Another essay, a bit shorter this time, on maturity structure of US debt. I was asked to give comments on a paper by Robin Greenwood, Sam Hanson, and Jeremy Stein *
at a conference at the Treasury. It's a really nice paper, and (unusually) I didn't have much incisive to say about it, except to say it didn't go far enough. And, I only had 10 minutes. So I gave a speech instead. (The pdf version on my webpage may be better reading, and will be updated if I ever do anything with this.)
Having your cake and eating it too: The maturity structure of US debt
John H. Cochrane
1
November 15 2012
Robin Greenwood, Sam Hanson, and Jeremy Stein
2
nicely model two important considerations for the maturity structure of government debt: Long–term debt insulates government finances from interest-rate increases. Short-term debt is highly valued as a “liquid” asset, providing many “money-like” services, and potentially displacing run-prone financial intermediaries as suppliers of “liquidity.” Long-term debt also provides some liquidity and collateral services, (Krishnamurthy and Vissing-Jorgensen3 (2012)) but not as effectively as short-term debt. How do we think about this tradeoff?
Posing the question this way is already a pretty radical departure. The maturity structure of U.S. debt is traditionally perceived as a relatively technical job, to finance a given deficit stream at lowest long-run cost, as Colin Kim eloquently explained in the panel. Greenwood, Hanson and Stein, along with the other papers at this conference, are asking the Treasury’s Office of Debt Management to consider large economic issues far beyond this traditional question. For example, saying the Treasury should provide liquid debt because it helps the financial system and can substitute for banking regulation, whether or not that saves the Treasury money, asks the Treasury to think about its operations a lot more as the Fed does. Well, times have changed; the maturity structure of US debt does have important broader implications. And getting it right or wrong could make a huge difference in the difficult times ahead.
Go Long!
As I think about the choice between long and short term debt, I feel like screaming4 “Go Long. Now!” Bond markets are offering the US an incredible deal. The 30 year Treasury rate as I write is 2.77%. The government can lock in a nominal rate of 2.77% for the next 30 years, and even that can be paid back in inflated dollars! (Comments at the conference suggested that term structure models impute a negative risk premium to these low rates: They are below expected future short rates, so markets are paying us for the privilege of writing interest-rate insurance!)
Our Government has taken the opposite tack. When you include the Fed (The Fed has bought up most of the recent long-term Treasury issues, in a deliberate move to shorten the maturity structure) the US rolls over about half its debt every two years5.
Here’s the nightmare scenario: Suppose that four years from now, interest rates rise 5 percent, i.e. back to normal, and the US has $20 trillion outstanding. Interest costs alone will rise $1 trillion (5% of $20 trillion6 ) – doubling already unsustainable deficits! This is what happened to Italy, Spain, and Portugal. Don’t think it can’t happen to us. It’s even more likely, because fear of inflation – which did not hit them, since they are on the Euro – can hit us.
Moreover, the habit of rolling over debt every two years leaves us vulnerable to a rollover crisis. Each year our Treasury does not have to just borrow $1 trillion to fund that year’s deficits. It has to borrow about $4 trillion more to pay off maturing debt. If bond markets say no, we have a crisis on our hands.
Going long buys us insurance against all these events. And bond markets are begging us to do it! Most large companies are issuing as much long-term debt as they can.
I emphasize “insurance.” Long rates are low, and interest rate volatility is low. This isn’t about the forecast (you can’t buy insurance against something expected) and it’s not about volatility. It’s about a big left tail. What if the 4% growth underlying our already depressing deficit forecasts turns into another 4 years of sclerotic 1.5% growth, the CBOs static revenue forecasts from higher tax rates fail to materialize, inflation picks up, budget chaos raises the risk premium of US debt, and China7 stops buying?
The world has changed. In the past, the Treasury could adjust maturity structure thinking only about liquidity or term premiums. The fiscal risks were small, since the overall amount of debt was small. With debts above GDP, and 5 times Federal revenues, the old rules go out the window.
Fix the accounting
Why not go long? I suspect the Treasury is reluctant to go long because, under current accounting, moving $10 trillion of debt to long-term would add $277 billion to interest costs, which makes the current deficit look much worse.
But this accounting makes no economic sense. Yield to maturity is not the same thing as the annual cost of borrowing, which includes capital gains and losses. Confusing yield and one-year return is a classic fallacy. (It makes even less sense given that the Fed is buying all the long term debt, so that the maturity hasn’t really changed at all!)
If this consideration is holding the Treasury back, we should fix the accounting. Politically difficult you say. We’ll get accused of cooking the books, you say. OK, but is it really worth running the country into a fiscal crisis because we can’t fix the accounting? In simple ways that every business follows?
Simply marking to market capital gains and losses, and including that in the budget would be a good start. Then, we need to calculate and report expected capital gains and losses during the next year.
According to the expectations hypothesis, which holds well at well at the relevant multiple-year horizons, and perfectly if we are willing to footnote “expectation” with “risk-neutral,” the expected cost is independent of the maturity structure. An upward sloping yield curve means that the government expects to make capital gains on long-term bond issues that just offset their higher yields. I expect that the Treasury would use a more sophisticated term structure model, to isolate risk premia and liquidity premia as well as expectations effects. That would be all well and good, but the overwhelming effect would still be to remove the confusion of yield with return. You might see 20 or 30 basis point cost of going long, but not 2.77%.
Now, accounting is not miraculous. Interest costs don’t disappear. Higher long-term yields correspond to higher future interest rates, and thus higher interest costs in future years. But here, the calculation would correctly show that the US will pay these higher future expected interest costs independently of the maturity structure. Today’s 2.77% 30 year yield is not “paid” today, in any meaningful sense. It is paid when interest rates actually do rise. And rolled-over short term debt would pay the same costs, at the same time.
Go even longer, and more liquid
Why stop at 30 years? The Treasury should issue perpetuities – bonds with no principal repayment date. When the government wants to pay down the debt, it simply buys them back at market value.
Perpetuities pay a set coupon – say $1 – forever. Their price varies as interest rates rise and fall. It would be better for the Treasury to sell only one coupon amount – say $1 – rather than adjust the coupon amount so that the bond sells at par. After all, a $2 coupon is just two perpetuities, unlike the case of coupon bonds. (If it really matters to sell bonds at “par,” then the Treasury can simply bundle the perpertuities. At a 1% yield, one $1 perpetuity costs $100, so sells at par. If yields rise to 2%, so the price of a single perpetuity falls to $50, the Treasury can issue them in bundles of 2, at “par.” Or maybe people can figure this out on their own.)
Perpetuities do not age, so perpetuities issued at different times are identical securities. There will be no more on-the-run / off-the-run spreads, no more liquidity premiums, no more arbitrages between economically-equivalent bonds because one can’t be delivered when the other has been shorted. And there will be no need to roll over of maturing debt, ever.
This standardization would also sharply increase the liquidity of long-term debt. In turn, raising that liquidity should lower the overall rate the government pays. It’s a win-win all around.
(While we’re at it, the Treasury should also issue an inflation-protected perpetuity, with a fixed real coupon, and adjust that coupon downwards for deflation symmetrically with upwards adjustments for inflation. The coupon pays $1 2012 dollars, forever. That would be a better and more liquid version of its current TIPS. Finally, the Treasury should issue variable-coupon debt. The coupon on this debt would act like corporate dividends, and variable-coupon debt would function like an equity source of government financing. By cutting the dividend in bad times, the government could reduce its debts without the calamities of default or inflation. By raising the coupon in good times, the government would establish a reputation that makes the bonds saleable, and convince investors to hold on through coupon reductions. Coupon adjustments should be made by Congress, of course.)
