Monday, January 3, 2011

The Demand For Treasuries.

There have been a number of things lately such as the SS debate, reading both the General Theory and Hyman Minsky's "Stabilizing and Unstable Economy", and--not least of all--my dissertation that have got me thinking about the demand for treasuries. We are used to thinking about government debt as a supply side phenomenon, simply politicians turning on the printing presses so to speak.

To illustrate, here is a question from my final (both Marco and Money and Banking) that I asked:

In the US right now corporate investment is extremely low as corporations are now holding historically high levels of liquid assets instead of spending their profits. As well, foreign savings continues to flow into the US because US assets/investments increasingly looks good compared to European assets. Finally, private savings rates are increasing as American households try to "repair their balance sheets" and make up for wealth lost when the housing bubble popped. Use the “Savings/Investment Identity” to show what must happen if capital inflows and households savings are increasing while at the same time investment is decreasing.

To answer this question you need this identity:

Investment (I) = Private Savings (PS) + Capital Inflows (KI) +Government Savings (GS)

Necessarily, if the events I outlined are true, Government Savings has to fall, that is, the government has to run a deficit. Now, this is an idenity and it doesn't tell you anything about what is driving what. But the way I framed the identity it is all about the demand side for treasuries. In a weird way, the extension of the Bush tax cuts following on the heals of the Eurozone crisis can be seen as a kind of market response to demand.

Anyway, I decided to dig around in the Fed's Flow of Funds and the Federal Government's Budget data to see what the demand side has looked like historically.

Right away I'm gonna deal with the mot controversial part of this little exercise. I am including the Social Securty Trust Fund as part of the demand for debt. Here is my version of a graph I'm sure you've seen a million times:

Figure 1

So Social Security is about half of the debt that the federal government owes itself. The reason I have included social security is because even though it is classified as debt that the government owes itself it also represents (potentially) future public debt. Social Security debt is held in special "non-marketable" treasuries and so currently they aren't part of the market for treasury bonds and to that extent the debt is actually different than debt to the public.

However, as the Social Security system starts to take in less money than gets paid into it the Social Security Administration will cash in those bonds. In order to pay back those bonds the federal government will have to pay that back with taxes or issue new debt issued to the open market. Social Security is "postponed debt to the public". I need to be careful and point out that this is not a problem with SS. I'm not much of a deficit/debt hawk and to the extent the debt is worrisome the issue is how we manage the debt/GDP ratio. The shift of trust fund debt to the public would have no effect on the debt/GDP ratio. Depending on how rapidly the trust fund got used up it may have an effect on treasury bond yields but that seems to me like mostly a secondary concern.

I don't want to dwell on Social Security. The dudes (gender neutral!) over at Planet Money have a really good podcast about social security. Maybe my next post will be about Social Security. Anyway, I do need to admit a couple of things. First, it's a little unfair to single out social security for my analysis but I had to make my graphs intelligible. The social security trust fund made up about $2.6 trillion of the $4.3 in debt the government owes itself at the end of 2009. So I'm ignoring $1.7 trillion which is a lot even when talking about an $11.8 trillion deficit.

That $1.7 is mostly made up of the:

Civil Service Retirement Fund ($750 billion)
Department of Defense retirement and Medicare funds ($144+ $295 billion)
The Medicare trust fund ($390 billion)

Anyway, the vast majority of the debt the government owes itself is the investment of retirement entitlements of one kind or another. But like I said, i had to keep my graphs reasonably clear so I'm ignoring $1.7 trillion!

Alright so here is the first graph:

Figure 2

This graph is included for completeness but its kind of hard to read because the Great Recession kind of explodes the graph. It's a good place though to look to explain a few things. First, of all these are "flows" which means what is being shown here are either new (net) purchases or sales of treasuries by each sector for each year. Secondly, the "Remainder" line represents the total new treasury issued in each year minus the sectors show in the graph. It just shows how much of the new treasury debt issued was bought by the sectors I'm looking at. If the Remainder is positive it means the sectors shown under account for new treasury issues in each year. If the Remainder is negative the sectors shown over account for new treasuries. Finally, I chose 1975 as the starting point because that's around when the post-war debt/GDP ratio bottomed out.

I'm going to chop off the Great Recession (and come back to it later. Here we have a picture of what should probably be called the structural deficit that started in the early 80s:

Figure 3

In figure 3 I have lopped off 2007-2010 or, roughly speaking, the Great Recession. I have also put everything into 2005 prices. I am not so sure that was a good idea but I felt like keeping it in nominal dollars distorted the relative importance of each sector over time. I would have preferred to make this a logarithmic chart, but I can't because there are negative values. Anyway, this this is essentially unreadable and won't make sense until after looking at figure 4. However, two things are pretty clear. First, the financial industry seems pretty important to the demand side through the 80s. Second, while state and local government (includes "regular budget" and pension funds) sell off a lot of treasuries in the 90s their purchases seem to recover in the mid 2000s. However, in the 90s households start dumping treasuries and don't look back (until 2008!). Did all the money wind up in the stock market? Did treasuries become a quaint, old timey way to save?

