When Interest Rates Rise

Martin Feldstein

30 March 2013
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CAMBRIDGE – Long-term interest rates are now unsustainably low, implying bubbles in the prices of bonds and other securities. When interest rates rise, as they surely will, the bubbles will burst, the prices of those securities will fall, and anyone holding them will be hurt. To the extent that Banks and other highly leveraged financial institutions hold them, the bursting bubbles could cause bankruptcies and financial-market breakdown.
The very low interest rate on long-term United States Treasury bonds is a clear example of the current mispricing of financial assets. A ten-year Treasury has a nominal interest rate of less than 2%. Because the inflation rate is also about 2%, this implies a negative real interest rate, which is confirmed by the interest rate of -0.6% on ten-year Treasury Inflation Protected Securities (TIPS), which adjust interest and principal payments for inflation.
Historically, the real interest rate on ten-year Treasuries has been above 2%; thus, today’s rate is about two percentage points below its historical average. But those historical rates prevailed at times when fiscal deficits and federal government debt were much lower than they are today. With budget deficits that are projected to be 5% of GDP by the end of the coming decade, and a debt/GDP ratio that has roughly doubled in the past five years and is continuing to grow, the real interest rate on Treasuries should be significantly higher than it was in the past.
The reason for today’s unsustainably low long-term rates is not a mystery. The Federal Reserve’s policy of “long-term asset purchases,” also known as “quantitative easing,” has intentionally kept long-term rates low. The Fed is buying Treasury bonds and long-term mortgage-backed securities at a rate of $85 billion a month, equivalent to an annual rate of $1,020 billion. Since that exceeds the size of the government deficit, it implies that private markets do not need to buy any of the newly issued government debt.
The Fed has indicated that it will eventually end its program of long-term asset purchases and allow rates to rise to more normal levels. Although it has not indicated just when rates will rise or how high they will go, the Congressional Budget Office (CBO) projects that the rate on ten-year Treasuries will rise above 5% by 2019 and remain above that level for the next five years.
The interest rates projected by the CBO assume that future inflation will be only 2.2%. If inflation turns out to be higher (a very likely outcome of the Fed’s recent policy), the interest rate on long-term bonds could be correspondingly higher.
Investors are buying long-term bonds at the current low interest rates because the interest rate on short-term investments is now close to zero. In other words, buyers are getting an additional 2% current yield in exchange for assuming the risk of holding long-term bonds.
That is likely to be a money-losing strategy unless an investor is sagacious or lucky enough to sell the bond before interest rates rise. If not, the loss in the price of the bond would more than wipe out the extra interest that he earned, even if rates remain unchanged for five years.
Here is how the arithmetic works for an investor who rolls over ten-year bonds for the next five years, thus earning 2% more each year than he would by investing in Treasury bills or bank deposits.
Assume that the interest rate on ten-year bonds remains unchanged for the next five years and then rises from 2% to 5%. During those five years, the investor earns an additional 2% each year, for a cumulative gain of 10%. But when the interest rate on a ten-year bond rises to 5%, the bond’s price falls from $100 to $69. The investor loses $31 on the price of the bond, or three times more than he had gained in higher interest payments.
The low interest rate on long-term Treasury bonds has also boosted demand for other long-term assets that promise higher yields, including equities, farm land, high-yield corporate bonds, gold, and real estate. When interest rates rise, the prices of those assets will fall as well.
The Fed has pursued its strategy of low long-term interest rates in the hope of stimulating economic activity. At this point, the extent of the stimulus seems very small, and the risk of financial bubbles is increasingly worrying.
The US is not the only country with very low or negative real long-term interest rates. Germany, Britain, and Japan all have similarly low long rates. And, in each of these countries, it is likely that interest rates will rise during the next few years, imposing losses on holders of long-term bonds and potentially impairing the stability of financial institutions.
Even if the major advanced economies’ current monetary strategies do not lead to rising inflation, we may look back on these years as a time when official policy led to individual losses and overall financial instability.

Martin Feldstein, Professor of Economics at Harvard University and President Emeritus of the National Bureau of Economic Research, chaired President Ronald Reagan’s Council of Economic Advisers from 1982 to 1984. In 2006, he was appointed to President Bush's Foreign Intelligence Advisory Board, and, in 2009, was appointed to President Obama's Economic Recovery Advisory Board. Currently, he is on the board of directors of the Council on Foreign Relations, the Trilateral Commission, and the Group of 30, a non-profit, international body that seeks greater understanding of global economic issues.