Go modern
If we go long, what about the liquidity advantages of short-term debt? Just a little financial engineering could avoid the apparent tradeoff between long and short term debt, allow the Treasury to quickly go longer without having to dramatically reform the maturity structure of government securities, which will take far more time than we have, and it could help to get around faulty accounting.
In modern finance, exposure is no longer tied to investment amounts. With aggressive use of interest rate swaps, (and, potentially, futures, interest-rate options, or CPI swaps,) the Treasury could buy the interest rate protection the government urgently needs, supply as much short-term debt as liquidity demands, and satisfy the political demands of budget accounting. There need be no tradeoff at all. We can have our cake and eat it too.
For example, suppose the Treasury issues only one-month debt, but then swaps it all to fixed rate. The Treasury agrees to pay to swap counterparties the fixed (2.77%) rate and receive the floating one-year rate. Now, it has issued $16 trillion of one-month debt, surely satisfying any liquidity demand to the utmost. But the Treasury is fully protected against interest rate rises just as if it had issued the entire amount in 30 year bonds. The investment amount is one month, the risk exposure is 30 years. Every bank routinely uses swaps to adjust its interest-rate exposure without touching its low-cost source of funds (sticky liabilities) or its profitable but illiquid assets (loans). The Treasury should do the same!
(I don’t know enough about deficit accounting to know where swap payments go, but I’ll leave it as an article of faith that the sharpies at Goldman Sachs who made Greek debt disappear in 2006 can get around that one too.
Yes, we need to make sure that swap counterparties are not too-big-to-fail banks, of course! But swap contracts are collateralized, so counterparty credit risk is not really that big an issue. The lower posts enough collateral that the winner can replace the contract in the event the loser defaults And if Dodd-Frank is good for anything, it ought to be good for keeping plain-vanilla interest rate risk off the balance sheets of “systemically important” banks.
Finally, I say “Treasury,” but what matters of course is the consolidated government. If it makes more sense for the Treasury to issue and pass on government interest-rate risk management to the Fed, so be it. The Fed can more explicitly be the Treasury’s asset management service.)
The bigger point: The Treasury should enlarge its “maturity” selection beyond the 18th century choice of maturity among coupon bonds, to include at least 20th century plain-vanilla modern fixed income instruments.
Go long, again
I don’t know if I’ve pounded my fists on the table enough. Historically normal interest rate rises will send the US into a fiscal tailspin, with interest costs doubling our deficit, and thus forcing a true fiscal crisis. The markets are offering to take this risk from us for next to nothing. For a while.
I don’t exaggerate much when I say, the fate of the Republic is in your hands!
Go Short
On the other side, Greenwood, Hanson, and Stein remind us of the liquidity value of short-term US Treasury debt. For example, it is the most widely accepted form of collateral, even in crises. Owning a one-month Treasury always allows you to borrow. Many accounting rules treat short-term Treasury debt as equal to cash. More of that too seems a good idea.
Again, though, we can do better, and we can avoid the tradeoff.
Why stop at traditional Treasury bills? These have awkward properties: They are only issued in large denominations, and they are rolled over frequently. The Treasury should go beyond bills, and issue floating-rate debt, held in electronic book-entry form. Either the Treasury can directly allow small denomination, or it can encourage money-market funds to intermediate for retail clients.
The most “liquid” floating-rate debt has a constant principal value of $1.00, always. It’s like a money-market fund, where each share is always worth $1, and interest is paid on top of that. That can be achieved by a daily auction, as overnight repo rates were set in a market each day. However, a daily auction is not necessary, if the Treasury simply guarantees the value at 1.00 like a money market fund. Then the rate can then be indexed or simply adjusted at a periodic auction to adjust the quantity outstanding. (The Treasury maintains an account at the Fed, and uses that buffer to freely trade bonds for reserves at 1.00 between interest-rate reset periods.)
Yes, this is interest-paying money, issued by the Treasury. Every collateral, liquidity, or money-like feature of one-month Treasury debt I can think of works better with such fixed-value floating rate debt. Why bother “money-like” monthly Treasuries, when we can have money itself, without suffering any interest cost?
Overnight, floating-rate, electronic-entry Federal debt already exists. It’s called bank reserves. However, bank reserves are only available to banks, so have to be intermediated again to be available to the rest of the financial system. Also the Fed’s current “exit strategy” involves reestablishing a spread between reserves and market rates, which means reducing the quantity of reserves and sending the financial system off to other sources of “liquidity.”
Fixed-value, floating-rate, Treasury debt -- interest on reserves for everyone -- allows us to live the “optimum quantity of money” described by Milton Friedman. With an interest cost, people unnecessarily economize on money balances by spending more time and effort economizing on money balances. Without an interest cost, they voluntarily hold huge money balances and save all that time, effort, and cash-conserving financial engineering.
The advantages for our modern financial system are much deeper. With abundant floating-rate, fixed-value government debt, there is simply no need for all the complicated and run-prone “liquidity creation” that engulfed the financial system. Special purpose vehicles holding mortgage tranches funded by short-term debt, overnight repo, money market funds holding Lehman Brothers debt and promising fixed value, even bank deposits funding mortgages all become unnecessary for the purpose of creating liquid assets. Rather than allow all this intermediation and then hope that regulation can stop the next run, why not fully satisfy the demand for such assets directly? Then we need not fear requiring that anyone who wants to hold risky or illiquid liabilities match those liabilities with similar assets, eliminating runs and the need for extensive risk regulation. Greenwood, Hanson and Stein call it “crowding out,” and a partial substitute for regulation. Yes, but let’s crowd out entirely and substitute for a lot more regulation!
No theory of inflation says there is any problem with the creation of such “money-like” assets, any more than the liquidity value of one-month bonds causes a problem for price-level control. Keynesian and new-Keynesian models say that the level of interest rates, which the Fed still controls by announcing the rate on reserves and discount window lending, controls inflation. An artificial interest spread between classes of Fed liabilities doesn’t matter. The Fiscal theory of the price level says that fiscal solvency gives price level control, not a scarcity of “liquid” vs. “illiquid” government debt. Monetarists thinks of reserves that pay full interest as bonds, not money, so arbitrary amounts are not inflationary. Milton Friedman himself called for interest on reserves.
Bottom line
As a policy priority, buying insurance against interest rate spikes at our current extremely low interest rates is the first priority. This has to be accomplished before long-term interest rates rise. The left-tail danger of a run on US Treasury debt, and an interest-cost death spiral, is real.
Providing abundant liquidity with floating-rate debt, which will discourage the reconstruction of a run-prone shadow banking system, is only a slightly longer term priority.
An ideal maturity structure of government debt is perpetual. Long-term debt has a fixed $1 coupon, and a floating price. Short-term debt has a fixed $1 price debt and a floating coupon. Then there is never rollover risk, or rollover transactions cost. Making all Treasury debt even more liquid, by standardizing the long issues and allowing low-cost electronic transactions of the short issues, greases the financial system and lowers the rates the Treasury will pay.
