt without reducing private savings.
I think of government debt as much more of an effect than a cause.
It makes sense, as far as I can understand it.
But if there are less fruit trees planted, (and more “risk free” debt issued) who are they going to get the future money from? Debasement, right?
So why would the market accept this? Or is the market being irrational?
To minimize distortions, shouldn’t they use the treasury revenue to subsidize bank lending?
If they plant fruit trees that is basic fascism. If they build unneeded infrastructure that is Japan. If they prop up consumer spending…how would they even do that?
I suggest the causal relationship works in he opposite way.
Investors quite planting fruit trees because their animal spirits are low. This causes low growth and an increase in the federal deficit. But this is OK , because when the economy is weak and investors are fearful of investing they want risk free or low risks assets which the increased government debt provides.
Remember, every time we have a Republican administration the Wall Street Journal Editorial Page takes great pleasure in pointing out that the federal deficit and interest rates have a negative correlation. It is true because the increased federal debt is accompanied by an even larger drop in private debt so that total debt –at least as a share of GDP –falls.
Nick has it almost right, but just enough of a not-right perspective to get to some incorrect questions/conclusions. Beginning with Nick’s …
“More liquid assets will have a lower real yield than less liquid assets.”
That is correct, but I would phrase it differently in order to start with a slightly different perspective …
“Investors will pay a premium for the liquidity characteristic of an asset.”
(Which of course leads to higher prices/lower yields for more liquid assets, as Nick phrases it.)
Where Nick (and others) kind of gets it wrong, and my equivalent phraseology may help, is reflected in his question 4.,
“Is it plausible that houses and farmland have become more liquid over time, so that the Liquidity Hypothesis can explain falling rent/price ratios too?”
What is missing is the understanding that houses and farmland* are inherently highly illiquid assets – they can only be traded, and their “market value” is only relevant, within the geographical market in which they exist. They are geographically illiquid assets. And that illiquid characteristic of those underlying assets never changes – it’s inherent.
Even if I (or “the bank”) create a debt instrument against those houses or farmland*, that is itself a highly liquid (trade-able in much broader geographical context) asset, the underlying asset remains (geographically) illiquid.
A very LARGE contributing/explanatory factor to both the “housing bubble”, and the to subsequent “financial crisis” of the 2000-2009 period is that a lot of folks ignored the fact that the liquidity of the debt instruments DO NOT change the inherent geographical illiquidity of the underlying collateral asset.
*Farmland is slightly different in asset liquidity characteristic than are houses. While the farmland itself is a geographically illiquid asset, its product is, or can be, a highly liquid asset. But the error of conflating the liquidity of the related debt instruments with the illiquidity of the underlying farmland assets is just as pronounced – and it has happened before …
Recall the “farm” crisis back in the late 1970’s/early 1980’s, which inspired all manner of “Farm Aid” programs/concerts/charities/etc.? That was, for lack of a more current example, a mini-“Farmland Bubble”/”Financial Crisis”. Lots of farmers and even non-farmers borrowed extensively to buy farmland, bidding up prices and talking on enormous debt burdens. Seemed like a good idea and a great “investment” at the time, right? After all, the supply of land is absolutely limited/scarce, right? – nobody can just create more land.
EXCEPT, an acre of farmland, that can produce say 50 bushels of wheat at $5.00 per bushel, is still going to produce that much at that price, completely irrespective of whether the debt-financed price of the land itself is $100 per acre or $10,000 per acre. LOTS of farmers lost their land to foreclosure due to the fact they ignored that reality.
The lesson being, THE ILLIQUID CHARACTERISTIC OF REAL-PROPERTY ASSETS NEVER CHANGES. That illiquidity characteristic is resilient to market price, interest rate, debt and/or equity funding, money supply, etc., etc., etc.
Two words: financial repression. High sovereign debt gives the sovereign an incentive to keep rates low.