WSJ 4 June p. C22

[Greg Nowell <GN842@xxxxxxxxxxxxxxxxx>]

David--thanks for your note--I'm simultaneously posting
this one to pkt.

You'll find an article here of relevance to our
discussion.    Discussing debt issue by both Russia and
Fannie MAE (federally guaranteed mortgages as "the
latest installment in the federall sponsored mortgage
agency's Benchmark Note proram, launched this year in a
bid to offer investors an alternative to the dwindling
supply of Treasury securities." [!!  W/over $4 trillion
outstanding!!]), the article notes that the "onslaught
of nearly $6.3 billion of corporate bonds forced many
other issuers to rejigger structures and boost yields
to grab buyers' attention."

I don't have any problem with your comments about govt
guaranteed debt trading at a premium to corporate debt,
although, it would not be hard to imagine a situation
in which some govts were accorded a lower debt status
than some corporations.  But that's not germane to the
issue of whether quantity of bond issuance can affect
the interest rate.   Unless the WSJ was hallucinating
it said that some bond prices had to be lowered in the
face of a big supply burst from Russia and Fannie Mae,
as well as the corporate sector.    And if that
happened on one day, what about when a govt embarks on
a sustained program of bond issuance?

I agree with your point about deficits and saving, but
to the existence of an accounting identity may not
suffice to explain the *price* of borrowing.  The govt
may be forced to borrow what it spends, and by
definition, savings occurs when the bond is purchased.
But the bond is purchased against a future revenue
stream whose valuation does not depend on the act of
deficit spending or saving.  There is always enough
money to fund the borrowing, but that does not say at
what price.  If, for example, you go to see the movie
"Deep Impact" you will see that after the small comet
wiped out the Eastern half of the US, the same
theoretical model would apply--always enough money to
supply the issuance of a bond--but what does that tell
us about the *price* that investors would exact from a
US govt minus the Eastern seaboard (and its revenues)
vs. the pre-comet government?  (esp. if the post-comet
US were held liable, domestically and internationally,
for *all* the pre-existing debt!)

It seems to me that Keynes places *price* squarely in
the hands of the investors, who are paid "to part with
their liquidity."   They part at the price that pleases
them.  That is why we have "Treasury auctions."  They
are not compelled to buy bonds (though that can happen,
as in the French case).  [Aside: There have been
historical instances (esp in France) of the government
unilaterally changing the interest rate on outstanding
debts.   In each instance the government was later
chucked out.  I think that such actions make people
unhappy...]

But to get back to the point.  It is perhaps easier to
dispense with the whole notion of money as a thing,
derived from barter concepts and enshrined in
monetarism, and look at it for what it in fact is: a
zero term debt instrument payable on demand, bearing
zero interest (and hence minimizing transaction costs,
in paper form; in electronic form in the US demand
deposits now pay interest and hence electronic money is
now similar to the US Confederacy's paper money,  which
was printed with a 5% annual interest redeemable after
peace was signed with the Yankees) and exchangeable
against other debt instruments of longer duration.   If
the govt defict spends and does not offer a bond, the
accumulation of surplus in the banking system would
force a lowering of rates as banks sought to clear
themselves of surplus deposits.   But nonbank investors
in long bonds might not buy unless they were offered a
higher rate, which they might choose to exact in the
long run if the demand stimulus of the lower rate
caused a general rise in prices.   In this no-bond
case, deficit spending=>lowers interest
rate=>incentivizing investment=>increase in production
of real goods=>demand-caused inflation=>investors to
ask for a higher interest rate.

I don't think this is a pure quantity theory of money,
which would see real production as unaffected and price
levels changing as a result of money as a ratio to
goods.  If the state of demand is anemic the
aforementioned increase in money supply (zero term
debt) may lower interest rates without cauasing an
increase in investment.  As, for example, if the
government were deficit spenidng to fight proliferating
Godzillas and the Godzillas were winning anyhow, which
might deter real estate investment more than it
stimulated defense spending.  In this case, deficit
spending=>lower interest rate=>inc. investment in
military but "capital strike" by terrozied capitalists
in all other sectors=>uncertain inflation effects
(consumer goods hoarded as people head for the hills,
but no demand for capital goods)=>unchanged or lower
interest rate=>higher output in military but lower
output everywhere else.  If you substitute for Godzilla
some other unspecified capitalist terror, such as an
organized working class, you might see the same
thing.   The election of social democrats might be the
stimulus for investment in healthcare-related
industries (wheelchairs and vaccines would benefit from
larger demand even if hospitals and doctors were
nationalized) but be bad news for the yacht, golf
course, and diamond industries.   Indeed, even the
discretionary expenditure of the working poor might
decline if they were brought into some system in which
they had to make compulsory working payments (if you
$1,500 and can't afford the $3,600 insurance, as is the
case in this country, you might as well go bowling or
to the movies with the $1,500; if the govt mandates
everyone contributes a minimum of $1200 to a socialized
program, you have $300 for discretionary spending).
The question is what happens in the tug of war between
the optimism of those who benefit directly and
indirectly from the deficit spending (and presumably
invest and generate real goods and income) versus those
that see themselves as losers.  This is probably an
empirical question which cannot be settled
theoretically.  The average "price" at which investors
as an aggregate would part with their liquidity would
reflect to some degree their emotional state and also
the supply of bonds available to satisfy their demand
at that degree of emotional state.  The emotional state
would be a result of some amalgam of real and perceived
investment opportunities.