By opening up to swap and other derivative transactions, the Treasury can dissociate the amount of interest-rate insurance it purchases or sells on behalf of taxpayers from the task of supplying the amount of these fundamental securities that private-sector “liquidity” demands require, and that provide the least-cost source of funding.
Obviously, these moves need to be coordinated with the Fed. There is no point in lengthening if the Fed just twists it away. I notice a tendency of the two institutions to follow parochial concerns and to forget that there is a single budget constraint uniting them!
Enjoy your cake.
Footnotes
1
Professor of Finance, University of Chicago Booth School of Business, Research Associate, NBER, Senior Fellow, Hoover Institution, and Adjunct Scholar, Cato institution. John.cochrane@chicagobooth.edu, http://faculty.chicagobooth.edu/john.cochrane. These are comments prepared for the Second Annual Roundtable on Treasury Markets and Debt Management, Department of the Treasury, November 15, 2012.
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2
Robin Greenwood, Samuel Hanson, and Jeremy Stein, 2012,
“A Comparative-Advantage Approach to Government Debt Maturity” Manuscript, Harvard University.
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3
Krishnamurthy, Arvind and Annette Vissing-Jorgensen, 2012, “The Aggregate Demand for Treasury Debt. Journal of Political Economy. (Aril 2012)
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4
Actually, I’ve been screaming “go long” for a while now. In particular, see “Inflation and Debt,”
National Affairs 9 (Fall 2011), and “Understanding fiscal and monetary policy in the great recession: Some unpleasant fiscal arithmetic,” European Economic Review 55 (2011), 2-30.
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5
I got this from Hamilton, James D. and Cynthia Wu, 2011, “The Effectiveness of Alternative Monetary Policy Tools in a Zero Lower Bound Environment,” Manuscript, UCSD and University of Chicago. They put all debt on a zero coupon equivalent basis. Beware the average maturity numbers, as this ignores coupons and weights long maturities too heavily. What we want of course is the duration of US debt – change in market value in response to interest rate changes – which I don’t have handy.
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6
I use the total debt, including that held by government agencies, as these are the claims on the Federal income tax. Using debt held by the public does not generate a much prettier picture.
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7
Daniel Beltran’s paper presented at the conference, said China alone is worth 2%! (Beltran, Daniel, Maxwell Kretchmer, Jaime Marquez, Charles P. Thomas (2012) “Foreign Holdings of U.S. Treasuries and U.S. Treasury Yields” Federal Reserve Board.
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Friday, November 16, 2012
65 comments:
Comments are welcome. Keep it short, polite, and on topic.
Thanks to a few abusers I am now moderating comments. I welcome thoughtful disagreement. I will block comments with insulting or abusive language. I'm also blocking totally inane comments. Try to make some sense. I am much more likely to allow critical comments if you have the honesty and courage to use your real name.
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but if inflation causes rates to spike, won't it simultaneously relieve the outstanding debt burden in real terms ?
ReplyDeleteNot really. US debt is pretty short term. If we roll over every two years, then the inflation has only two years to devalue the debt.
DeleteBut don't we constantly have 5yr, 10yr, 39yr auctions? Plus long term agency debt. ?
DeleteNobody buys 30 year T's, other than the Fed. I love John, but I think he is being silly when he says we should go long because we can get 2.77% or slightly higher (we should go long, because whatever we get is better than the Lehmanesque gamble of trying to roll over 4+T per year). The market does not value 30 year T's from the US at 2.77%. If we issued large sums that the Fed did not wind up buying, the rates on those would go up incredibly fast. Anyone smart enough to be buying 30 year bonds knows that's a really crappy deal, just as John knows it's a really sweet deal for the Treasury.
DeleteThere is no way to avoid the oncoming fiscal collapse. No way. There isn't the political will to do so. American's are illiterate when it comes to economic reality.
30-year debt used to be liquid. When the Government went into surplus in the late 1990s, they told the market that the 30-year was going away, and that they cut out auctions of new 30-year debt and buy back the supply of existing long bonds. The 10-year became the benchmark bond and has been so, since.
DeleteIsn't the real reason why the Treasury won't “go long“ on its debt entirely political?
ReplyDeleteIsn't going long an explicit admission that rates must rise in the future — and that there are perilous risks to our continued borrowing that cannot be alleviated simply because we also control our currency?
Isn't the real reason why the Treasury won't “go long” because doing so would be an explicit disavowal of Paul Krugman — not out of any partisan favor towards Krugman but because he accurately represents current Administration policy?
Where's the proof Krugman is wrong? We don't live in the pre-1971 world. The modified gold standard is long gone. China chooses to peg it's currency to ours (!). We don't have significant inflation. We haven't for many years. The supply of money isn't particularly relevant now. How many more years of disproving your views (see Japan and the rest of the "modern" economies) do we have to go through before you get it? Maybe the real reason is you're wrong and ordinary Americans are starting to realize it, even if only implicitly.
DeleteKrugman may be right or he may be wrong. Either our ever-increasing debt will cause big problems or it won't. And at some point, this will cease to be an issue of debate or belief. It will be an indisputable fact.
DeleteIn the meantime, because economics isn't a science, these issues are political.
Going long on our debt would be a moderately conservative tactic that could offer some protection in the event that Krugman is wrong. While there may be some technical reasons (other than the short-term increase in interest costs) currently preventing such a course, it is much more likely that the Treasury simply agrees with you and Krugman and believes — as a matter of politics — that more debt is actually beneficial.
The purpose of my comment was to argue that politics rather obscure details of government accounting are driving Treasury's decisions.
On the bigger picture, if Krugman and the Treasury are right, then we have nothing to worry about. But if they're wrong, then they've made the situation much, much worse.
Unfortunately, no one who is advocating that debt doesn't matter will be around to make us whole if they're wrong.
You're right, this isn't pre-1971. But to say "look at Japan" is absurd. That is the path we are following. Do you really want to follow that path? I promise you we will. We will issue more and more debt, with the Fed buying more and more of it, inflation will stay low to moderate from the deflationary pressures of an aging demographic. Growth will stink and the general quality of life will be worse and worse the later you are born.
DeleteGreat post. I nominate you for Secretary of the Treasury!
ReplyDeleteWhile we're fixing things, can we get rid of the insanely inefficient tax exempt bond market? (Somebody explain to right wingers that rich people don't benefit from it...)
Not sure if this argument is even worth having. Our total debt is so out of control now if inflation should increase a little bit then that will bump up interest rates and the debt service will begin to eat our lunch.
ReplyDeleteIn the near future the western nations will be hard pressed to try any expedient to lower their debt service.
"We can have our cake and eat it too."
ReplyDeleteThat kind of thinking brought us the financial crisis. There is no free lunch.
Financial engineering does not reduce risk - it just moves it around and makes it more difficult to see. Risk is like entropy - it always increases for the system as a whole. Repackage risk and all of the old risk is still there plus any new risk that arises from the "packaging" itself.
Financial engineering has mostly succeeded in taking large numbers of small risks and aggregating them through a portfolio so that there are less frequent but much bigger risks.
I agree that the Federal government should borrow long (and then use the money to build Federal, State and local infrastructure).
It seems to me that such may or may not be true.
DeleteAdam Smith recognized that there is only one protection against risk and that is insurance, where everyone assumes a part of the risk, which I would call risk spreading.
Risk spreading should be contrasted with risk shifting ( with perhaps a synthetic CDO being its worst form)
It seems to me that the financial crisis happened because of risk shifting (counterparties like Goldman, AIG, etc) not risk spreading (Fannie Mae, or FHA).
