5/31/10 5:48 PMThe Flight to Quality: Project Syndicate - Grasping Reality with Both Hands

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Grasping Reality with Both HandsThe Semi-Daily Journal of Economist J. Bradford DeLong: Fair, Balanced, Reality-Based, and Even-HandedDepartment of Economics, U.C. Berkeley #3880, Berkeley, CA 94720-3880; 925 708 0467; delong@econ.berkeley.edu.

Economics 210aWeblog ArchivesDeLong Hot on GoogleDeLong Hot on Google BlogsearchMay 27, 2010

The Flight to Quality: Project Syndicate

The Flight to Quality - Project Syndicate: BERKELEY – In late May, the yield to maturity of the 30-year United States Treasurybond was 4.07% per year – down a full half a percentage point since the start of the month. That means that a 30-year Treasurybond had jumped in price by more than 15%. So a marginal investor was willing to pay more than 15% more cash and more than30% more equities for US Treasury bonds at the end of the month than at the beginning. This signals a remarkable shift inrelative demand for high-quality and liquid financial assets – an extraordinary rise in market-wide excess demand for suchassets.

Why does this matter? Because, as economist John Stuart Mill wrote in the first half of the nineteenth century, excess demandfor cash (or for some broader range of high-quality and liquid assets) is excess supply of everything else. What economists threegenerations later were to call Walras’s Law is the principle that any market in which people are planning to buy more than is forsale must be counterbalanced by a market or markets in which people are planning to buy less.

We have seen this principle in action since the early fall of 2007, as growing excess demand for safe, liquid, high-qualityfinancial assets has carried with it growing excess supply for the goods and services that are the products of ongoing humanlabor. This is true to such an extent that there is now a 10% gap between the global economy’s current output and what it wouldbe producing if it were in its normal relatively healthy state of near-balance.

And global financial markets are now telling us that this excess demand for safe, liquid, high-quality financial assets has justgotten bigger.

To some small degree, a change in investor sentiment has induced the rise in excess demand for such assets. After all, we canassume that the animal spirits of investors and financiers has been further depressed as a psychological reaction to theexuberant belief just a few years ago in the powers of financial engineering.

But most of the recent shift has come not from an increase in demand for safe, liquid, high-quality financial assets, but from adecrease in supply: six months ago, bonds issued by the governments of southern Europe were regarded as among the high-quality assets in the world economy that one could safely and securely hold; now they are not.

The argument six months ago in favor of those bonds seemed nearly airtight. Yes, the liabilities of southern Europe’s privatesector were speculative and potentially insecure; but the region was part of the eurozone, and thus its governments’ debts werebacked by the European Central Bank, which in turn was backed by the governments of France and Germany, which in turnwere backed by the willingness of French and German taxpayers to pay for the long-run project of closer European integration.Neither the French nor the Germans, obviously, want to contemplate any possibility of a return to the days when everygeneration they would kill each other over the question of which language should be spoken by the mayor of Strasbourg (or is itStrassburg?).

Now things are not so certain.

When there is excess demand for safe, liquid, high-quality financial assets, the rule for which economic policy to pursue – if,that is, you want to avoid a deeper depression – has been well-established since 1825. If the market wants more safe, high-quality, liquid financial assets, give the market what it wants.

After all, as a social-resource planning mechanism does, a market tells us which things are valuable and thus gives us the signalto make more of them. Markets are now signaling that US Treasury bonds are much more valuable assets than they were amonth ago. So those governments whose credit is still unshaken and whose assets are still the benchmarks of quality for theworld economy should be creating a lot more of them.

Creditworthy governments around the world can create more safe, liquid, high-quality financial assets through a number ofchannels. They can spend more or tax less and borrow the difference. They can guarantee the debt of private-sector entities,thus transforming now-risky leaden assets back into golden ones. Their central banks can borrow and use the money to buy upsome of the flood of risky assets in the market.

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some of the flood of risky assets in the market.

Which of these steps should the world’s creditworthy governments take in response to the asset-price movements of May? All ofthem, because we really are not sure which would be the most effective and efficient at the task of draining excess demand forhigh-quality assets.

How much should they do? As long as there is a clear global excess supply of goods and services – as long as unemploymentremains highly elevated and inflation rates are falling – they are not doing enough. And the gap between what they should bedoing and what they are doing grew markedly in May.

This isn’t rocket science or capping deep-sea oil blowouts. These are problems that we have long known how to solve.