My point being that "investor sentiment" is the
determining factor of bond price levels in each
instance.
Since capital costs are part of overall production
costs it is reasonable to argue (as have many PKTers,
notably Turgeon) that you can get capital-caused
inflation.

Now, in the case where the govt issues a long-term
security at the same time that it issues zero-term
securities (deficit spending), there is nothing to keep
them from exchanging their zero-term securities against
the long-term security.  They will save, but at what
price?  It is reasonable to suppose that their demand
for govt issued securities will be some function of
their demand for securities generally, subject to risk
considerations, and that they will take into account
all options, including, as I have mentioned, the
possibility for large reservoirs of cash accumulations
in major cash operations.   Must this be inflationary
at levels less than full employment?

>From the old quantity theory, yes, because you have
issued not only zero-term notes but a long-term one,
and long-term notes also chase goods (usually big ones,
like corporations).   However, the banking system does
not end up with a cash surplus in this scenario,
forcing it to lower rates.  The cash surplus is used to
purchase a bond, which becomes part of the circular
pattern of  spend-borrow 'n' tax-spend of govt
expenditure.  Aggregate demand is increased and
deoending on how various sectors respnd (and are
organized, oligopoly vs. competitive) you may or may
not get inflation.  To the extent that we get
inflation, it must be due to price increases when and
if demand accelerates past productivie capability.
Since there is the potential for lags between increased
production and increased demand (the oil we burn today
left Saudi Arabia three months ago) I don't see why one
might not get demand-caused inflation at levels less
than full employment.

Just as per today's WSJ, however, purchasers of bonds
would be confronted with an increased menu of options,
a greater supply to choose from, and it follows that
some one of the offerers will have to "jigger" in the
WSJ's term in order to secure placement.  That would
imply an increase in rates, but not necessarily a
decrease in investment, since rates are only a
component factor in the decision to invest.
Nonetheless, borrowing-intensive industries,
particularly the less competitive ones, might pass on
the higher costs of borrowing in the form of price
hikes.  These in turn could inspire bondholders to
factor an inflation premium into their bond pricing, in
addition to the supply considerations.   It is likely
that, per Keynes, they will be "excessively
pessimistic" in their inflation premium demands, and
this could lead to an unncessarily high
inflation-premium and an unnecessarily high increase in
interest rates, exacerbating interest-rate derived
inflation, and simultaneously discouraging some real
investment.

An example of investor pessimism is in US mortgage
prices, which are "pegged" to the long bond.  But they
are not pegged at a fixed spread, and recent declines
in the long bond have been not been accompanied by
corresponding decreases in the mortgage rate, because
investors are trying to cover, in today's mortgage
pricing, *anticipated* possible losses due to
refinancing among existing loans.  This of course has
an impact on "real" activity in the housing sector.

It seems to me you could get higher interest rates and
higher rates of real economic activity, just as you can
have, in the 1930s and contemporary Japan, low rates
and decreased economic activity.

In any case the identity between the government deficit
and aggregate savings does not explain the price at
which people exchange their zero-term debt against
long-term debt.    It is rational for the rentier class
to oppose "excessive" expansions of bond issues, though
just what "irrationality" would be is of course
subjectively determined, as are all factors affecting
the magical moment at which investors part with
liquidity.

I think that we can go this far without being
monetarists.  At least I hope so.  I think I am
circling around to a position held by some left
economists in the 1970s, that deficits and inflation
aren't necessarily a bad thing.  But that's rather
different than saying that unlimited deficits have no
impact on the interest rate.

This would explain the serious component to Keynes'
suggestion about the need for the "euthanasia" of the
rentier class.  It is not because their narrow sectoral
interests are unfounded, but rather because, they
determinedly, effectively, and rationally defend a
partiucular position that is antithetical to the use of
societal resources (full employment).   It would not be
inconsistent to note that the position of bond traders
(who make their money on each issuance and each trade)
could have a different position than bond holders on
these matters.

--
Gregory P. Nowell
Associate Professor
Department of Political Science, Milne 100
State University of New York
135 Western Ave.
Albany, New York 12222

Fax 518-442-5298