Noah just made a good argument for federal high schools and universities. Now would be an ideal time to borrow money long and build and endow such schools for future operation.
Or the federal government could involve us in a couple more nonproductive wars.
DeleteWhen you figure out how to separate the two in a political body like the federal government, let the rest of us know.
"It seems to me that the financial crisis happened because of risk shifting"
DeleteI think the financial crisis happened because:
1) the instruments being used made it difficult to determine the actual risks which led to serious mis-pricing (with proper pricing the market would not have bought the MBS and CDO products that made the housing bubble possible);
2) the arrangements created whole new types of risk out of thin air - as you put more and more layers of institutions and legal relationships between the ultimate lender and ultimate borrower you create more and more risks that one of those intermediate layers will "break" by, for example, suffering a solvency or liquidity crisis that then spreads through other parts of the total system.
The crises happened for the same reason every other bubble ever happened, Easy money, easy credit, and herd mentality.
DeleteAbsalon,
DeleteFirst -- it actually is possible to reduce risk via finacial engineering up to a limit. e.g. a diversified fund has less risk than any of its holdings.
Risk tranferrence is okay, so long as the person buying the risk is capable of withstaining the losses. In 2008, people had more at risk that they could afford to lose. Furthermore, there was a lot of risk that was tranferred only cosmetically. i.e. the banks sold the high risk bonds from the CDO and held overcollateralized "high quality" bonds on thier ballance sheets. It turned out that there was not nearly enouhg OC on the high quality bonds.
But this is a little bit beside the point. When the Treasury runs a 4 year average maturity, while forecasting deficits well beyond 4 years, they are engaging in a little financial engineering of thier own, leaving the taxpayer holding this risk. Longer maturity bonds pass the more risk to investors and leave the Treasury with a less risky liablity profile.
Has it ever occurred to you that the federal government should sell equity instead of debt?
ReplyDeleteRepublicans talk all the time about permanent tax cuts. Recognizing that a government bond is simply a guaranteed claim against future tax revenue, government equity would simply be a non-guaranteed claim against the same revenue.
Meaning that instead of the federal government paying a return on investment for no productive effort, it should pay a rate of return that is only realizable against a taxable revenue stream (a job).
As for TIP's, they were one of the stupidest concoctions ever put forth by a Treasury Secretary (Bob Rubin). The whole rationale for them was that they prevented the federal government from trying to "inflate" its way out of debt. Anyone who understands even basic economics realizes that the federal government services its debt through tax revenues and the federal government's ability to collect tax revenue is unencumbered by the price level. Prices can fall and the federal government can get the same revenue as when prices rise.
"Why not go long? I suspect the Treasury is reluctant to go long because, under current accounting, moving $10 trillion of debt to long-term would add $277 billion to interest costs, which makes the current deficit look much worse. But this accounting makes no economic sense. Yield to maturity is not the same thing as the annual cost of borrowing, which includes capital gains and losses"
Huh??? To escape any budget window Congress throws up (10 year for instance), all the Treasury would need to do was extend the maturity beyond that window. The current deficit is the current interest payments on debt that comes due versus the current tax receipts. Because most of the federal debt is accrual rather than coupon type, interest payments are not made until the bond matures. And so your argument that this is about mark to market accounting only makes sense if federal debt is callable (and most of it isn't).
"The Treasury should issue perpetuities – bonds with no principal repayment date. When the government wants to pay down the debt, it simply buys them back at market value."
This is an even worse idea. The only way you would get anyone to buy those things would be for them to make coupon interest payments. Then you can really watch a government go over the edge as interest payments adjust upward without sufficient tax revenue backing. And again you are assuming that the federal government sells callable bonds - they haven't done that since about 1985.
When Bill Clinton was reducing the federal debt in the 1990's, guess which bonds were being bought back.
Good comments, thanks.
DeleteOn "government equity" that is what my variable-coupon debt really is. Also, nominal debt really is already "government equity," as inflation works like the "stock price" to change its real values when earnings (tax revenues) fall.
You seem to understand budget accounting better than I do. (In "huh??? to escape any budget window..." My understanding is that most long-term US debt is coupon debt, issued close to par. Thus, if the government issues $100 30 year debt, it will pay $2.77 coupons each year for 30 years and then principal, and the $2.77 shows up on each year's annual "interest cost" number. Am I wrong about that? Also, I don't understand how mark to market is related to callability. If I buy a house and it falls in value by half, that's a mark to market loss.
And with perpetuities. The point is that they do pay coupons. A perpetuity pays $1 coupon, forever. At 1% yield, it costs $100.
It might be worth following up offline. One reason I post these sorts of things is to hear from people who know more about accounting than I do!
John,
Delete"On government equity that is what my variable-coupon debt really is. Also, nominal debt really is already government equity, as inflation works like the stock price to change its real values when earnings (tax revenues) fall."
Not really. Any accounting definition will tell you that equity is the residual claim on the cash flow / net worth of an enterprise after all bond holders are made whole. Meaning in any capital structure equity is a junior claim to bonds senior claim. The variable-coupon debt is still debt because payments on those debt are guaranteed by the 14th amendment to the Constitution. What I am referring to is a government liability that offers a non-guaranteed rate of return.
Picture the federal government selling you a tax break that has a rate of return and a duration (similar to a bond). The only way for you to realize the return on investment is against your tax liability. For instance suppose the federal government sold you equity that matured within 5 years and had a rate of return of 8%. On a $10,000 investment, the value of that tax break would be $14,774. But the only way for you to realize that rate of return is to have a tax liability after five years of at least that amount.
John,
DeleteI was mistaken on the coupon issue.
http://www.treasurydirect.gov/indiv/research/indepth/tbonds/res_tbond.htm
http://www.treasurydirect.gov/indiv/products/prod_tnotes_glance.htm
They make semi-annual interest payments. I must have been thinking of zeroes (created by primary dealers by stripping the coupons).
"Has it ever occurred to you that the federal government should sell equity instead of debt?"
DeleteThe French tried that. It contributed to the Revolution and the tax farmers went to the guillotine.
Absalon,
DeleteTax farming was a process by which the collection of taxes was subcontracted out to a third party to eliminate the cost of a bureaucracy. In essence governments created for profit tax collection agencies.
That is not what I am talking about.
Frank
DeleteTax farming had two aspects. The private administration of tax collection and fixed payments from the tax farmer to the state. There is little economic difference between selling the right to an uncertain future tax revenue stream in exchange for, on the one hand, an agreed stream of future payments versus, on the other hand, a single lump sum. Who is responsible for the administration of the tax collection is a secondary matter when considering the economic effect of the arrangement.
There are fundamentally two problems with selling "equity". First, legally defining the revenue stream the buyer is getting would be almost impossible. Second, the uncertainties of the revenue stream would probably result in a higher discount rate than investors apply to existing forms of fixed rate debt. Any investor who wants to invest in the long run prospects of the US economy can buy an index fund on the S&P 500.
The congress sets the coupon, just as the corporation's board of directors sets the dividend. If congress doesn't set the coupon high enough, the voters fire them. If the board doesn't set the dividend payment high enough, the shareholders fire them. Not all bondholders are shareholders and vice versa, but the rough picture is the same. Variable coupon debt set by rule -- say proportional to GDP growth -- has also been advocated.
