In an editorial yesterday ("US not in bondage") the FT editors wrote,
Shock, horror: US government bond rates are jumping. Soon, goes the story, long-term interest rates will leap, the Federal Reserve will monetise, inflation will soar and civilisation will end. Actually, no. What is happening is precisely the normalisation the Fed has sought. The government is not off the fiscal hook. But it does have at least some time.
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What has happened, quite simply, is normalisation of inflation expectations
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Does this mean nobody needs to worry? Certainly not. Desirable normalisation could yet become a panic over the massive prospective bond issuance. Now that the worst of the panic has passed, the administration and Congress need to agree a credible plan for elimination of the huge structural fiscal deficits. As the Congressional Budget Office’s forecasts demonstrate, President Barack Obama’s budget proposal is not such a plan: it leaves deficits of between 4 and 6 per cent of gross domestic product as far as the eye can see. This will need to change soon. But, right now, everybody needs to keep calm. Normalisation is a big success, not a danger.
In his New York Times column yesterday ("The Big Inflation Scare"), Dr. Krugman made a similar point: Inflation isn't a near-term concern, but we do
[H]ave a long-run budget problem, and we need to start laying the groundwork for a long-run solution.
Krugman also brought up the example of Japan, which has borrowed massively in recent years without driving up its interest rates or inflation. What many Americans fear -- our country losing its triple-A credit rating and having its government debt exceed 100% of its GDP -- has already happened in Japan (The CIA World Factbook says Japan's public debt exceeds 170% of its GDP). And yet, Japan's borrowing costs are significantly lower than ours. For example, according to Bloomberg, the current yield on 10-year U.S. Treasuries is 3.46%, versus 1.49% on the 10-year Japanese government bond.
I've wondered for some time about why Japan has so much lower borrowing costs than the U.S., despite having a lower sovereign debt rating and a much higher ratio of debt to GDP, but I haven't heard a convincing explanation yet. When I asked The Atlantic's Megan McCardle about this, she said the answer was Japan's Postal Savings System, but according to Wikipedia, prior to the beginning of its privatization in 2007, that system only held about 20% of Japan's government debt. Perhaps someone will leave a more convincing answer in the comment thread below.
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Good question about Japan's lower yields. IANAE (I'm not an economist) but I suspect it is because something like 90% of the government debt is owned by individuals. As for why individuals choose to invest at such low returns, that's hard to say. I imagine it's because bonds have outperformed all other major assets (such as stocks and real estate).
Another thing to note is that real yields aren't that different in Japan. Given their near-zero, and indeed periodically negative, inflation, Japanese investors were probably earning the same real return as anyone investing in American bonds in the last decade.
That's a good point about the real yields, Sivaram, but it raises a related question: why hasn't such massive borrowing and spending by the Japanese government spurred inflation? Maybe it's because as big as the borrowing and spending has been, it hasn't been enough to offset the massive wealth destruction caused by the collapse of the stock and real estate markets.
I don't know the answer, but I think it would be good to know, because it might give us a better idea of what to expect in the U.S.
Japan hasn't spurred inflation because the government borrowing and spending is offset by the large Japanese saving rate, which was around 15% during their boom period in the 1980s. With their aging populace and 20 years of asset deflation and a global recession it has now dropped to around 2%. Contrast this with the US savings rate which averaged around 1% during the boomtime.
Japan's cumulative savings are now so high that not only do they own over 90% of their own government debt (compared to the US owning about 50% of our own treasureis) but they own about $600 billion of our debt. This results in their govt, institutions, and citizens holding about twice as much government debt as US govt, institutions, and citizens own. And they are less than half of our population and GDP.
So what we have is an economy that has a huge demand for sovereign debt for whatever reason (4x per capita compared to the US). Considering Japanese have cornered the market on their own treasuries, we should expect that this would be a buffer against higher govt borrowing costs for Japan.
The reason I fear higher US borrowing costs is because:
a) In 2017 (under outdated pre-recession assumptions) our Social Security trust fund, who own more US treasuries than China and Japan combined, will start to liquidate its holdings that it has been building over the last 70 years to pay for retiring boomers.
b) A rapidly aging US, Japanese, and European population is likely to reduce its demand for our debt at this time also. They will try to sell their securities in advance of our trust fund, driving up yields, driving down market values, and putting Social Security and other trusts in worse financial straits.
c) China has already announced its willingness to sell US debt. They are no dummies, they may not have as much demographic incentive but they have a strategic incentive to impair the US and will also try to front-sell their holdings.
Anonymous,
So are you saying that the yields in Japan are low due to a "savings glut"? Is that your view?
My understanding, and by all means correct me if I'm wrong because I'm looking at this from the standpoint of my own investing, is that inflation would come about when the Fed buys US government debt, thus creating money and circulating it. Perhaps Japan doesn't practice this, and that's why inflation has been low? IOW, all of Japan's money is tied up in debt and not circulating.
Anon,
The U.S. savings rate was 5.7% at the beginning of April. See these data from the St. Louis Fed. Our savings rate has spiked since last fall. Your comment makes some good points, but raises the question of why there is such high demand for sovereign debt among the Japanese. A related question is to what extent Americans, who are now saving again, will increase their demand for sovereign debt.
Regarding China, our economic relationship with them is, to a large extent, now symbiotic. It would be difficult for them to hurt us economically without hurting themselves (though this dynamic could perhaps change in the future. A common thread in China's global economic policies seems to be a desire its trade relationships and hedge its risks).
Dennis,
Japan has practiced the same sort of quantitative easing we are practicing today. See, for example, this brief article on it from the Cleveland Fed last year, "Japan's Quantitative Easing Policy". The Bank of Japan did essentially the same thing our Fed is doing now: it created money to buy its government's debt. It didn't result in significant inflation. I'll post the chart separately. Also, there have been a couple of columns this week on the inflation versus deflation debate that I haven't had a chance to blog about yet. I'll try to write a post on them today.
I should add another question I have here. I'm familiar with Milton Friedman's adage that inflation is always a monetary phenomena, but I wonder how this squares with the wage and price spirals of the 1970s. When more workers were unionized, they could strike for higher wages, which employers would pass along as higher prices. That dynamic seems to be dead, for the most part, these days. Of course you can have inflation without that, but it would seem that the absence of wage price spirals ought to remove one potential source of inflation.
1. Yes, I'm saying a savings glut in Japan causes them to have lower yields. Despite their size, the Japanese control a larger pool of savings than the US. They also dominate the market in their own government debt. THe two of these together drive down Japanese yields.
2. Why do Japanese like sovereign debt so much? It could be a cultural preference, but where else could they park $7 trillion? It is a huge amount of money. They used to be able to park it in Japanese real estate but that market crashed. They used to be able to park it in stocks but the Japanese stock market plummeted and it has a smaller market cap now, of $5 trillion (large crossholdings mean that much of this market cap is double-counting)
3. I realize that in recent months US savings rates have soared, but the relevant figure here is not the savings rate but the amount available for investment. So the cumulative level of savings in recent years is the more relevant figure. We have to look at a decade of non-saving by the US rather than how much of last month's paycheck they put away.
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