A new good called ‘security’

In the last few weeks the “Is QE deflationary?” debate has fused with the “What’s the natural rate of interest anyway?” and the “Is it really all about the risk premium?” conversation.

Many important insights have been offered by a whole host of people. A notable development, however, came in the shape of Tyler Cowen’s post on negative T-bill returns in which he considered the phenomenon of T-bill “entrance fees” during a zero-rate climate and how this can take returns for many investors into negative nominal territory, while providing advantages to those with access to “special technologies’” even when official rates are very mildly positive.

Amongst the points Cowen considers (our emphasis):

10. The John Taylors and Stephen Williamsons of the world are right to suggest there is something screwy about the persistently low interest rates, and thus they grasp a central point which many of their critics do not. Yet they don’t diagnose the dilemma properly. Tighter monetary policy would simply add another problem to the mix without curing the underlying dysfunctionality.

11. In this model, fixing the negative dynamic requires financial sector reform of such a magnitude that real rates of return on safe assets rise significantly. That is hard to pull off, yet important to achieve.

11b. It would help for the Chinese and some other East Asian economies to diversify their foreign holdings into riskier and higher-earning investments. They need a new trading technology in a different way, and you can think of their demands for safe assets as a major market distortion. Edward Conard saw a significant piece of this puzzle early on, by noting that a globalized world will skew real rates of return on safe assets (it is easiest to overcome “home bias” on the safest and most homogenized assets of a foreign country). Singapore and Norway are to be lionized in this regard for their risk-taking abroad.

Andy Harless, meanwhile, made an interesting point that if we all agree that the natural growth rate is a better target than an inflation rate during a recession, it’s possibly better to begin factoring in the concept of a “natural discounted growth rate”. Another way of describing this is as the additional money that needs to be added into the system to ensure that the target NGDP rate can be achieved with price stability. Though, as Harless also notes, it’s important to stress this rate doesn’t necessarily imply dynamic efficiency.

Harless also adds that in the context of secular stagnation, the natural discounted growth rate would necessarily exceed the growth rate of the NGDP target path.

In other words, the target path would require a negative nominal interest rate. Under a level targeting regime, an attempt to pursue such a path will result in either monetary instrument instability or a “zigzag” growth pattern in which recessions alternate with inflationary catch-up periods. Under a growth rate targeting regime, you’ll just keep missing the target from below, much like most of the developed world’s central banks today.

As he further explains:

… an economy with a strictly positive natural discounted growth rate would be dynamically inefficient. Overall welfare could be improved by instituting a stable Ponzi scheme that transfers consumption backward across generations.

To cut a long story short (because it gets complicated), Harless concludes that risk probably accounts for the reason why some investors are prepared to settle for returns that undershoot growth expectations.

On that basis:

So, given the risk preferences of the marginal investor, the government could, by operating a stable Ponzi scheme, be producing assets that have a higher risk-adjusted return than newly created capital. Given the risk preferences of the marginal investor, it’s inefficient for the government not to be producing such assets.

Now, the important thing for economists to understand is that even though it may appear that the investor who is parking his money in Treasuries is worse off in a material sense than the investor who is allocating funds to new capital — and thus that the system is efficient — this may not be the case once risk is factored in.

As Harless himself concludes:

But the concept of risk preferences models a subjective good – call it “security” – and we’re not producing enough of this good. The history of interest rates and growth rates suggests that we have seldom produced enough security, but the deficiency today is clearly worse than usual.

This echoes points we’ve made for a long time. For example, in our “Is QE deflationary or not?” post, we noted that deflationary shocks, just like inflationary shocks, are associated with too much money chasing not enough goods. Except that whilst inflationary shocks are associated with a scramble over goods and services in the real economy, deflationary shocks are associated with a scramble over safe financial securities.

What’s more, like we also noted, unless those shortages are addressed by central banks, loose monetary policy — especially the sort focused on pumping more base money into the system — turns out to have paradoxical effects. This is partly because the transmission mechanism itself gets clogged up but also because the solution only exacerbates the problem if it takes safe assets out of the system.

As to why government securities equal safety, some have suggested this is due to liquidity reasons. We disagree. We suspect it has much more to do with fiscal distribution effects. The problem after all is not so much “too little demand” as it is “too little demand in the wrong hands”. The current distribution of wealth fails to generate the demand needed to consume the products and services the economy is capable of producing. The consequence is a surplus that must either be continuously destroyed (at the cost of resources and margins), taken out of the picture permanently by means of bankruptcies (and further wealth segregation due to unemployment), or distributed at much lower clearing prices.

Dropping prices is dangerous, leading to a scenario of mass discounting or even free goods for bargain hunters (i.e. those willing to wait for older products or inventory de-stocking). But this would only undermine the market further, since no manufacturer or retailer wants to shed the bulk of its inventory below cost price voluntarily. Neither does it want to encourage consumers to delay spending decisions until goods are effectively free. Which is why the market economy tends to opt for bankruptcies, production shut-ins or artificial scarcity tactics instead.

But as Opec has learned, there can be a cost to such cartel-like behaviour. What you gain in prices, you lose in sales volumes and velocity.

Fiscal spending — as represented by “safe assets” — however, can guarantee (through the de facto creation of money-like instruments) that surpluses can be redistributed to a much wider consumer base without the need for prices to fall below cost levels. Not only does this keep more corporates in business and unemployment in check, it helps to distribute goods and services to where needs for such goods have not yet been saturated.

When viewed from this perspective, demand for safe assets is better interpreted as investor awareness that low-risk returns can only be achieved with government-assisted distribution. For only government-assisted distribution can at this stage prevent further inequality and stagnation.

It also means that additional money supply without fiscal distribution can turn out to be ineffective due to the fragmentation, if not lead to paradoxical outcomes in its own right. This *we think* is because unless money supply is forced to spread itself to new areas of demand — where surpluses can still be appreciated — it begins to generate a diminishing return in the oversupplied areas.

As Cowen notes, the only way this diminishing return can be compensated for — i.e., if money expansion is not accompanied with fiscal redistribution — is if more and more talent is misallocated to special trading technologies that are exploitative or based on pariah-esque trading strategies.

Related links:
Is QE deflationary or not? - FT Alphaville
An “entrance fee” theory of why some real rates of return are persistently low – Marginal Revolution