DeleteYes, it would sell for a lot lower price than bonds, or require a higher average coupon. For the government to buy the right to suspend payments in bad times, it will pay a premium. Buying insurance is a good idea even though you pay for it.
"Buying insurance is a good idea even though you pay for it."
DeleteNot always. I maximize the deductible on my car insurance when I have a new car and do not buy collision insurance at all when I have an old car. It only makes sense to insure a risk that would cause you hardship if it came to pass (or where the market is undercharging for the risk).
Correct. Both of which seem to me to be the case right now. 5% interest rate rise would cause the US a lot of hardship, and 2.77% 30 year rates strike me as the market charging very little premium.
DeleteAbsalon,
Delete"There is little economic difference between selling the right to an uncertain future tax revenue stream in exchange for, on the one hand, an agreed stream of future payments versus, on the other hand, a single lump sum."
I don't think you quite understand what I am talking about.
"There are fundamentally two problems with selling equity. First, legally defining the revenue stream the buyer is getting would be almost impossible. Second, the uncertainties of the revenue stream would probably result in a higher discount rate than investors apply to existing forms of fixed rate debt. Any investor who wants to invest in the long run prospects of the US economy can buy an index fund on the S&P 500."
Um, no. First the revenue stream that the buyer is getting is his or her own pretax income. What the federal government would be doing is offering a secondary means of settling a tax burden. A person could either pay his or her taxes in cash or use previously acquired equity to fulfill a tax obligation. The federal government would not be making cash payment "dividends" on the equity that it sells.
Second, yes there would be a discount between riskless Treasuries and a risk asset like equity - by design. The only question would be - should the federal government set the rate of return on its equity or should it rely on markets to set it.
Any investor that wants to invest in a broad swath of the US economy can buy S&P futures. Any producer that wants to lower his costs of production would buy government equity. The reason that I bring up government equity deals with a limitation of monetary policy - during severe deflation (an economy produces more than it consumes) the real cost of debt can be exhorbitant while the nominal cost is low. By selling government equity, the federal government can lower the after tax cost of money in the private sector below 0%. Meaning someone can produce more than what is consumed, fund that production with debt, and still say solvent.
John,
"Variable coupon debt set by rule -- say proportional to GDP growth -- has also been advocated." You are mistaken in believing that the rate of return should be pro cyclical. That is like saying that government spending should contract and taxes should be raised during a recession. Instead the rate of return on government equity should be countercyclical. Meaning the rate of return should be set to something like the output gap ( Real Potential GDP - Real GDP / Real Potential GDP).
And I agree with you that it would be prudent for the government to lengthen the maturity of bonds. The difference in coupon on a two year vs a thirty year is well worth it for the extra security. I think the market is mis-pricing the risk in a thirty year bond. However, that mis-pricing is partly due to intervention by the Fed in the bond market (quantitative easing) so there may be a limit on the ability of the government to go long.
DeleteFrank For the record: in my last post I was agreeing with Professor Cochrane's comment at 4:33, not your subsequent comment.
DeleteI went back and re-read your comments. What you are calling a sale of equity, I see as a non-refundable prepayment of taxes (with interest accruing on the prepayment). Given the risks and discounts involved I see no advantage to the government in such a plan.
If you want to set aside money to pay your taxes five years from now, you are perfectly free to buy a five year Treasury and use the proceeds in five years to pay your taxes. As a bonus, if your income falls you do not forfeit any part of the money you invested in the Treasury.
"Given the risks and discounts involved I see no advantage to the government in such a plan."
DeleteFirst, the government exists to serve the interests of the voting public. Second, what risks to the government? Obviously there is a cash flow issue that occurs when government sells liabilies that offer a rate of return. That rate of return can be coupon type (regular fixed interval payments) or lump sum accrual type (return on investment is realized at maturity).
With accrual securities, the federal government can escape any short term cash flow problems by simply extending the average maturity of the liabilities that it sells. In addition, because government equity would be non-guaranteed it incentivizes productive effort to realize the return on investment.
If a buyer is unable to realize the return in any one year he / she simply rolls over an existing investment to another year. The incentive still exists but in this case the buyer of the security has opted to extend the maturity of the government's liabilities.
"If you want to set aside money to pay your taxes five years from now, you are perfectly free to buy a five year Treasury and use the proceeds in five years to pay your taxes. As a bonus, if your income falls you do not forfeit any part of the money you invested in the Treasury."
If you are a producer looking to lower your cost of production you look at three things - capital, labor, and materials. If you do not have equity financing available (typical for most small businesses) your financing is limited to debt. As a producer your cost of debt service is realized on an after tax basis. And so the federal government by selling you equity (instead of playing give away / take away with rates) can lower your after tax cost of debt capital below 0%.
In which case, why would you "need" higher inflation - ever?
Frank
DeleteI really do not understand your reasoning. The cost of debt financing for a business is deductible in calculating taxable income. If a business does not have financing: where does the money come from to buy the "equity" from the government.
I am giving up trying to understand your proposal.
Absalon,
DeleteThe interest expense on debt financing is tax deductible, not the principle.
A business will have some available funds, but not enough to fund an investment which is typically the case. And so picture this as a for instance:
Company A has $1 million in free cash flow but it wants to invest in a new production facility that costs $5 million to build. It anticipates a lifespan of 30 years for the facility and so it decides to borrow at the going rate of 5%. Suppose that the federal government is selling 30 year equity that has a 10% return.
Should the company borrow $4 million at 5% using the free cash flow to reduce the amount borrowed OR should it borrow $5 million at 5% and use the free cash flow to buy $1 million in 30 year federal equity?
If you run the numbers it should be obvious that while buying the $1 million in 30 year federal equity is riskier, it reduces that after tax cost of servicing the debt significantly.
Frank
DeleteThe principal of a loan is not tax deductible but if the money is invested in buildings or equipment the depreciation of the capital cost is deductible over time.
You example says: assume companies can borrow at 5%; assume that the government is offering a 10% return on a prepayment of taxes. If companies can borrow at 5% there is no reason to think that the government of the United States would have to offer 10%. If I could lock in a 5% borrowing cost and a 10% investment return I would be leveraged to the hilt. In the real world, I sold off some equities and paid off my margin loan in August 2011.
Absalon,
Delete"If companies can borrow at 5% there is no reason to think that the government of the United States would have to offer 10%."
This is not a question of the government of the United States having to do anything. It is a question of is it in the best interests of the people of the United States for the federal government to do something like this.
"If I could lock in a 5% borrowing cost and a 10% investment return I would be leveraged to the hilt."
I doubt it. The 10% investment return is not guaranteed and so there is no way you could lock it in. That was the point. To realize that 10% investment return you would need to factor in what your anticipated tax liability would be when the government equity that you own matures. In essence you are buying government equity on the anticipation that you will have a tax liability 30 years (10 years, 2 years, whatever) down the road equal to or greater than the future value of the government equity that you bought.
You would be buying a risk asset, but you yourself would be responsible for realizing the return (as opposed to relying on 500 separate companies in the US).
"Anyone who understands even basic economics realizes that the federal government services its debt through tax revenues and the federal government's ability to collect tax revenue is unencumbered by the price level" ->
DeleteWow. Go tell that to Spain. The biggest determinant to tax revenues/govt expenses, for a given tax structure, is nominal GDP (real output * price level). And trying to increase taxes when NGDP drops due to low growth generally pushes NGDP down and gives a lower than hoped increase of in tax revenues.