March 31, 2013 4:46 pm
Confessions of a Keynesian heretic

I may be the only self-professed Keynesian who is not actively campaigning for large public infrastructure projects. Don’t get me wrong; I believe repairing a few bridges or building an oil pipeline or two would be good things to do. But it is unhelpful to confuse arguments for public investment with plans to restore full employment.

Would a big-state investment programme increase employment? Yes. Would it be cheap, since interest rates are low? Absolutely. But it is much easier to increase the size of government than to shrink it.

The Keynesians are right: we need to increase demand. But what is the best way to do that? I prefer to see the creation of more private sector jobs, not more government jobs. One way to do that is through managing the value of financial wealth, an approach that offers a creative alternative to more government spending in a time of austerity.

John Maynard Keynes thought that public investment would restore full employment even in the extreme case when spending had no social value; for example, a scheme to dig holes and fill them in. He thought that the newly employed workers would spend more on consumer goods and trigger a virtuous cycle of increasing income and employment. Some argue that for every newly created public sector job, the associated increase in demand might trigger as many as two new private sector jobs. I disagree.

The social benefit of more government spending of this kind rests on the answer to a simple question. Does every extra pound of government expenditure raise gross domestic product by more tan £1? If so, the so-called multiplier is bigger than one. If, on the other hand, every pound of government expenditure raises GDP by less than £1, the multiplier is less than one. My reading of the facts is that this latter situation is closer to the truth.

If the multiplier is bigger than one, social investment projects, whatever their intrinsic worth, will increase private consumption and make everybody better off. If the multiplier is less than one, digging holes will create jobs but we will be worse off. We will have gained full employment at the cost of less consumption. We cannot eat holes in the road.

Until economies hit hard by the financial crisis grow to a point where we need all of those houses in Ireland or Nevada, they should, primarily, produce more consumer goods. Sincé households spend more when they feel wealthy, one way to get people back to work is to reflate the asset markets. Central banks and treasuries should actively intervene to reflate the asset market bubble.

This heretical view will be widely denounced by those who think that free trade in financial instruments leads to an efficient allocation of capital. That notion is hard to defend in the wake of yet another financial collapse. It has long been known that financial markets are excessively volatile.

Recent research has shown why: for markets to work well, everybody who has an interest in the outcome of volatility must be able to trade in those markets.

Financial crises have effects that last for decades and the earnings of those who enter the workforce in a boom, as opposed to a slump, can vary substantially. Many people who will be affected were not alive on the date the crisis hit and those people are unable to buy insurance against severe recessions. Government can and should trade on their behalf.

A further increase in equity prices, engineered by government, will benefit us all. As the economy recovers, employment will rise, tax revenues will rise and the need for austerity will fade.

For example, the Bank of England, backed by the Treasury, does not need to print money to restore full employment – a move that would potentially be inflationary. They need simply to absorb the risky assets that private markets are unable to absorb by swapping debt for equity held by the public.

If the market was overvalued in 2007, how could we possibly gain by going back to a situation of apparently unrealistic equity prices? An analogy may help. If we are sitting in a hot-air balloon that is out of control, the solution is not to burst the balloon and crash back to earth.

It is to install an escape valve and let the gas out slowly. So it is with the financial markets. Governments can, and should, restore demand and engineer a smooth return to sustainable growth.

The writer is distinguished professor of economics at the University of California, Los Angeles 

Copyright The Financial Times Limited 2013.

martes, abril 02, 2013



China on the Move

Stephen S. Roach

29 March 2013
This illustration is by Paul Lachine and comes from <a href="http://www.newsart.com">NewsArt.com</a>, and is the property of the NewsArt organization and of its artist. Reproducing this image is a violation of copyright law.