Okay so Figure 4 can help make sense of Figure 3:

Figure 4

So figure 4 is not really "to scale" in any way. Each bar represents 100% of treasury purchases by the sectors I'm looking at (plus the remainder) for each year. However, this does not give any sense of the relative scale of each year. For that look at figures 1 and figures 2.

What's interesting about this chart is that there seems to be a clear shift in the demand for treasury bonds that takes place in the mid 90s. It looks to me like "core demand" shifts from the financial industry to foreign demand. As well in the 90s there seems to be shift of demand from state and local government to Social Security. However, remember these are all shares of a pie that is growing every year. If you look back at figure 2 it seems more that state and local demand remains steady (though falls a little) while SS demand starts to take off in the late 80 due to the 1983 Social Security Amendment.

I found the results from figure 5 to be pretty surprising:

Figure 5

I chose 1971 because that's when the US went off the gold standard (officially) and I was curious to see if that meant anything. Now what'ss obvious here is how important foreign "official" institutions (mostly foreign central banks) are as a source of treasury demand. I had taken the role of the US dollar as a "reserve currency"--as a currency other central banks hold as a way of managing their own currencies-- for granted. However, it is quite striking how important our role as a reserve currency is in creating demand for our treasury bonds. Other countries prefer to hold treasury bonds instead of dollars because they are essentially as safe as dollars and they pay a return.

I want to go over two things. First, I don't think this post would be complete without a graph of the last couple of years (at least through 2009, which is all I have numbers for):

Figure 5

The scale of figure 5 is nominal dollars. The Fed sold off a whole bunch of treasury bonds in 2008 in order to purchase (or sometimes exchange) for things that were not treasury bonds like a Mall in Oklahoma (Planet Money Again). Foreign demand went through the roof and financial business came back to buying treasuries. Foreign demand is probably going to get stronger now that Europe is becoming more and more of a mess, a phenomenon called "flight to quality". As far as the financial industry buying treasuries that's a function of the Fed loaning tons of money to banks basically for free. Banks and other financial intermediaries then take the money and buy safe as houses treasury bonds and take home the difference. It helps keep treasury bond yields low and Wall Street bonuses flowing.

Finally, I'm not 100% sure I've done a good job making it clear how important governments are to the demand for treasuries. Here is one more homemade chart:

Figure 6

I double checked this graph after I made it because I find it really surprising. I feel that this really makes it clear how important political entities are to the demand side of the treasury debt market. I know I'm trying to play both sides of the fence here by saying that SS should be thought of as simply postponed debt to the public and then putting it up here as part of "political" debt. But I think its justifiable because a lot of the discussion these days is about "the market" for treasury bonds and how market bond vigilantes may soon send us the way of Greece and Ireland. However, the vast majority of treasury debt is dependent on political decisions and political entities (in 2009, the gray area of figure 6 was only $3.4 trillion of 11.9 trillion). Here again Social Security is useful as illustration. While I do believe Social Security is "real debt" the political debate today seems to be all about trying to avoid having to turn these non-marketable securities into "general fund" debt very quickly or at all either by cutting benefits or by raising current taxes. As well, it seems highly unlikely that the Chinese are going to stop pegging the Yuan to the dollar any time soon even if they are going to tweak it here and there. As well, the Fed is obviously extremely sensitive to what it does to the treasury market and even a good portion of the private market debt are essentially back door "open market purchases" made through arbitraging financial intermediaries.

Now, I'm not willing necessarily to call demand based on political decisions more stable, but it's not obvious that even if the fantasy of bond vigilantism came true that they would have necessarily that much of an effect.

Oh and also on the "we aren't Greece or Ireland" tip. I feel like this is a good place to put this graph from the Financial Times:

Figure 7

The basic point to be made here is that the analogy is not between the US and the second tier developed nations of the Eurozone. The proper comparison is the comparison between the US, the financial center of the world with the world's reserve currency is with the UK when it held that position. However, I do have to admit it's not entirely clear which UK we are talking about. The post Napoleon UK was an empire experiencing very robust growth on the whole. The post Hitler UK on the other hand was the shell of a collapsed empire that eventually needed to be bailed out by the IMF in the mid 70s.

it should be pointed out that the post WWII UK had lost it's prominent position as the worlds financial center with the world's reserve currency. The US remains strong on both fronts. While there is much talk of China, their financial markets are still in their infancy and you aren't even allowed to trade Yuan. Before their own subprime crises the EU looked like it could possibly be a contender but that seems far more remote now although this crisis may bring the Eurozone closer to a fiscal union which they would need to compete effectively with treasury bonds. At any rate the US seems pretty secure as the worlds tallest midget.

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