Thursday, June 09, 2005

Less shrill

The usually shrill DeLong has 2 good posts:

1) Alan Greenspan proposes "pay-go" caps on Federal spending. This means that the Federal government *always* has to run balanced budgets, much like many states do.

I find this a strange recommendation for several reasons. Firstly I don't care about budget deficits, I only care about interest rates and payments, and budget deficits are just one factor in that. Our borrowing should be curtailed by our willingness (and ability) to pay and the US continues to enjoy very low real interest rates, both short term and long term. When this changes, and it will, tighter fiscal policy will be one of several levers used to rebalance things. But until then, I think it is a mistake to say no to free money.

Secondly, I find this an odd recommendation because the US fiscal imbalance primarily comes from entitlement schemes that will blow up when the ratio of old to young suddenly tips into the grey. "Pay go" will do nothing to 1) prevent such schemes from being set up or 2) prevent such schemes from becoming enlarged. So why bother?

Thirdly, I don't care that pay go will reduce the government's ability to use fiscal policy to smooth out a business cycle. Fiscal changes are too slow, and government too unable to run a surplus during peaks for this to work.

But on the subject of interest rates,

2) Brad DeLong speculates that hedge funds might be the solution to the low long term interest rate puzzle. The puzzle is that the yeild curve is flat to inverting, that is, even as short term rates climb higher, long term rates remain low. This is additionally confusing given all of the long term inflationary pressure we see in the economy from 1) housing prices, 2) fiscal deficit, 3) trade deficit. The dollar is primed to lose value, but long term bond holders don't seem to care.

Brad suggests that hedge funds are betting that bond prices will not move, and so keep prices for long term bonds low by buying them whenever short term rates increase. I have no idea if this is true, but having worked for a hedge fund, and knowing how much marginal money is in marginal hedge funds today, it's quite possible that lots of funds are doing the same thing and will lose their shirts when liquidity (which currently gluts the market) dries up and prices move.

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