Default in a liquidity trap

Here is a very interesting Krugman analysis of this problem.  It ends up with the Fed owning all T-bills, and, in Anil Kashyap’s opinion (and mine; there’s not enough cash to cover all the required collateral) the Repo market collapsing.  I do see an alternative path.  Krugman writes:

What we normally say in a liquidity trap is that the Fed is keeping short-term interest rates at zero, which is as low as they can go because below that cash dominates bonds. And the Fed achieves that zero rate by being willing to buy short-term government debt whenever the rate threatens to rise above zero.

That’s a fair description, but perhaps it is a description rather than a binding equilibrium response; the Fed doesn’t have to do that and why should they if it ends in ruin?  (There’s the further tricky question of whether Krugman’s assumption is holding expected fiscal policy constant.)

T-Bills are almost like money today, especially with low short rates.  Think of higher default risk as like a Gesellian stamp tax on T-Bills.  One equilibrium is that people spend more on durables as they shift out of liquidity, which has now been partially taxed.  Another equilibrium is that everyone rushes into the truly safe asset, namely cash, and the T-Bills do truly disappear.  Or heterogeneous agents may do a bit of both.

It would seem to boil down to the third derivative on the utility function.  Still, empirically cash does not soak up all the periodic shifts out of other risky assets (e.g., commercial paper), so why should it soak up all the shifts out of T-Bills?

More concretely, in a liquidity trap model (which I reject, by the way, but that’s another story) an increase in default risk could have some expansionary properties.

Addendum: Brad DeLong offers comment.


I find all the complexities in the linked articles to be somewhat amusing, because they overlook the most fundamental behavioral truism:

Ignore, for the moment, the paper-only machinations of left-hand/right-hand prestidigitation. Real people have "real money" (as though there were such a thing!) Surplus cash will be lent wherever it finds the best combination of low risk and high return. The reason the Government is able to borrow such huge amounts of money at such low rates is because folks at home and abroad (think China banking) all believe that U.S. debt is the safest place to make a return, albeit small, so they are willing to accept a low rate of return. Default on any U.S. debt, even for just a moment in time, would hugely change that perception, and all over the world the folks with cash to lend would start thinking maybe GE and Ford, where the return would be higher, would be a better place to put their money.

I had a similar take on Nick's hypothesis, but Krugman didn't cite me. :(

Tyler, you write "T-Bills are almost like money today, especially with low short rates."

Indeed, that statement is wrong. What you mean is that as a store of value, the fact that short rates are low means that the benefit of holding T-bills is quite low, but as long as it's positive (we are ignoring transaction costs and any other benefit or cost associated with holding T-bills) economic theory concludes that people will hold T-bills (yes, they may be frustrated by their low returns but this is because we all want more of a good than less of it). More important, you ignore that T-bills are not means of payments and therefore --regardless of the low short rates-- people will not use them to settle the transactions in which cash is still used.

That from the demand side. Let us see from the supply side. Ignoring the debt ceiling, your statement would imply that the best way to inflate the economy is that Treasury issues new T-bills to pay employees, suppliers, creditors and beneficiaries of transfer programs. What do you think it will happen? Well the most likely outcome is that T-bills will trade at a huge discount --I still remember Argentina in late 1962 when the government issued bonds to pay a large part of its bills. Would you then say that T-bills are almost like cash?

In sum, forget what textbooks say about money, liquidity traps, and monetary policy. In the current institutional frameworks of both the monetary and accounting systems of payments and the financial system, governments have two choices to influence the expenditure decisions of people and enterprises (this is in addition to the many instruments governments have to provide positive and negative incentives to undertake particular activities):

1. Fiscal policy: to influence how much revenue the government will collect from the economy, how much of that revenue will spend in redistributing incomes and in producing goods and services, and therefore how much it will be borrow or save for the future. Indeed, seignorage from the issue of currency is a source of government revenue.

2. Financial policy: to influence some asset prices with the ultimate purpose of influencing people and enterprises' expenditure decisions. Think of the Fed as a typical state bank that has been mandated to affect the prices of some financial assets (note that state banks are financial intermediaries like private banks and the only relevant difference is the mandate they have in relation to their portfolios of assets). The main problem with financial policy is how little we still know about its effectiveness in influencing people and enterprises' expenditure decisions (for those familiar with the history of this issue I recommend to go back to Modigliani 1944 and particularly to Patinkin 2nd. ed. 1965).

Unfortunately, we know that those government policies are not designed and implemented by politicians' Good Wife but by the politicians themselves. I don't need to write again what I usually say about politics and politicians. Let us hope that in the next wave of textbooks on macro and monetary economics, both the institutional frameworks of payments and financial systems and the institutional framework of politics are taken into account explicitly.

I think that KO stock is already safer than T-bills because it is diversified over countries. This threat of default just makes KO look relatively even better. I hope that I am correct. Safer than KO are things like home insulation if it has a payback, more efficient cars and appliances if they have a payback.

Okay. Will one of the wise ones here PLEASE explain to me what changes on August 2 (or whenever) that would cause a default? Anyone seeking to redeem rollover debt does, by presenting his claim, reduce the debt sufficient to allow new debt to be issued to make payment, minus interest. That interest is vanishingly small, certainly less than the govt will have received if Treasury is being even remotely responsible. Default only becomes an issue if no one is willing to buy the newly issued debt. And the Fed has had no problem in acquiring US debt in the past.

How dare you do the budget arithmetic yourself instead of believing what your are told. What are you some kind of nut?

Oh, so it's nothing.

Meanwhile back in the real world, the 10-year T-note is at 2.95%. Treasuries have been trading around 3% for the last three weeks even as the Beltway hysteria over "default! default!" has reached ever greater fever pitches and the odds of raising the debt ceiling have substantially declined. InTrade odds of a debt ceiling deal during that period have gone from over 50% three weeks ago to 26% today.

Indeed, a few months ago the InTrade odds were near 100% and Treasuries were trading at 3.55%. Over that period confidence in the federal debt has _increased_ as the debt ceiling brought normally free spenders to the spending-cut table.

I guess if we can't have a real default we can always fall back on talking about theoretical defaults. Much like Harold Camping's exquisitely detailed Biblical scholarship showing that Judgment Day was nigh. While the Beltway based press mindlessly parrot the party line hysteria that the debt ceiling Apocalypse is near, and professors gleefully trot out their theoretical models of the Economic End Days, Treasury investors actually bother to do the federal budget arithmetic for themselves and life goes on.

Next theory we will see: the market actually _has_ crashed, only it was a spiritual crash not a physical one.

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