Seance on Wall Street
There is a long history of mediums who claim to communicate with the dead. They sell their services to people anxious to talk to relatives or great figures of the past. Such exercises can be dismissed as harmless entertainment - people spend a few dollars to be treated to tall tales.
There is a Wall Street equivalent to these seances. People who claim to be knowledgeable about financial markets tell policy makers and reporters what the financial markets are thinking about current policy. These Wall Street seers claim to interpret events in financial markets for those of us who are less familiar with the mysteries of market movements.
In recent weeks, the Wall Street seers have been spinning stories about how the financial markets are very worried over the US budget deficit.
They have told us that the markets are concerned about the government's ability to repay its debt. The seers tell us that the markets may soon demand much higher interest rates, if the government does not get its deficit under control.
The seers tell us that the government must take steps to rein in the budget deficits projected for the future by cutting back Medicare and Social Security. They also warn us about the risks of adding to the deficit with healthcare reform. And, the seers tell us that we certainly should not try to tackle the problem of 25 million unemployed or underemployed workers with another big round of stimulus. That would make the financial markets very angry.
Those of us who were not born with the gift of being able to communicate with financial markets cannot directly evaluate the information that the financial markets are passing on to the Wall Street seers. However, we can easily determine the risk that investors assign to holding long-term US government debt. This requires looking at interest rates.
Interest rates appear to be directly contradicting the seers' assertions about financial markets. The interest rate on 10-year Treasury bonds is currently near 3.5%. The interest rate is not determined by people rattling off their visions about future debt defaults. It is determined by investors putting their money on the line.
These investors are willing to hold hundreds of billions of dollars in long-term government debt at a return of just 3.5%. By contrast, they demanded a return of more than 5% in 2000, back when the US government was running a large budget surplus. If there is widespread fear in financial markets of a default on government debt, it is difficult to understand why investors would be willing to hold it at such a low rate of return. Usually investors demand high returns for holding risky assets.
In addition to interest rates, we could evaluate the seers' assessment by trying to carry through other implications of the bad news debt default scenario. Presumably, the stock market would be headed downwards with the financial sector stocks leading the way. After all, a default on US government debt would be cataclysmic for the US economy and especially for the banks who hold trillions of dollars in government debt or government-backed debt.
Here also the news doesn't seem to fit the seers' vision. The markets have been rallying lately, and many financial stocks are doing quite well.
One piece of evidence that these seers have occasionally used to support their case is the fact that the price of credit default swaps on US debt has risen. Credit default swaps (CDS) are in effect insurance against default. If the price of this insurance rises, then presumably the markets judge default to be a more likely event. That is the reason that people in their 60s pay more for life insurance than people in their 20s.
There is one problem with this story. The payoff of a CDS depends not only on the default but also, as those who did business with AIG know, on the ability of the counter-party to pay. What is the likelihood that JP Morgan, Goldman Sachs or anyone else will be left standing in a world where the US government has defaulted on its debt? It's not clear what the price of CDS issued on US government bonds means, but it is not a straightforward assessment of the probability of default on the government's debt.
It should not be surprising that the vision of the Wall Street seers seem to be far from reality. After all, their crystal balls could not see the $8tn housing bubble, the collapse of which has wrecked the economy.
In fact, the self-proclaimed seers are using their visions to try to discourage the public from supporting policies that the seers don't like. These people want to see cutbacks in Social Security, Medicare and other social programs. They are more concerned that higher deficits could mean higher taxes on the wealthy at some point in the future than they are about the tens of millions of unemployed or under-employed today.
In short, those who want fantastic stories about the unknowable would be much better off visiting the people who promise to communicate with the dead than listening to the Wall Street spokespeople. They will learn more and be associating with people of greater integrity.
Government securities were being bought by the Federal Reserve with newly printed blimps on the screen. Therefore, brand new money competing for the same securities. That drives the price of those securities down. Furthermore, where else are those who want to punish the government going to invest their money? They are acting as if they are willing to take their money and put it under the mattress.
July 20, 2009 6:29 PM | Reply | Permalink
Nice piece.
It's good to remind people that there is no person with the crystal ball. Like all economics we only find out who was right after the event. We all now know who were the Casandras unbelieved. All indicators at the moment say that those who lie to the right of economic policy are so far being spanked by the Keynesian (if severely compromised) policies so far adopted. And it's a pretty fair conclusion that things would be far worse now if those who called for fiscal discipline/conservatism had been listened to.
There's no convincing believers who never admit to contrary evidence. Marginalize them.
