08 Oct 2013

US Government Starting to Face a Cash Crunch

Debt, Economics, Federal Reserve, Krugman 14 Comments

This Neil Irwin post is pretty good (I think I got this from Alex Tabarrok on Twitter):

[I]n the…market for Treasury bills, things are starting to get scary. These are short-term IOU’s of the U.S. government, bills issued for 30, 60 or 90 days. They enable Uncle Sam to manage cash flow much the way a homeowner might use a credit card. They also form the backbone of trillions of dollars in transactions: Major corporations and banks use them as a place to park short-term cash; they are held by money market mutual funds; and they serve as collateral for millions of transactions in markets around the world.

…[O]n Sept. 30, eight days ago, the interest rate on Treasury bills maturing Oct. 17 was a mere 0.03 percent. Nothing, in other words.

But since then, the possibility that the Treasury might have trouble paying or might not be able to pay its bills over the next few weeks has grown — and the interest rate has skyrocketed. It was at 0.16 percent at Monday’s close. On Tuesday the rate so far has been almost double that, as high as 0.297 percent.

Ironically, this can create self-fulfilling problems for the Treasury. Treasury bills roll over every week, on Thursdays. Here’s how it works: The government issues the bills for a “discount,” then refunds the par value when they come due. So, for example, an investor might pay $995 for a bill that returns $1,000 in three months, for an equivalent of about a 2 percent annual interest rate.

But if buyers don’t want to roll over their bills — if they don’t trust the government enough to pay the usual high price for that debt — then the government’s cash crunch becomes even more severe. If, for example, investors were only willing to pay $950 for a 90-day, $1,000 bill (about a 20 percent annualized interest rate), then the government would run into its legal debt limit even faster than it is now scheduled to. We’re nowhere near that point now. The rate has risen to 0.3 percent, not to single-digit, let alone double-digit, percent levels. But the abruptness of the move, in a market that usually is rock-solid and stable, is startling nonetheless.

In the 2008, post-Lehman Bros. crisis, major banks — even those that seemed to be fundamentally solvent — were facing a liquidity crisis, as short-term access to cash became a challenge. Buyers of Treasury bills have no evident concerns about the longer-term solvency of the United States. But the action on the bill market over the last several days, and especially Tuesday, looks like the early phase of a liquidity crisis.

So I’ll repeat my question for Keynesians: Why isn’t this at least a partially good thing, since it clearly gets us out of the liquidity trap? If the above trend continues, then clearly short-term nominal interest rates are no longer stuck against the zero lower bound.

In fact, why isn’t Krugman arguing that by definition, we can’t have a crisis unless interest rates rise, and yet if interest rates rise the Fed can gobble up bonds and push them back down? The only reason the Fed wouldn’t want to do that, is if (price) inflation starts rising, which will only happen once we’ve restored Aggregate Demand.

I have asked this three times now, and have yet to see a satisfactory explanation. Sure, the federal government will slash spending, but the Fed can counteract that by more expansionary policy. The only time this can’t happen–according to Krugman–is when we’re at the zero lower bound, and the central bank can’t offset fiscal austerity.

So I ask again: If we take the framework Krugman has developed over the last five years on his blog, how can a US government debt default possibly hurt the US economy?

14 Responses to “US Government Starting to Face a Cash Crunch”

  1. Daniel Kuehn says:

    This might be interesting: http://krugman.blogs.nytimes.com/2011/07/25/default-in-a-liquidity-trap-very-wonkish/?_r=0

    He was commenting on the recent spike a couple days ago.

    The short story above is that if they buy bonds, which would be worth less than cash, the shadow price is going to still be high and that will feed into long rates. If (what is more likely) they don’t buy it all than you’ve got a negative demand shock from the Fed.

    Krugman wants higher rates from a positive shift in the supply of bonds. You’re asking why he isn’t satisfied with the same interest rate result from a negative shift in the demand for government bonds. The reason, it seems to me, is that the former involves and increase in aggregate demand and the latter involves a decrease.