If the price level drops due to an increase in productivity in a healthy economy that's growing, not much of a problem with taxes, but that's not what we're seeing now.
I think nominal bonds are fine if the central bank is targeting the level of NGDP. But with a vague inflation/unemployment mandate, TIPs can indeed tame the temptation of "inflating" to get out of debt problems.
DOB,
Delete"Wow. Go tell that to Spain. The biggest determinant to tax revenues/govt expenses, for a given tax structure, is nominal GDP (real output * price level). And trying to increase taxes when NGDP drops due to low growth generally pushes NGDP down and gives a lower than hoped increase of in tax revenues."
First I said the federal government's ability to "collect" tax revenue is unencumbered by the price level. The federal government's ability to "maximize" tax revenue does indeed depend on other factors. So what should I tell Spain?
"I think nominal bonds are fine if the central bank is targeting the level of NGDP. But with a vague inflation/unemployment mandate, TIPs can indeed tame the temptation of "inflating" to get out of debt problems."
You wouldn't have the "temptation" of inflating to get out of debt problems if someone would realize that the capital markets allow for both debt AND equity. And please tell me how negative market yields on TIPs eliminate the temptation of inflating?
Frank,
Delete"First I said the federal government's ability to "collect" tax revenue is unencumbered by the price level. The federal government's ability to "maximize" tax revenue does indeed depend on other factors." ->
Fair enough. If you're statement was simply that the activity (not amount) of tax collection isn't affected by the price-level, then I guess I mostly buy that.
"You wouldn't have the "temptation" of inflating to get out of debt problems if someone would realize that the capital markets allow for both debt AND equity."
The equity idea is an interesting one. As of now, all citizens (taxpayers?) are implicitly holders of a share. When you're born a citizen (or is it when you enter the tax residency?), or naturalized, you get a share. When you die, or give up citizenship, you lose a share.
You want these shares to trade in the markets I assume? What kind of "voting rights" would these shareholders have? If none, then what's the incentive for non-shareholding citizens to not undertax? If much, then does that mean it's no longer a democracy? What's to prevent the shareholders "overtax" the citizens for profit?
I personally think it's simpler to pass some kind of golden rule (#4 in my list of proposals) whereby the book value of the government is kept near zero at all times so that people can enter/exit the citizenry/taxbase freely without having a wealth impact on themselves or others. I understand book value isn't stock price, but this is a good enough proxy for keeping thinks in check.
Negative market yields in TIPs just mean it's cheap for the government to issue. When it's cheap in TIPs, it's also cheap in nominals. TIPs vs nominals have the same expected returns, it's the sensitivities that change. If the govt issued 100% of its debt in TIPs, nudging the Fed to target a higher inflation rate would not help the government get relief on the liability side.
DOB,
Delete"The equity idea is an interesting one. As of now, all citizens (taxpayers?) are implicitly holders of a share. When you're born a citizen (or is it when you enter the tax residency?), or naturalized, you get a share. When you die, or give up citizenship, you lose a share."
Correct, but with implicit ownership you are at the mercy of political machinations that changes every 2 to 4 years. With explicit ownership (government equity) your sensitivity to changes in poltical guardianship of the economy drop.
"You want these shares to trade in the markets I assume?"
They could trade on the markets but that is not a requirement. Ultimately I want the federal government to realize that contracts work better than discretion (from a long term growth perspective) and nonguaranteed contracts work better than guaranteed contracts (from a productivity perspective).
"What kind of voting rights would these shareholders have?"
Obviously, tax rates still play a part. If the federal government sets all tax rates to 0% or 100% then there is no way it can sell equity claims against zero future revenue and there is no way to sell equity claims when no one has any money to buy them. The voting rights come from the ability to vote and shape what tax rates should be.
"If none, then what's the incentive for non-shareholding citizens to not undertax?"
I am not sure what you mean by undertax. If the federal government sets all tax rates to 0% then there is no way for any equity buyer to realize a rate of return.
"If much, then does that mean it's no longer a democracy? What's to prevent the shareholders "overtax" the citizens for profit?"
Again I am not sure what you mean by overtax. If the federal government sets all tax rates to 100% then no one would have any money to buy government equity.
"I personally think it's simpler to pass some kind of golden rule (#4 in my list of proposals) whereby the book value of the government is kept near zero at all times so that people can enter/exit the citizenry/taxbase freely without having a wealth impact on themselves or others."
I am not sure what you mean by the book value of the federal government. You do realize that its liabilities (bonds) are not claims on physical assets - yes?
Absalon,
DeleteOne other thing:
"The principal of a loan is not tax deductible but if the money is invested in buildings or equipment the depreciation of the capital cost is deductible over time."
Incorrect. Depreciation is treated by the tax code as the result of normal wear and tear on an asset. A building or piece of equipment has an anticipated useable life of 5, 10, 15, 30 years and so the tax code allows you to deduct the loss of usable life from an asset.
On the other hand, capital losses / capital gains of long lived assets (like buildings) are only realized when those assets are bought and sold.
Greg Mankiw bemoans Warren Buffets "tax avoidance" scheme of being a long term investor:
http://gregmankiw.blogspot.com/
But the only other alternative is for the federal government to tax unrealized gains and refund unrealized losses. That creates a perverse incentive to always report losses. Because those losses are anticipated rather than realized, they are based on a guess of what the market value of assets at sale is.
What the tax code does not address however is the possibility that competition (from a foreign country for instance) reduces the utilitarian value of an asset below its cost of purchase. Meaning that a new piece of equipment loses value both because it is getting older and because it is not being used to its potential.
See output gap:
http://research.stlouisfed.org/fred2/graph/fredgraph.pdf?&chart_type=line&graph_id=&category_id=&recession_bars=On&width=630&height=378&bgcolor=%23b3cde7&graph_bgcolor=%23ffffff&txtcolor=%23000000&ts=8&preserve_ratio=true&fo=ve&id=GDPPOT_GDPCA&transformation=lin_lin&scale=Left&range=Custom&cosd=1960-01-01&coed=2022-10-01&line_color=%230000ff&link_values=&mark_type=NONE&mw=4&line_style=Solid&lw=1&vintage_date=2012-11-29_2012-11-29&revision_date=2012-11-29_2012-11-29&mma=0&nd=_&ost=&oet=&fml=%28a-b%29%2Fa&fq=Annual&fam=avg&fgst=lin
Frank,
DeleteI think I'm starting to understand what you're trying to say.
Sounds like you rely a lot on the repeated game aspect of equity issuance. For instance: assume the equity program has grown and the government has issued a meaningful amount of equity to fund itself. Then some political party comes in power and decides something along the lines of:
"A rich minority holds most of the equity of the govt. Screw them, let's give a tax break to the poor rather than pay any dividend"
Yes, the price of the shares should drop to zero and yes, the govt will never be able to issue any equity after that. But assuming the "market cap" (which is the PV of the expected dividend stream) was high, that's a huge windfall for the taxpayer, who is still the ultimate equity holder in your system. In that sense your system works more like a preferred stock than actual equity, since it gives no control to the securities holders.
How do you prevent that situation from occurring? What's the incentive for a government to pay dividends given that its electoral base is very different from the stock holder base?