July 20, 2009 11:15 PM | Reply | Permalink
Dean,
One piece of evidence that these seers have occasionally used to support their case is the fact that the price of credit default swaps on US debt has risen.
Your counter-party argument is inverted. An increased risk of counter-party failure would decrease the price the CDS fetches. Thus increased CDS price is a stronger argument for US default given the counter-party risk.
July 21, 2009 12:53 AM | Reply | Permalink
One piece of evidence that these seers have occasionally used to support their case is the fact that the price of credit default swaps on US debt has risen.
To be fair on this point, an increase in the cost of protection is less to do with an increase in the likelihood of default (although mathematically that is what the move also implies), and more an expectation of higher yields. This expectation may be wrong, I think it is, but it is nonetheless consistent with the debt and deficit narrative.
As an aside, I had this weekend to sit through a Wall Street in-law's blathering about debts, deficits and inflation (you know the argument, cf Niall Ferguson and co). I tried to go with the Keynesian response initially, about liquidity traps etc, all of which is logically coherent but also largely abstract. And I didn't make any headway.
So when the next iteration ended, "QED we will have Big Inflation", I simply responded, "You mean like Japan for the last 10 years?"
I just mention this because for a minute I stumbled upon something that seemed to shift the argument in my favor; at least, it stopped the Big Inflation monster dead in its tracks.
July 21, 2009 6:44 AM | Reply | Permalink
Short term Wall Street worries about budget deficits have not been enough to check a rise in the stock market since its lows early this year. A genuine concern about about the long term structural imbalance between government spending and revenue in the U.S. nonetheless exists. It has very little to do with people who don't like Obama's spending plans but is quite related to some of those same people cheerleading the reckless waste and irresponsible giveaways of the preceding administration.
July 21, 2009 8:01 AM | Reply | Permalink
I hope to live long enough for people to finally call what is done in the "financial markets" by its true name - gambling. Those people who are making a killing now at Goldman Sachs are on a lucky winning streak, as gamblers.
Don't tell me they make that money by virtue of being very smart. There are lots of very smart gamblers in Las Vegas, and eventually most of them lose along with the other suckers. All that keeps the "financial market" gamblers winning is the intervention by the US government - after all the world would end in a big bang if ever the "financial market" were to collapse. (i.e. the gambling winnings would end.)
Like most right wing activities, the "financial market" activities serve almost entirely to further enrich the very wealthy. That the majority of our country seems to find this acceptable is the ultimate triumph of con artists.
July 21, 2009 10:21 AM | Reply | Permalink
Indeed, hoppycalif2, it is a sorry state of affairs.
We were told that for our own good we had to pay off the gambling debts incurred by the financial sector - more to the point, we've freed them of their debt by making it our debt.
In a perverse way we've become indentured servants, perverse in that for years to come we must pay off a debt which we did not incur in the first place. In the meantime, the financial sector is free and clear to frequent the big casino as often and as much as it likes. Where is the justice in this arrangement.
July 21, 2009 10:52 AM | Reply | Permalink
I see this more as criminal. When you repackage risky mortgages and turn them from C to AAA securities without one thing having changed, I don't know what else to call it.
July 21, 2009 11:24 AM | Reply | Permalink
I agree with thepeoplechoose. It takes more than just luck to achieve what Goldman Sucks has achieved. It takes a sociopathic level of greed and a criminal disregard for the suffering caused.
July 21, 2009 1:13 PM | Reply | Permalink
People like Goldman Sachs aren't really gamblers. They're the people who manufacture chips to sell to gamblers. Every now and then they gamble with some of the chips they've made (which is nice, because they didn't have to pay retail) but most of the money they make is off the top.
July 21, 2009 2:06 PM | Reply | Permalink
Goldman is the gambler who works for the house, playing with house money. They are an element of the system they gamble on, which can give them certain advantages. Calling it criminal is inaccurate, because to my knowledge they've done nothing illegal.
Dean Baker's argument is basically nonsense. No one is saying that they have particular insight into what the markets are "saying". Markets don't say anything except what the price is. People who are concerned about deficits (Good morning.) are concerned because the levels of debt, deficit, and spending going on in Washington are both unprecedented and unsustainable. They will not lead to high inflation, because the Federal Reserve won't let them.
They will, by definition, lead to higher interest rates. Indeed, they already have done so. However, thus far, demand by private issuers remains so low that "crowding out" isn't an issue; and demand for private issuance is so low that the Federal Government benefits by being the only trusted issuer in the world.