    • Bob Murphy says:

      DK wrote:

      You’re asking why he isn’t satisfied with the same interest rate result from a negative shift in the demand for government bonds. The reason, it seems to me, is that the former involves and increase in aggregate demand and the latter involves a decrease.

      Daniel, you seem to be arguing that Krugman would never like it if interest rates went up from a negative shift in the demand for government bonds. But that can’t be right, since he was written many posts explaining that if the bond vigilantes attack, it will be good for the economy (so long as little foreign-denominated debt and fiat money).

      • Daniel Kuehn says:

        The invisible ones?

        I’m sure you’re not making this up, but I just don’t know which discussion you’re talking about.

        I think it largely depends on why the bond vigilantes are attacking, right? If they’re attacking because demand for government bonds has gone down and everything else has stayed the same, that’s clearly bad. If they attack because the relative demand for government bonds has gone down because the bond vigilantes have better investment options and are disciplining the government to stay competitive with private investment opportunities, that’s obviously very good.

        Could that be the difference between the two claims?

        • Bob Murphy says:

          Try this one Daniel. It’s pretty open ended; Krugman is saying that if investors don’t want British government bonds “for some reason” then it will, if anything, help the British economy. It doesn’t matter what the reason is.

    • Bob Murphy says:

      Ah but thanks: this is exactly what I wanted from Krugman. I can’t digest it tonight but I’ll check it out.

  2. Daniel Kuehn says:

    A default is really out of the frying pan and into the fire: we’re moving from a flight to safety to a flight to the mattress.

    Nothing in that implies any positive move in aggregate demand.

  3. Daniel Kuehn says:

    Kind of like saying “Oh, you like going to the beach because you like how it’s nice and warm? Why don’t you just get sick, run a fever, and then sit on your porch in your bathing suit. Same thing, right?”

    • skylien says:

      Well, sounds like the same thing as trying to ‘cure’ lack of demand from the private part of the economy with artificial increase of government demand to counter that, or/and to decrease interest rates by the CB to create the illusion of more available capital than there really is.

      However just like getting into the fresh air and into the sun might give you a good feeling which overrides your sick feeling, so that you act for some time as if you weren’t ill, might look to other people (economists) as if this really was a solution, though eventually at some point not resting to cure your illness will matters worse and the sick feeling will return. And at some point more fresh air and more sun just can’t set off enough dopamine anymore to override your sick feeling, which then looks like a sun-light/fresh air trap.

      • skylien says:

        *…will make matters…*

      • Daniel Kuehn says:

        By “artificial increase of government demand” I’m assuming you mean “increase of demand I don’t like”, because as far as I can tell there’s nothing artificial at all about government’s demand when it demands things.

        So why not just say that?

        • skylien says:

          No by artificial I just mean something like a stimulus package. Government spending that is not intended to be done for the sake of utility yielded by the goods/services bought, but only to ‘stimulate”.

          I am therefore not claiming that a stimulus package would be 100% artificial. It is only to the degree that it is preponed, bought at a higher price than otherwise would be accepted or spent on something that otherwise never would have been bought at all. So it might be quite tricky to evaluate how much of a stimulus package actually was artificial stimulus and how much was not.

        • skylien says:

          Can you accept such a definition?

        • skylien says:

          Daniel, I think I am capable of distinguishing the two issues which you accuse me of throwing together.

          It is one thing to argue about the usefulness of stimulus spending, and it is another to argue about government spending in general, which is more about if governments should exist at all.

          I am not talking about the latter here. And no I still cannot answer that even for me.

          And even if I was a convinced ancap, I guess this would not automatically disqualify me of having an opinion on the former, would it?

  4. joe says:

    The relevant interest rate for a liquidity trap is the federal funds rate. So if credit tightens due to the debt ceiling debacle, then the liquidity trap would become more severe, not resolved. The Fed funds rate will still be stuck at .25 while credit contracts. That’s a more severe liquidity crisis.

Leave a Reply