"I am not sure what you mean by the book value of the federal government. You do realize that its liabilities (bonds) are not claims on physical assets - yes?" ->
Just because the bankruptcy process works differently for sovereigns doesn't mean the economics are so different. The transmission works this way:
- If the assets of the govt aren't worth much, then the govt can't justify taxing its citizen that much for their use
- If it does attempt to tax anyway, the citizens will either suck it up and enjoy a lower standard of living, or flee to countries where they get better public service for their money
That's why we must keep the assets in line with the level of liabilities. This way those who come and go don't benefit at the expense of those who remain. Yes, it's not exactly well defined how to value the assets; that's just one more reason to keep government small.
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DeleteDOB,
Delete"How do you prevent that situation from occurring? What's the incentive for a government to pay dividends given that its electoral base is very different from the stock holder base?"
The incentive is for the federal government to allow equal market access to purchasing its equity and to resist the temptation of equity grants. In short, the federal government must practice egalitarianism instead of cronyism. Difficult for politicians? Yes - they can't see beyond the next election.
"A rich minority holds most of the equity of the govt. Screw them, let's give a tax break to the poor rather than pay any dividend"
Problems don't arise when the rich minority hold most of the equity of the government. Problems arise when the rich minority are the only people permitted to buy the equity of the government. It is a market access problem, not an ownership problem.
DOB,
Delete"How do you prevent that situation from occurring? What's the incentive for a government to pay dividends given that its electoral base is very different from the stock holder base?"
The only way for a government's electoral base to become very different from it's stockholder base is when the government places limitations on who can buy it's equity and who can't.
"A rich minority holds most of the equity of the govt. Screw them, let's give a tax break to the poor rather than pay any dividend"
The only way for a minority to hold most of the equity of the government is for the government to discriminate who is permitted to buy it's equity and who is not permitted.
Rich or poor has very little to do with it. Even if the very rich buy a lot of government equity, then can still lose money on the investment.
Sorry but you're not answering any of my questions..
DeleteThe richest X% of the population owns Y% of such or such asset, with X small and Y large is true for virtually every asset class. That's just the natural order of things and it would be the case regardless of any legislation on market access or lack thereof.
Assuming this happens, what's to prevent a populist politician to screw the holders of the stock in favor of everyone else?
In the case of a regular company, it's obvious: the stockholder control the activity of the company either directly or through the board when they're too large in number.
Here, the control is democratic and unrelated to ownership, so what gives?
DOB,
Delete"The richest X% of the population owns Y% of such or such asset, with X small and Y large is true for virtually every asset class. That's just the natural order of things and it would be the case regardless of any legislation on market access or lack thereof."
"Assuming this happens, what's to prevent a populist politician to screw the holders of the stock in favor of everyone else?"
Maybe your definition of populist differs from mine. You view a populist politician as a politician that tries to equalize outcomes, my definition is a politician that tries to equalize opportunities.
And so you say a populist politician would try to "screw the holders of government equity" by giving a tax break to the poor rather than paying a dividend.
Let me step back and try to explain what I mean by government equity. Equity in an accounting sense is a residual claim on a cash flow after debt claims have been paid. In that strict definition, it is a junior claim to a bond's senior claim. A financial asset is not equity because it pays a dividend. It is equity because the rate of return on the asset is not afforded the same legal protection that bonds are. For government bonds, that protection comes from the 14th amendment to the Constitution of the United States - payments to bondholders in the form of interest supercede all other government expenditures.
Now let me answer your question. The ONLY way for an owner of government equity to realize the rate of return on that equity is to have a tax burden at a future date that is equal to or greater than the value of that equity at a future date. The equity that I imagine does NOT make cash payments in the form of dividends.
And so a politician (populist or non-populist) can only "screw" a person by first selling him equity AND then lowering that same person's tax rate. Imagine you bought government equity to offset an anticipated tax rate of 35% of your income. Then a "populist politician" comes along and lowers your tax rate to 20% of your income. That politician just screwed you.
Like I said, it has nothing to do with rich or poor. If a politician sold a lot of government equity to rich guys and then another politician cut the tax rate faced by those rich guys, those rich guys just bought a bunch of equity that would become a lot less valuable (they would lose money on the investment).
Frank,
DeleteSorry, but I still have no idea what you're talking about.
"And so a politician (populist or non-populist) can only "screw" a person by first selling him equity AND then lowering that same person's tax rate."
Are you assuming these shares aren't fungible, i.e. they're attached to the name of a certain person and depend on what taxes he's paying somehow?
DOB,
DeleteLet me try again.
"The richest X% of the population owns Y% of such or such asset, with X small and Y large is true for virtually every asset class. That's just the natural order of things and it would be the case regardless of any legislation on market access or lack thereof."
And that is only problematic for fixed resources. The present value of all tax revenue the federal government is ever going to collect is - infinite - at any tax rate other than 0% and 100%. Government equity is a claim against that infinite source.
"Are you assuming these shares aren't fungible, i.e. they're attached to the name of a certain person and depend on what taxes he's paying somehow?"
The realized rate of return on the investment is dependent on the tax rate that the person is paying - yes. I am not assuming that the equity is attached to the name of some person. I am assuming that the only person who can realize the rate of return on the equity is someone who has a tax liability when the equity reaches maturity (that may or may not be the original owner).
What I am saying is that the owner of the equity is responsible for generating the return on that equity. And so government equity would not be making dividend payments.
Let me give an example:
Government sells you 30 year government equity with a fixed 8% annualized return on investment. You are anticipating a taxable income of $100,000.00 30 years from now and an after tax income of $70,000 30 years from now (30% tax rate). You buy $2,980 of 30 year equity. After 30 years that $2,980 of initial investment will cover $30,000 of tax liability.
20 years from your purchase, some populist politician decides to lower your tax rate to 20%. Suddenly your return on investment can shrink unless your pretax income is larger than you anticipated.
Frank,
DeleteAlright, thanks for clarifying. The instrument you describe might be junior to bonds, but it has fixed return and a fixed maturity so it doesn't feel or smell like equities. Maybe a preferred stock. So the taxpayer/citizen is still the ultimate implicit equity owner.
Moreover, you're assuming taxation is kept proportional to income. To use your example above, I'm expecting $100k taxed at 30%, leaving me with $70k of after tax income. Imagine the government changes the tax structure to exempt the first $50k, but now the marginal tax rate is 60% after that. My tax burden is still $30k. But depending on the income distribution at that time, the return on my shares has either skyrocketed or plummeted. This just doesn't work as a tax hedge.
You also haven't specified under which conditions the government chooses to not pay return to the preferred shares..
Finally, you're missing the spending side of the equation: without taxes changing at all, if spending increases, my shares aren't worth much, yet my taxes are still there. The present value of all government expenditure probably isn't any smaller than that of taxes.
DOB,
Delete"Moreover, you're assuming taxation is kept proportional to income. To use your example above, I'm expecting $100k taxed at 30%, leaving me with $70k of after tax income. Imagine the government changes the tax structure to exempt the first $50k, but now the marginal tax rate is 60% after that. My tax burden is still $30k. But depending on the income distribution at that time, the return on my shares has either skyrocketed or plummeted. This just doesn't work as a tax hedge."
Fair enough. I was primarily concerned with tax burden of original owner. Yes changes in marginal tax rates and income distribution will affect the pool of buyers and sellers of equity and can thus affect the market value of the equity. If as you say, the first $50,000 of income is excluded from taxation and the distribution of U. S. income is skewed so that a lot of people pay no taxes (incomes below $50,000) then suddenly a lot of potential equity buyers disappear.
