J. Bradford DeLong
Reacting to May, 2010: Give the Market What It Wants J. Bradford DeLong Professor of Economics, U.C. Berkeley Research Associate, NBER May 24, 2010
May 2010 The yield to maturity of the 30-year U.S. Treasury bond in late May was 4.07% per year--down a full half a percentage point since the start of the month. That means that a 30-year U.S. Treasury bond had jumped in price by more than 15%: the marginal investor was willing to pay more than 15% more cash and more than 30% more equities for U.S. Treasury bonds at the end of the month than at the beginning. This is a mark of an extraordinary shift in relative demand for high-quality and liquid financial assets--an extraordinary rise in marketwide excess demand for such assets. Why does this jump matter? Because, as economist John Stuart Mill wrote well before 1850, excess demand for cash (or for some broader range of high-quality and liquid assets) is excess supply of everything else. What economists three generations later were to call Walras's Law is the principle that any market in which people are planning to buy more than is up for sale must be counterbalanced by a market or market's in which people are planning to buy less. We have seen this principle in action since the early fall of 2007, as growing excess demand for safe, liquid, highquality financial assets has carried with it growing excess supply for the goods and services that are the products of ongoing human labor to such
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J. Bradford DeLong
an extent that there is now a ten percent gap between what the global economy would be producing if it were in its normal relatively-healthy state of near-balance and what it is now producing.
And global financial markets are now telling us that this excess demand for safe, liquid, high-quality financial assets has just gotten bigger.
Supply and Demand for Liquid, High-Quality Assets To some small degree the rise in excess demand has been induced by a change in investor sentiment: by a further depression of the animal spirits of investors and financiers as a psychological reaction to the exuberant belief in the powers of financial engineering of just a few short years ago. But most of the recent shift has come not from an increase in the demand for safe, liquid, high-quality financial assets but from a decrease in supply: the liabilities of the governments of southern Europe were, six months ago, regarded as among the high-quality assets in the world economy that one cooed safely and securely hold; now they are not.
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J. Bradford DeLong
The argument six months ago for the bonds of the governments of southern Europe seemed nearly airtight. Yes, the liabilities of the private sector of southern Europe were speculative and potentially insecure, but southern Europe was part of the euro zone, and thus the debts of its governments were backed by the European Central Bank, which was in its turn backed by the governments of France and Germany, which see in their turn backed by the willingness of the taxpayers of France and Germany to. Pay for the long-run project of closer European integration. Neither the French nor the Germans, obviously, wants to contemplate any possibility of return to the days when every generation they would kill each other over the question of which language should be spoken by the mayor of Strasbourg... or is it Strassburg... Now things are not so certain.
Implications for Economic Policy When there is an excess demand for safe, liquid, high-quality financial assets, then the rule for what to do in economic policy--if, that is, you want to avoid a deeper depression--has been well-established since 1825. The market wants more safely, high-quality, liquid financial assets? Then give the market what it wants. Those governments whose credit is still unshaken and whose assets are still the benchmarks of quality for the world economy need to create a lot more of them. That is what the market is telling us to do. It is signalling that U.S. Treasury bonds are now much more valuable assets than they were a month ago. So we should be creating more of them. That is, after all, what a market as a social resource planning mechanism does: it tells us what things are valuable and thus gives us the signal to make more of them. The credit-worthy governments of the world can create more safe, liquid, high-quality financial assets through a number of channels. They can spend more or tax less and borrow the difference. They can guarantee the debt of private-sector entities, thus transforming now-risky leaden assets back into golden ones. Their central banks can borrow and use the money
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to buy up some of the flood of risky assets in the market. Which of these should the credit-worthy governments of the world do in response to the asset price movements of May? All of them--for we really are not sure which would be the most effective and efficient at the task of removing financial market excess demand for high-quality assets. How much should they do? Well, as long as there is clear global excess supply of goods and services--as long as unemployment remains highly elevated and rates of inflation are falling--they are not doing enough. And the gap between what they should be doing and what they are doing grew markedly in May. This isn't rocket science or deep-sea drilling accidents, people. These are problems we know how to solve. May 24, 2010: 945 words
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