Brad DeLong on May 27, 2010 at 01:53 PM in Economics, Economics: Federal Reserve, Economics: Finance, Economics: FiscalPolicy, Economics: International Finance | Permalink

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Neal said...Per the Institutional Investor, the 5 most credit-worthy countries are Switzerland, Norway, Luxembourg, Finland and theNetherlands.

How much in bonds should they issue?

And, per PIMCO,

(quote)

Government bailouts and guarantees such as those evidenced and envisioned in Dubai and Greece, as well as those for the last18 months with banks and large industrial corporations across the globe, suggest a more homogeneous “unicredit” type of bondmarket. If core sovereigns such as the U.S., Germany, U.K., and Japan “absorb” more and more credit risk, then the creditspreads and yields of these sovereigns should look more and more like the markets that they guarantee. The Kings, in otherwords, in the process of increasingly shedding their clothes, begin to look more and more like their subjects. Kings and serfsbegin to share the same castle.

This metaphor doesn’t really answer the critical question of whether a debt crisis can be cured by issuing more debt. Theanswer remains: It depends – on initial debt levels and whether or not private economies can be reinvigorated. But it doessuggest the likely direction of sovereign yields IF global policymakers are successful with their rescue efforts: Sovereign yieldswill narrow in spreads compared to other high-quality alternatives. In other words, sovereign yields will become more creditlike. When sovereign issues become more credit-like, as evidenced in Greece, Spain, Portugal, and a host of others, they movecloser in yield to the corporate and Agency debt that supposedly rank lower in the hierarchy. That process of course can beaccomplished in two ways: high-quality non-sovereigns move down to lower levels or governments move up. The answer towhich one depends significantly on future inflation, the aftermath of quantitative easing programs, and the vigor of the privateeconomy going forward. But the contamination of sovereign credit space with past and future bailouts is a leveler, ahomogenizer, a negative for those sovereigns that fail to exert necessary discipline. Only if global economies stumble and revisitthe recessionary depths of a year ago should the process reverse direction and place Treasuries, Gilts, et al. back in the driver’sseat.

Investors should obviously focus on those sovereigns where fundamentals promise lower credit or inflationary risk. Germanyand Canada are amongst those at the top of our list while a rogues’ gallery of the obvious, including Greece, Eurolandlookalikes, and the U.K. gather near the bottom. (end quote)

Reply May 27, 2010 at 03:21 PMchristofay said...The flight to relative quality

Greenspan, Bernanke and Geithner couldn't manage a good cupcake shop so they went into central planning.

It's the dead relic, gold, that is the true flight to quality over the past lost American decade

Reply May 27, 2010 at 06:18 PMMatt said...Brad,

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I agree with your policy prescription--but with trepidation. You evince a remarkable faith in the wisdom of markets. U.S. bondyields are low, and have recently fallen. Markets have deemed the U.S. government a good credit. There is no downside tofurther fiscal expansion.

Haven't recent events demonstrated--and for the hundredth time--that pointing to current asset prices as proof of afundamental proposition is rank foolishness. Where were Greek bonds trading two years ago? Where high-yield bond spreadsthree years ago?

You say: "If the market want more safe, liquid, high-quality financial assets, give the market what it wants"--or risk a muchdeeper downturn or even recession. That assumes precisely what is at issue. What is "safe and high quality"? How long will itstay that way?

There is a tipping point somewhere out there, at which U.S. credit quality would turn from unassailable to predictably (ex post)poor. No one knows where that tipping point is. Our broken political system--in which one party will never under anycircumstances vote for tax increases, and under which political cover for same requires bipartisan agreement--combined withthe very poor long, term trajectory, inspires no reasonable confidence that we won't bump up against an actual fiscal crisisbefore the needed long-term adjustments are made.

Your argument is essentially: "We can easily support another 20% of GDP in debt. It's necessary given the lack of privatedemand. We simply need to make the right fiscal corrections later." The last part, and the unknowable durability of the market'sfaith in it, is precisely the problem. You don't even acknowledge there's an issue.

Reply May 27, 2010 at 11:15 PMmhnj said...You and Krugman should stop quoting current Treasury bond yields as an indicator of value. Market prices are unreliableindiators of value when there is a bubble. So please don't use current low Treasury yields to justify larger fiscal deficits. Themarket can change its mind in an instant. In this environment, governments have to pay attention to tail risks that aren't pricedinto current market prices.

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Me: Economists:

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Juicebox Mafia:

Ezra KleinMatthew YglesiasSpencer AckermanDana GoldsteinDan Froomkin

Moral

Philosophers:

Hilzoy and FriendsCrooked Timber ofHumanityMark Kleiman andFriendsEric Rauchwayand FriendsJohn Holbo andFriends

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