Neither will last forever. As soon as a recovery begins, private issuers will want money; money that won't be available cheap because the government is hogging it all. This will drive up interest rates and slow economic growth.
Also, when economic conditions improve, borrowers will go looking for a better yield than the Feds offer right now, and the Feds will have to offer more yield (meaning that refinancing current debt will be more expensive, in addition to financing new debt).
Baker, of course, completely ignores the fact that interest rates move in response to economic conditions and Federal Reserve policy, and equates interest rates with risk of default. Let's be perfectly clear on one issue: There isn't any.
The U.S. Government only borrows in its own currency. It can't default. It can only back the Federal Reserve into a corner where the Fed has to accept inflation to print enough money. Even that isn't really in the offing here. As stupid and counterproductive as the current deficits would be if sustained for more than a year or two, they'll only cause inflation if they affect Federal Reserve policy. And if they're limited in time and scope, they shouldn't do so significantly.
They will still affect the markets, and make it more difficult for anyone else to get funding (incrementally - we're not talking night and day here - it's a meaningful and harmful but limited effect). But neither the inflation worriers (the above commenter's "Japan" point is well taken) nor Baker are telling the real story.
July 21, 2009 2:32 PM | Reply | Permalink
I think that's more than a bit harsh to say Dean's argument is nonsense. His point that 10 year treasuries paid a higher yield back in 2000 when there were projected budget surpluses, is a particularly valid counterpoint to the debts, deficits and inflation scaremongering that frankly is quite de rigeur on Wall St currently.
I've seen Krugman argue that this situation has a lot to do with the broadly conservative ideological make up of Wall St economists. To my mind, it has a lot more to do with the fact Wall Streeters are both pretty parochial and so hardwired to the recent past, such that they don't really understand Japan post-1992 and know close to nothing about the 1930s.
But it is unquestionably the case that many developed countries survive with a larger debt burden than what we have presently - and none of these countries havcan rest on the luxury of control of the global reserve currency.
That is not to say more debt is better than less - it isn't, for example, interest payments get in the way of other budget priorities - but the debt "crisis" is way overblown in my view, the macro-crisis, by that I mean mainly declining real wages and rising unemployment, is so much more severe. Until someone comes up with a better solution than deficit spending, it's the only game in town for tackling the macro crisis.
Several of your assertions I would question:
1. "Markets don't say anything except what the price is." Seeing as the price is often dependent on market participants' views of the future, the so-called discounting process, I don't see how this point undermines anything Dean argued here.
2. "They will not lead to high inflation, because the Federal Reserve won't let them." I dunno, personally, I don't think the Fed would be averse to a dose of inflation in part to erode the real value of the debt overhang from the credit bubble blow-out. I think the more relevant point however is that the Fed may not have the ability to inflate away the problems.
3. "They will, by definition, lead to higher interest rates. Indeed, they already have done so." I presume you are referring to the widening of spreads since the turn of the year. Here's where I'm coming from. Yields through Q4 2008 were off the charts in terms of being so low. There were several occasions where three month t-bills were paying negative returns.
I read this to be a consequence of the biggest flight to quality we have witnessed. Ever. When year-end pressures were relieved, spreads widened again, but to still pretty narrow levels. I think reading this widening as a function of deficit fears is completely wrong, much better to see it as the market exhaling after the most severe liquidity crisis imaginable.
4. "As soon as a recovery begins, private issuers will want money; money that won't be available cheap because the government is hogging it all. This will drive up interest rates and slow economic growth." It could also lead to a more judicious allocation of capital, which, after the last decade or so, may be no bad thing.
Mainly though, this is looking at the current macro situation through the lens of the recent past. I was a fan of Rubinomics in its era, it made a degree of sense in the 90s, but now, with confidence at an unfathomably low ebb, the marginal impact of crowding out in the future seems a pretty small price to pay in order to buy an economic recovery in the foreeable timeframe.
That's the trade-off we face. Nothing in your post attempts to explain why this is perhaps a crappy trade-off, or even if there is an alternative approach we should consider.
July 22, 2009 6:32 AM | Reply | Permalink
Comparing mediums (cheap entertainment?) to Wall Street seers? Boy talk about adding insult to injury. What did mediums ever do to you?
Okay, I'm kidding...sort of. FYI, I have lived with a skilled intuitive for 16 years, and I assure you that she's the real deal.
Here's where your analogy seems inappropriate to me: Your WS seers are the ones attempting to convince people that something made of hot air and fabrications is real. Legitimate intuitives deal with things that actually exist.
July 22, 2009 6:13 PM | Reply | Permalink