Operation Un-Twist

This morning's WSJ has a great piece by Todd Buchholz, titled "Washington Should Lock in Low Rates" This is in the context of increasing speculation that the Fed will do another "operation twist," buying long term bonds and selling short term bonds in an effort to drive long term rates even further down.

Long term rates are absurdly low.

I don't know who in their right mind is lending the US government money for 10 years at 1.59% and for thirty years at 2.67%. You have to believe inflation will be lower than these values just to get your money back, let alone make any real return.  (The best I can do is to opine that these are not long-term investors, and they think they can get out before rates rise. I will admit that understanding such low rates is stretching my rational-investor efficient-market prejudices.)

Well, no matter. When offered a screaming good deal, you should take it!

Restructuring US debt to longer maturities has all sorts of advantages. (Restructuring. I am not advocating stimulus!) It buys lots of insurance, very cheaply.

Think about what happens with very long term debt vs. rolling over one or two year debt, which is what the US does now.  Sooner or later, interest rates will surely rise to normal, 5-6%. If we are rolling over debt, that means the US Treasury has to come up with an extra 4-5% times the outstanding stock of debt, each year, to pay interest. 5% of $15 trillion is $750 billion, more than half our current (and already unsustainable) deficit. Oh, and by then the debt will be a lot more than $15 trillion by then.

And that's just the "return to normal" scenario. What if the exploding euro leads bond investors to wake up that all debt of highly-indebted, sclerotic-growth, perpetual-deficit, can't-cure-runaway-entitlement governments is dubious?  Greece didn't get in trouble trying to borrow for one year -- it got in trouble trying to roll over debt. If that moment comes and the US has lots of long-term debt outstanding, it just means a mark-to-market loss for bondholders. If we are rolling over short term debt, then the debt crisis comes to the US. And there is no Germany to bail us out.

Todd goes beyond the usual 30 year Treasuries, and advocates 50 or 100 year Treasuries. Good idea! I have wilder ideas. We should think about bonds with no principal repayment at all. 30 years of coupons, or even perpetuities. These bonds never have to be rolled over -- you never have to issue new debt to pay off the principal of the old debt. Or, if we want to maximize the duration of the bonds, issue the opposite: zero-coupon 50 year bonds.  At least that puts off any problems for 50 years!  If restructuring physical debt is hard, do what the private sector does: Massive fixed-for-floating swaps could lengthen the US maturity structure very quickly without unsettling somewhat illiquid markets for seasoned bonds.

Lots of smart money is locking in absurdly low rates. Why not the US?

The Treasury is trying, a bit. But the Fed is undoing what the Treasury is trying with "twist." And the Treasury isn't going nearly long enough, in both my and Todd's view.

Why is the Fed undoing even the Treasury's small lengthening? The Fed seems to think that shortening the maturity structure will lower long-term rates, and this will stimulate the economy. I doubt it can lower long term rates at all, but we don't have to fight about that. Even if it could lower 10 year rates another, say, 15 bp, from 1.59% to say 1.44%, really, how much stimulation would that accomplish? Is the economy really sluggish (and it is) because it's strangling on 1.59% -- substantially negative in real terms -- 10 year benchmark rates?

Todd takes a darker view.

The short answer is: out of shrewd political self-interest...borrowing short gives the illusion of a lower budget deficit, flattering President Obama's fiscal profile—if anything can flatter a deficit-to-GDP ratio approaching 9%.

With a generous Federal Reserve squeezing short rates down to zero, the interest cost of existing debt looks pretty meager at 1.4% of GDP. But this is a terrible trade-off that makes President Obama look better while almost guaranteeing that our children are worse off. Issuing 100-year bonds, or at least 50-year bonds, would require a higher interest rate, perhaps 3%. Sure, that would put more pressure on near-term deficit reports. But leaders should be willing to let their personal image take a dent if it clearly helps the American people. Locking in 100 years of borrowing at a 3% rate would be the best deal since Pope Julius paid a pittance to have Michelangelo paint his ceiling

To emphasize what Todd says very briefly, borrowing short only helps deficit "reports," and gives the "illusion" of a lower deficit. Standard budget accounting does not mark to market, so borrowing at 3% yield for 50 years counts as 3% interest cost, even though the one-year return on the bonds may only be zero -- the government could buy back the bonds next year at appreciated prices, and the carrying cost is zero. 

Is this really they story? I don't know anything about politics, but it is tough to believe. As Todd points out, what's another drink among sinners? If you weren't bothered by 9% deficit-to-GDP, you probably think of another percent or so as valuable fiscal stimulus. If you're an anti-Obama, he's-spending-us-to-oblivion Tea Partier, it's hard to see that an extra percent or so of bogus-accounting interest cost is going to make you feel that the Administration is serious about deficits.

Moreover, surely the Administration hopes still to be in office in four years, and hopes the economy returns to normal growth, which means normal interest rates, by then. This isn't about "our children," this is about us, very soon. If they're doing it for political calculus, they are cooking their own goose. (Or maybe Hilary Clinton's goose!)

I think the answer is much simpler. "The right maturity structure of government debt" is something economists haven't thought about much, the functionaries in charge at the Treasury have thought less about, certainly in these big-picture terms, and the higher-ups at Treasury and in the political parts of the Administration even less so still. They've got enough on their hands.

If my theory is true, that people just haven't thought about what a great deal markets are offering, and how valuable that insurance could be, perhaps there is hope of a quick, healthy, un-twist.

But, as the car salesman says, the big sale prices aren't going to be here forever.