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Friday, August 23, 2019

Negative Bond Yield and Austrian Economics

The Federal Reserve has declared that it may push U.S. interest rates into sub-zero territory. This will have a load of unforeseen consequences. In this article I take a look at what Austrian economics can tell us about this new, dangerous economic territory.


As regular readers of this blog know, I am one of two libertarian Keynesians in the world (the other one is in Australia). I am also generally skeptical of Austrian economics, but that does not mean I dismiss it entirely. On the contrary, I do believe there is fertile ground for a fusion of traditional Keynesian economics - as Keynes invented - and Austrian theory.

In today's economic environment, when negative interest rates are raging through our debt markets, it is particularly important that we cross-breed between Austrian economics and original Keynesian theory. As I will explain in this article, only then can we see the real substance of the consequences we face, both in America and in Europe, in this new sub-zero yield economy.

One of the upfront consequences is the destruction of the corporate-bond market. At this point, sub-zero yield corporate bonds are thriving, with the international market for them having grown 50-fold so far in 2019 alone. However, as other analysts have explained, there are enormous risks associated with this market - risks the nature and consequences of which we can only explain comprehensively explain if, again, we combine Austrian and Keynesian economics.

To understand what this combination means in practice, let us start with a very quick theoretical review. Austrian theory and original Keynesian theory (as formulated primarily but not only in Keynes's Treatise on Probability and General Theory) share two important postulates that make them particularly intriguing for economic analysis:
  • Humans are imperfect, therefore there can be nothing perfect about the economy; and
  • Because humans are imperfect, the future is fundamentally uncertain until we make it predictable.
For those who want to study what this means for macroeconomic analysis, I recommend this paper. More to the point, though, there is a compelling practical application of these two postulates. In Austrian theory it centers around the theory of the natural interest rate; in Keynesian theory its focal point is the liquidity trap.

What makes Austrian and Keynesian economics stand out over mainstream theory in this regard is that they both logically incorporate time and space into the definition of allocation. Mainstream economics, based as it is on Walrasian price theory, cannot do that. Walrasian price theory is in fact the logical opposite of intertemporal analysis - it does not work unless it removes the distinction between the future from the present. Austrian economics - like Keynesian theory - separates the present from the future by, in brief, recognizing that the future by default is fundamentally uncertain.

It is here that we find the bridge into the negative-yield economy, and in this article we will explore it from an Austrian perspective. A coming article will take the Keynesian view. 

Entrepreneurs, investors and households all weigh the assessment of an uncertain future against what rewards they see in exposing themselves to it. The instrument used for that assessment is risk, but a risk calculation is only an imperfect method for quantifying our exposure to uncertainty.

Risk assessments are by necessity quantitative, and in being so cannot capture aspects of the future that are relevant for the investment decision but do not lend themselves to quantitative analysis. To mitigate this problem, advanced economies have developed markets for managing risk.  A key ingredient of those markets is the interest rate. Therefore, when the free market is left alone it will provide an imperfect but still the best possible pricing of risk vs. reward on allocating capital over time.

Austrian economists, using their theorem of the natural interest rate, explain well what the virtues are when the interest rate is allowed to work as an intertemporal allocation mechanism for capital. They also explain well what happens when government distorts risk markets by means of excessive money printing. However, the conclusions we can draw from simply applying excessive money printing to the natural-rate theorem are too limited to explain today's sub-zero yield environment. We need to add that sub-zero component, and expand our understanding of it with its original cause.

Government debt.

Without government debt we would not have a negative-yield problem. I recently pointed to how the trillion-dollar budget deficit that Congress and President Trump have created, is about to return us to Quantitative Easing. We would not be going there if we did not have an explosive deficit in the federal budget - and we would not have such a grim outlook on the return of QE if it weren't for the fact that the federal government is borrowing 24 cents of every dollar it spends in the middle of the strongest economy in 20 years.

A return to QE and a very big deficit are bad enough, but there is a new component that makes this entire situation particularly volatile - and uncertain. There is a rapidly growing market for corporate debt with negative yield. MSN reports:
Investors these days are facing huge amounts of fixed income instruments that carry no yield. Various estimates of sovereign debt in that category put the total in excess of $15 trillion, a number that has been escalating over the past several years while central banks drive interest rates to zero and below. Negative-yielding corporate debt, though, is a relatively new thing, rising from just $20 billion in January to pass the $1 trillion mark recently, according to Jim Bianco, founder of Bianco Research. ... "The interest rate risk that these bonds carry is huge," Bianco said in a recent interview. "The financial system doesn't work with negative rates. If the economy recovers, the losses that investors would take are unlike anything they've ever seen."
Bianco, as quoted by MSN, points to part of the problem. If you lend someone $100 on the explicit term that you will only get $98 back a year later, you have accepted a two-percent negative rate. It does not take much increase in the market interest before you are left with a substantial loss. 

Arithmetically, of course, the difference between a three-percent positive rate and a two-percent negative rate is the same as the difference between the market rate climbing to ten percent while you only get five percent. In reality, though, there is a substantial difference. In the latter case you get a premium for taking the risk of investing in corporate debt; in the former case you take a loss on top of exposing yourself to risk, while the market rate rewards risk taking. 

Herein lies the significance in the negative rate, a significance that is best understood within the context of Austrian theory (and, later, Keynesian theory). In a manner of speaking, negative interest rates have the same distortionary effect on intertemporal resource allocation as deflation has on product and labor markets. (No, there is no Pigou effect...) When the market interest rate is pushed below the natural rate, the private sector will over-invest for the future. This over-investment leads to excess capital and excess production capacity at some future point in time; the economy goes into a recession. 

This is the traditional Austrian explanation of what role intertemporal resource allocation plays in the economy. Let us now add two components: sub-zero rates and their origin, namely government deficits. 

When central banks drive interest rates negative under Quantitative Easing, this should exacerbate over-allocation of capital as we just explained. However, the negative rate on corporate debt changes the investment calculation that normally applies to the bond market. Buying corporate debt is, at least in theory, associated with a greater-than-zero risk. To attract investors, this risk requires a mark-up over risk-free alternatives, such as cash deposits or treasury bonds. When interest rates are negative, the yield on the bond does not mitigate, but instead exacerbates the risk taken by the investor. 

Since the market for negative-yield corporate debt is new - at least in its size - it has not yet been tried in a recession to any significant degree. However, as the macroeconomic outlook worsens and both Europe and America inch closer to a recession, we can expect a more risk-conscious approach to negative-yield corporate bonds. Together with a continued growth in that market, this opens for a scenario where the negative-yield private debt market loses out, and loses out fast, to the market for negative-yield government debt.

Under negative interest rates, the upfront question for the investor is already how much money he is willing to lose. When there is no yield to compensate for greater-than-zero risk, all the investor has to look at is - yes - the risk for losses. Since treasury bonds such as those issued by the U.S. government remain zero-risk investments, they will become increasingly attractive to investors.

This is significant from the perspective of Austrian theory. It means that government manipulates the debt market to a point where they can attract more investors to fund their spending today. In macroeconomic terms, this reverts the intertemporal allocation of economic resources compared to what Austrian theory tells us, but it a logical conclusion precisely based on that theory. There is an over-allocation of resources today - in the form of excessive government spending - and an under-appreciation of the need for investments for tomorrow (i.e., in the form of private-sector investments). 

Plainly: negative interest rates, driven by government debt, will aggravate the economic imbalance we already have between government and the private sector.

In the next article we will look at the same problem of government deficits and sub-zero yield from a Keynesian perspective.

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