BEIJINGThe debate is over. After six years of weighing the options, China is now firmly committed to implementing a new growth strategy. At least, that’s the verdict I gleaned from the just-completed annual China Development Forum, long China’s most important dialogue with the outside world.
There were no surprises in the basic thrust of the strategy – a structural shift in China’s investment- and export-led growth model toward a more balanced consumer-based and services-led economy. The transformation reflects both necessity and design.
It is necessary because persistently weak global growth is unlikely to provide the solid external demand for Chinese exports that it once did. But it is also essential, because China’s new leadership seems determined to come to grips with a vast array of internal imbalances that threaten the environment, promote destabilizing income inequality, and exacerbate regional disparities.
The strategic shift is also a deliberate effort by Chinese policymakers to avoid the dreadedmiddle-income trap” – a mid-stage slowdown that has ensnared most emerging economies when per capita income nears the $17,000 threshold (in constant international prices). Developing economies that maintain their old growth models for too long fall into it, and China probably will hit the threshold in 3-5 years.
Three insights from this year’s China Development Forum deepened my confidence that a major structural transformation is now at hand that will enable China to avoid the middle-income trap. First, a well-articulated urbanization strategy has emerged as a key pillar of consumer-led rebalancing. This was emphasized by China’s new senior leaders – Executive Vice Premier Zhang Gaoli and Premier Li Keqiang – in the Forum’s opening and closing remarks, and considerable detail was provided in many of the working sessions.
Urbanization is a building block for consumption, because it provides powerful leverage to Chinese households’ purchasing power. Urban workers’ per capita income is more than three times higher tan that of their counterparts in the countryside.
The urban share of the Chinese population reached 52.6% in 2012up nearly three-fold from 18% in 1980, and is expected to rise toward 70% by 2030. If ongoing urbanization can be coupled with job creation – a distinct possibility in light of China’s emphasis on developing its embryonic labor-intensive services sector – the outlook for household-income growth is quite encouraging.
The pace of urbanization should dispel Western doubts stemming from concerns over so-called ghost cities and chronic over-investment. According to research by McKinsey & Company, with the annual influx of new urban residents totaling 15-20 million, China will need more than 220 large cities (at least one million people) by 2030, up from 125 in 2010. Moreover, because urbanization is a capital-intensive endeavor and China’s capital stock per worker – a key driver of productivity growth – is still only 13% of the levels in the United States and Japan, China has good reason to remain a high-investment economy for years to come.
What is new today is the focus on urbanization’s negative externalities – especially the thorny issues of land confiscation and environmental degradation. A well-developedeco-cityframework was presented at this year’s Forum to counter both concerns, and features incentives promoting a new urbanization model that stresses compact land usage, mixed modes of local transportation, lighter building materials, and non-carbon energy sources.
The second insight from the 2013 China Development Forum is the new government’s focus on strengthening the social safety net as a pillar of a modern consumer society. In particular, owing to the hukou (China’s antiquated household registration system), access to public services and benefits is not portable. As a result, migrant workers – an underclass numbering roughly 160 million – remain shut out of government-supported health care, education, and social security.
Holes in the social safety net have led to high and rising levels of precautionary saving driving a wedge between increases in labor income and any impetus to discretionary purchasing power. Significantly, there were strong hints from senior Chinese leaders at the Forum that hukou reform is now under active consideration.
While that would be welcome, such efforts need to be accompanied by an expansion of benefits. China’s retirement system has only about $430 billion of assets under management (national and local government social security and private-sector pensions). I pressed newly appointed Finance Minister Lou Jiwei on this point, suggesting that China deploy some of its excess foreign-exchange reserves to fund such an effort – the same tactic used to provide a $200 billion start-up injection for the China Investment Corporation, the sovereign wealth fund that he ran for the previous five and a half years. Unfortunately, he did not favor this suggestion.
The final – and possibly most importantinsight that I took away from the Forum concerned the quality of China’s new leaders. From President Xi Jinping and Premier Li Keqiang on down, China’s new leadership team is quite sophisticated in terms of analytics, risk assessment, scenario modeling, and devising innovative solutions to tough problems. Moreover, under the organizational umbrella of the National Development and Reform Commission (NDRC) – the latter-day version of the old central planning apparatusChina has marshaled considerable resources into the formulation of a comprehensive and well-thought-out economic strategy.
But, in the end, it takes more than strong policy and analytical skills to deal with tough economic challenges. We have seen unfortunate examples of that repeatedly in the West in recent years, and there are no guarantees that China’s newly installed leaders will avoid comparable pitfalls.
Vision and strategy are vital for realizing the “China Dream,” as the country’s new leaders are now calling it. But it will take courage and sheer determination to tackle what is perhaps the biggest obstacle of allresistance from deeply entrenched local and provincial power blocs. On this critical front, strong words must be accompanied by bold action.

Stephen S. Roach was Chairman of Morgan Stanley Asia and the firm's Chief Economist, and currently is a senior fellow at Yale University’s Jackson Institute of Global Affairs and a senior lecturer at Yale’s School of Management. His most recent book is The Next Asia.