"You also haven't specified under which conditions the government chooses to not pay return to the preferred shares."
It is not a question of the government refusing to pay the return on investment. The risk lies with the buyer not the seller (different than corporate equity). It is a question of the government equity buyer having a taxable revenue stream (and thus tax burden) to realize the rate of return against. There is no logical reason that I can think of why the federal government would sell equity and then refuse to accept it back as payment on a tax burden.
"Finally, you're missing the spending side of the equation: without taxes changing at all, if spending increases, my shares aren't worth much, yet my taxes are still there."
It took me this long just to explain the finance side :-)
Increased government spending can create an inflationary pressure (demand for goods increases without increasing supply). And so you would want a "Federal Reserve" type of independent body to set the initial rate of return that is offered when the government sells equity. In essence you want your return on investment to be positive on a inflation adjusted basis.
The logical choice for this would be the U. S. Treasury department. But for such a system to work and work well, Congress would have to cede some power to the Executive branch in exercising tax policy (Treasury department falls under Executive Branch of government). And second you would need a Treasury Secretary that is politically neutral - which is very atypical.
Frank,
DeleteAlright so we're back to something roughly equivalent to my initial proposal: some independent body of the government looks after the taxpayer equity (public assets - public liabilities).
Whether equity-like instruments are used for funding or not is optional, you need the watchdog either way..
DOB,
Delete"Alright so we're back to something roughly equivalent to my initial proposal: some independent body of the government looks after the taxpayer equity (public assets - public liabilities)."
You got it.
"Whether equity-like instruments are used for funding or not is optional, you need the watchdog either way."
Yes it is optional and yes you need an apolitical watchdog. However, there are reasons other than funding expenditures for the federal government to sell equity claims on its revenue. It comes down to a limitation of monetary policy. The central bank (Fed) buys and sells government debt to set a nominal cost of money (interest rate). But real interest rates can move independently of central bank operations depending on the productivity of a nation. During the Great Depression real interest rates rose to north of 15% while nominal interest rates were in the 3% to 4% range (severe deflation). If a government wants to embrace that productivity, they sell equity that reduces the after tax cost of money.
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ReplyDeleteJohn,
ReplyDelete"Our Government has taken the opposite tack. When you include the Fed (The Fed has bought up most of the recent long-term Treasury issues, in a deliberate move to shorten the maturity structure.."
The Fed's actions don't really shorten the maturity structure do they? It seems their actions would only shorten the non-Fed held treasury maturity structure. Overall treasury structure stays the same.
It shortens the maturity structure of debt held outside the government. Suppose one department of the Treasury issued long term bonds, but another department bought back the long term bonds and issued short term bonds. Then, it would be clear that the maturity structure is not longer. As far as the economy is concerned, whether that "other department" is part of the Fed, or the Treasury does not matter. They share the same budget constraint.
DeleteThanks for the reply. Shortening the maturity of debt held outside the government is what I meant by "only shorten[ing] the non-Fed held treasury maturity structure" so I get that. And as long as the Fed's holding of treasuries is a minor part--which it is in normal times and now it is only around 15%--then the rollover risk remains an issue for the non-government held debt.
DeleteDoes that sound right? Trying to wrap mind around this, lot to chew on.
Your point is right. The Fed has bought most of the flow of new long-term debt, but even the Fed's $2 trillion is small compared to the $16 trillion stock of debt, much of it short-term. So, while the Fed is not moving in the right direction (in my opinion), you are right that it has not changed the overall maturity structure (duration, if you wish) all that much. Even if the Fed stops paying the Treasury anything, that's still small compared to the $800 trillion increase in deficit that 5% more rates implies.
DeleteLast question, I promise. We don't need an inflation scare for the Treasury to face higher financing costs. Just a solid economic recovery would lead to higher yields. But while this would raise Treasury's financing costs, the recovery would also bring in more tax revenue. Would this be a wash or not? Thanks again.
DeleteSolid recovery -- and better, prospects for solid long-run growth would help enormously. The nightmare is stagflation, or run on debt in a stagnant real economy. Greece, Spain, Portugal.
DeleteIs it possible that the yield on 30 year treasury bonds would increase significantly if the Treasury starts to issue a lot more of them - following market segmentation theory of the yield curve. Or structuring their debt profile "long" with derivatives would cost more than current market prices imply, because of basic demand/supply effects?
ReplyDeleteThis is a really interesting question. (Other comments echo it.) Let's remember econ 1: everyone is "marginal" not just the largest purchaser. We can all buy sell and swap 30 year debt, and every pension fund, sovereign wealth fund, endowment and hedge fund and bank can and does operate in these markets. Just because the fed and central bank of china are the biggest buyers does not mean they "set the price." And econ 2: the general equilibrium version of supply and demand is Modigliani and Miller -- financing choices don't matter. So we do have to go out to some segmented markets or other story to think that the fed's purchases have any impact at all -- or that treasury selling more than the fed is buying has any impact. Even the event studies only found qe2 to have 15 bp impact, and that was for one day. Does it have any sustained impact, over years, when markets can unsegment?
DeleteIn any case, starting to sell or swap 30 year debt would be a great experiment. If, as you think, long term interest rates start to rise that certainly would be a canary in the coal mine. For if markets are unwilling to swap $1 trillion of short debt for $1 trillion of long debt, how long will they flat out buy $1 trillion of any debt to finance never ending deficits.
So, even if you're right, and there is no market depth, shouldn't we find that out, fast?
according to this chart http://en.wikipedia.org/wiki/File:Composition_of_U.S._Long-Term_Treasury_Debt_2005-2010.PNG
Deletewe have roughly 4.5 trillion of long term debt out of a total of 11 trillion held by the public. That's a fairly high percentage already, no ?
John,
Delete"And econ 2: the general equilibrium version of supply and demand is Modigliani and Miller -- financing choices don't matter."
They don't matter for monopoly enterprises. They matter a whole lot for enterprises that are or can be subject to outside competition. Miller Modigiliani specifically excludes the possibilty or bankruptcy or insolvency. It ultimately comes down to financing time horizon. The time horizon that any monopoly can issue securities for is infinite.
"For if markets are unwilling to swap $1 trillion of short debt for $1 trillion of long debt, how long will they flat out buy $1 trillion of any debt to finance never ending deficits?"
As long as it is profitable to do so. Everyone may be marginal but not all buyers are leveraged.
"Just because the fed and central bank of china are the biggest buyers does not mean they set the price."
Um,yes they do. The fed and central bank of china are in fact monopoly enterprises. And so with any monopoly, they have the final say on price. The markets can try to sell into a monopoly but to no avail. If the fed wants long term interest rates at 3% or 10%, they have all the ammunition they need to make it so.
You are assuming that the high rates/high inflation, difficult to rollover debt scenario is more likely and/or more dangerous than the scenario of high deflation, low rates for 20 years a la Japan. What if we end up in that scenario and also have locked in high borrowing costs for 20 years. It seems to be a quite dangerous proposition as well. The deflation scenario is also harder for the Fed to fight so technically we should be worried about it more than the opposite
ReplyDeleteCan I use the theories from corporate finance to analyze the maturity structure of sovereign debt? I would like to analyze the signallig theory, taxes theory, agency theory in the sovereign market using proxies for those theories. Would it have any sense?
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