And the interesting thing is that I almost believed that what we have seen was going to be what would happen. Almost, but not quite. You see, I had read John Hicks (1937). And I had almost believed him.Let me give you the Hicksian argument about what happens in a financial crisis--a sudden flight to safety that greatly raises interest rate spreads, and as a result diminishes firms' desires to sell bonds to raise capital for expansion and at the same time leads individuals to wish to save more and spend less on consumer goods as they, too, try to hunker down.
In Hicks's model, the immediate consequence is an excess demand for (safe) bonds in the hands of investment banks: bond prices rise, and interest rates falls. As interest rates fall, (a) firms see that they can get capital on more attractive terms and so seek to issue more bonds, and (b) households see the interest rate they can get on their savings fall, and so lose some of their desire to save. The market heads toward equilibrium. But as the market heads toward equilibrium, something else happens as well: the fall in interest rates and the rise in savings is accompanied by a greater desire on the part of households and businesses to hold more of their wealth safely--in pure cash. And so the speed with which cash turns over in the economy, the velocity of money, falls. And as the velocity of money falls, total spending falls, and workers are fired, and as workers are fired and lose their incomes their saving goes from positive to negative.
One of the primary reasons I love Brad DeLong's blog is he is one of the only economists who has literally read every major economic thinker of the last 200 years. As such, he brings up these great points.
One of the most perplexing things about the bond market right now is this: with the US running a big deficit and with the increased threat of a budget showdown delaying a hike in the debt ceiling, why are US interest rates so low? Logic tells us the bond market should be selling off, sending interest rates to sky high levels.
Let's look at Delong's statement.
In Hicks's model, the immediate consequence is an excess demand for (safe) bonds in the hands of investment banks: bond prices rise, and interest rates falls
As investors and savers become more and more concerned about the future, they start to buy safer and safer assets. At the same time, the central bank is lowering interest rates, increasing the spread between the short and long end of the bond market.
(a) firms see that they can get capital on more attractive terms adn so seek to issue more bonds, and (b) households see the interest rate they can get on their savings fall, and so lose some of their desire to save. The market heads toward equilibrium.
We've see the first point, as corporations have increased their debt issuance to take advantage of low rates. The personal savings rate has increased since the beginning of the recovery, so this hasn't happened according to the theory -- at least not yet. However, we have seen a flush out from Treasuries into other asset classes:
Rather than obsessing over absolute numbers, we focus on the relative movements and flows which are quite revealing. The Fed’s QE2 program has been quite successful in flushing households and nonprofits out of their Treasury holdings into asset classes such as mutual funds (see table F.100).
Delong continues:
But as the market heads toward equilibrium, something else happens as well: the fall in interest rates and the rise in savings is accompanied by a greater desire on the part of households and businesses to hold more of their wealth safely--in pure cash. And so the speed with which cash turns over in the economy, the velocity of money, falls. And as the velocity of money falls, total spending falls, and workers are fired, and as workers are fired and lose their incomes their saving goes from positive to negative.
This explains why monetary velocity is currently so low -- a point which I noted in late April, but for which I had no explanation. (Remember -- there is a decent relationship between the YOY percentage change in monetary velocity and GDP growth.)
The point is this passage explains what is happening right now -- both in the bond and velocity market -- very well. A big hat tip to professor Delong for reading, well, everybody.