March 31, 2013 5:42 pm

US inequality will define the Obama era
Since the financial crisis, each year has brought lower median incomes than the last
Comment Page©Matt Kenyon

Barack Obama has said his biggest goal is to revive the US middle class. “Our country cannot succeed when a shrinking few do very well and a growing many barely make it,” the president said in his inaugural address. It remains to be seen whether higher inequality lowers the US growth rate, as Mr Obama hinted (and some economists fear). The chances are that it does. Either way, Mr Obama has been unable to check America’s most unequal distribution of income since the 1920s. Is it within his means to do so?

The tide against him is powerful. For the past three years, Washington has been consumed in fiscal battles. But in his budget launch next week, Mr Obama will have his best chance before the 2014 midterm elections to shift the focus from deficit reduction to broad-based growththough the two are entirely compatible. The US budget deficit is already on course to fall to about 4 per cent of gross domestic product within five years. And America’s real fiscal challenge will only start to be felt 10 years from now when retirement costs, such as those from the Medicare healthcare programme, begin to rise sharply. It might be a good moment to pivot to today’s problems.

In June the US will enter its fifth year of post-financial crisis recovery. However, each year has brought slightly lower middle-class incomes than the last. According to data from Sentier Research, US median household income dropped by 1.1 per cent from January to February, to $51,404. It is now 5.6 per cent below where it was in June 2009, when the recovery began ($54,437).

And it is 8.9 per cent below where it was at the start of the century. At this rate – and for all Mr Obama’s efforts – the middle class could suffer a double-digit fall during his presidency

It is a different story at the top. According to David Cay Johnston of Syracuse University, the wealthiest 10 per cent of Americans have taken 149 per cent of the growth since 2009 (the bottom 90 per cent have seen their incomes shrink). The top 1 per cent – those earning $366,623 or more – have taken 81 per cent of the fruits of the recovery. And the top one in 1,000 – those starting at $7.97m a yearhogged an astonishing 39 per cent of the growth. That means America’s top 15,837 households have gained almost as much as the remaining 158.4m.

This is not the kind of record Mr Obama wants. John Rawls, the great US political philosopher, said inequality was justified if it was of greatest benefit to the worst off. Clearly, Rawls’ condition no longer holds. There is nothing inherently wrong with wide inequality. The prospect of large rewards spurs talented people to excel, which benefits everyone. But if growing inequality is accompanied by absolute declines in incomes, society is far less likely to tolerate it.

And there is a lot of evidence to suggest economic growth does suffer if inequality becomes too acute. In 2011 the International Monetary Fund published a paper that suggested economies grow faster when there is less inequality – a key reason why east Asia outpaced Latin America in the last generation. Sceptics point out that the IMF’s findings only show a correlation between inequality and lower growth, rather than a causal link. That is true.

But US growth is driven by consumer demand. It is hard to believe that higher spending by the very wealthy will indefinitely make up for the rest’s belt-tightening. Everyone, including US chief executives, who are sitting on $1.45tn of uninvested cash, has a stake in an economy that fires on all cylinders.

Few disagree that inequality is also blunting the effectiveness of US monetary policy. The Wall Street bull market has clearly returned. Last week both the Dow Jones Industrial Average and the S&P 500 broke through to new highs. But very little of the US Federal Reserve’s easy money has found its way on to Main Street.

Such deep-rooted trends are not easily fixed. There are many contributors to US inequality, including the rise of robots, faster globalisation and a domestic tax code customised largely for special interests.

Some of the more obvious palliatives, such as a higher minimum wage and a more progressive Social Security tax, would have an almost instant effect on incomes. Others, such as boosting the quality of US education, will take 20 years to bear fruit. Upgrading the quality of US infrastructure would fall somewhere in between.

In one form or another Mr Obama has proposed all these steps since 2009. But few stand any chance of enactment unless Republicans feel they have a stake in the outcome.

The White House’s only realistic chance lies in a fiscal grand bargain that would combine its “cut to investproposals with the promise of once-in-a-generation tax reform. Unlikely though its chances may be, it would still get better odds than the status quo.

And it would offer Republicans a chance to escape their plutocratic branding. Everyone likes to pay lip service to equality of opportunity.

Most Americans do not begrudge people such as Google co-founders Sergey Brin and Larry Page their fortunes. Nor should they. The question is whether high self-sustaining growth is possible amid flat or falling incomes. There are reasons to be sceptical. Mr Obama has so far failed to convince Washington that a stagnant middle class is bad for US growth. He should keep trying. If the US president means what he says, this is the challenge of his time.

Copyright The Financial Times Limited 2013