Random thoughts on Krugman and Treasuries

This came to me about halfway through watching Taxi Driver with Robert DeNiro:

Paul Krugman argues that further spending is necessary to stimulate the economy and prevent further contractions. Those who disagree with him, including myself, warn that excess government borrowings (in the form of increasing Debt/GDP ratio) will lead to a deterioration in market expectations that the debt will be paid off. Krugman's response is that if the market is spooked with treasuries, then why aren't bond rates going through the roof? He rightly points out that bond rates have fallen, not risen, in recent months.

My response to Krugman requires a bit of explaining on how bond markets work. When I first began to wrap my mind around bond investing, one thing which seemed incongruous was the fact that bond rates went down when the market purchased them, and went up when the market sold them off. It took me a while to realise that, while bonds are subject to the laws of supply and demand, the price measurement is inverted, which means that the interest rates on bonds drop whenever there is an increase in demand, and increase whenever there is a drop in demand.

In other words, if during a market day bond rates drop from, say, 2.8% to 2.7%, this means that there has been an increased demand for bonds. If the bond rates increase from, say, 2.8% to 2.9%, this means that there has been a decreased demand for bonds.

Bonds, like all investments, are driven by supply and demand. Moreover they are also subject to basic market failure which includes investment bubbles.

Many economists, Krugman included, warned the world that property prices in the US had developed a bubble and that a correction was overdue. In 2007 the market corrected and house prices began falling, which eventually led to the 2008 credit crisis and the subsequent "Great Recession". Those who predicted that property prices would not fall, or who then argued that the correction would be minor (Bernanke - I'm looking at you) were left with egg on their face. Moreover, market "experts" pre 2007 argued very strongly that the rise in property prices would continue and that the market was NOT going abandon it. Their reasoning was simple: "if the market was spooked, then why are property prices still rising?"

Let me just repeat that:

"If the market was spooked, then why are property prices still rising?"

Now compare that to what Krugman is saying:

"If the market is spooked, then why are bond rates falling and not increasing?"

I suppose you might guess what I am trying to say: Krugman's argument that the market will not be spooked by an oversupply of treasuries (due to increased deficit and government spending) is based upon the same logic that kept the market believing that the property prices will continue to increase, namely that the market obviously knows what is good for it. Paul Krugman, amongst others, knows just how limited and stupid the market can become but argues that, in the case of treasuries, the market does know what it is doing.

The property bubble between 2002 and 2007 was caused by a market failure. Too much money invested into one sector in too quick a time led to an investment bubble that popped and lost a lot of people a lot of money. In the same way US treasuries have developed an investment bubble. The market has dropped rates down to around 2.5%. With such a drastic increase in demand for bonds, the potential for a correction grows daily.

And what happens when investors lose confidence in both US shares and US bonds? A drop in the value of the US Dollar.

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