The price of security is the reciprocal of the interest rate

This blog didn't last long after I started it a year ago, but new years renew old resolutions, so here's another post. Russ Roberts and James Hamilton discuss mounting Federal government debt on EconTalk and touch briefly on the subject of this blog here. As always, EconTalk is well worth a listen.

The early discussion of state debt and unprecedented deficits presumes that "the market" now satisfies the Federal government's appetite for "credit". Does it? Who bought the four week notes discussed, outside of the Federal Reserve system itself and other central banks/sovereign authorities? I don't buy four week notes. You could say that I buy them indirectly when I deposit cash in my FDIC insured savings account. If that's "the market", shouldn't we throw up our hands and become socialists?

At one point, Hamilton basically asks, "If you can't trust the government, who can you trust?" He seems to argue that "sovereign debt" (marketable entitlement to tax revenue) must be beyond reproach; otherwise, all other financial obligations are suspect. If creditors can't trust the state ruling me, then they can't trust me either, so I inherit the state's bad credit rating somehow.

I don't inherit my dad's credit rating or my kid's credit rating or my neighbor's credit rating or even my employer's credit rating in quite the same way, but creditors will be less willing to lend to me if they can't expect the state to repay its bonds by taxing me. I don't understand this logic. I must be confused by some Ron Paulian mythology.

Russ and Hamilton agree that the looming demographic crisis is not directly relevant to the current financial crisis. I disagree for several reasons.

Who bought and sold the mortgage backed securities that the Fed recently monetized well above market valuations? One answer must be "would be retirees". We're in the last chance decade, the decade immediately preceding the first of wave of baby boom retirees. The "boom" is two decades long. The first half of it is now between 55 and 65. Most of these people haven't retired, but they're thinking very hard about retirement. They're doing what financial advisors tell people in their late fifties and early sixties to do. They're swapping equity for debt, growth for income, risk for security.

So these people, or their agents in pension funds and other institutions, bought many securities that turned out not to be so secure. The Fed then bought the securities from them for more than their market value, and with the proceeds of these sales, the would be retirees are buying Treasury securities in a "flight to safety". Maybe they're buying short term CDs in "the market", but that's practically the same thing.

What would be happening without this massive conversion of "market investments" to entitlement to tax revenue? The "investors" would lose entitlement to future consumption as the economic organizations on which they bet dissolve and the productive means reorganize otherwise. By replacing this lost entitlement with entitlement to tax revenue, states ensure that would be retirees do not themselves reorganize resources for more productive use. They don't labor longer themselves. They don't leverage their assets and thus risk further losses. They trust the government to raise taxes for them, because ... who else can you trust?

If everyone at once stops eating beef and starts eating chicken, does the supply of chicken immediately adjust to meet the demand or does the price of chicken rise? Do we really replace beef consumption with chicken consumption, or do we only eat less meat?

The price of security is the reciprocal of the interest rate. The price of security is now rising, because supply can't keep up with demand. States and statutory monetary authorities have a lot to do with precisely how this adjustment plays out, but it's playing out, and it's playing out now. No one can predict the future well enough to make credible promises to burgeoning purchasers of security, except possibly the statesmen who may simply seize produce to keep their promises.

Russ and Hamilton also agree that promises to Social Security beneficiaries are less sacrosanct than promises to Federal creditors. We'll see about that as inflation continues to swallow the value of Treasury notes yielding less than a percent while SS benefits continue to grow with inflation or faster. I expect Medicare to deliver fewer benefits to future retirees than it delivers currently, and statesmen will adjust other benefits as well, but the pressure to inflate away the value of Treasury notes instead is immense, and the statesmen don't require any cooperation from the market to do it. They need the cooperation of the Fed, but the Fed ain't the market.