How to untangle such a mess? Well, 14th century English logician William de Ockham created a helpful ‘rule’ that’s come to be known as Occam’s Razor. It recommends that when choosing between hypotheses which are equal in other respects, one should choose the hypothesis that makes the fewest new assumptions.
What does that mean in this situation?
Simply that Treasury yields have risen as a result of people’s perception of the economy improving, something that’s been evident by the broadly better data and by various economists (and Wall Street Banks) upping their GDP growth targets during November/December. Now, perhaps, time will also suggest that the alternative arguments are true…that QE2 was successful (though for $600bn, or 4% of GDP, you’d hope that the Fed’s aim was to increase actual growth not just people’s perceptions about it), that the bond bubble has burst (though the graph below would suggest “not yet”) or that hyperinflation is imminent (again the CPI, and other inflation measures don’t yet show it). For now, however, I’m sticking with the guy who lived over 600years ago.
Now, with all these worries about hyper-inflation and QE2’s impact on prices, a reasonable fellow might ask why is Our Man comfortable holding Treasuries and betting on deflation. Well, regular readers will know that Our Man doesn’t view this as your run-of-the-mill business cycle recession but instead one caused by the level of debt (see graph here) reaching unsustainable levels. As such, the typical monetarist solutions that are the foundation of central banking have little impact on the economy when contrasted against the size of the deleveraging that occurs as households rebuild their balance sheets. (While this is, of course, a simplistic overview...for those wanting to know a little more, I’d recommend this piece by Professor Steve Keen, and for the very geeky his entire blog).
This idea of debt-deflation was developed by Irving Fischer during the 1930’s. What makes it interesting is that it is the Gordian Knot of the economics profession; the traditional and preferred solutions (many of which are being attempted now) have no real impact on solving the underlying problem. Reductions in interest rates fail to spur businesses or households to relever. Supplying money to the system, either through fiscal policy (“stimulus”) or monetary policy (“quantitative easing”) produces an initial response which fades and then collapses each time the policy is stopped, and the longer it continues the greater the risk of the economy becoming dependent upon it. Austerity, while it may help reset the generation of future debts, merely increases the pain by future reducing demand and enhancing the deflationary forces. The “Alexandrian solution” to the challenge is of course default (in the private/household sector, preferably) but the resultant probable insolvency of financial institutions* is not something the powers that be are currently willing to accept. Thus for the foreseeable future, unless the household sectors starts to relever itself, Our Man will continue to bet on deflation and disinflation.
As for the long-term; here, Our Man will once again defer to some chap to lived a long time ago. Ludwig von Mises, the Austrian economist, wrote the following:
“There is no means of avoiding the final collapse of a boom expansion brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.”
* The side benefits of bankruptcy on the system are under-rated. As a simple example, Bank of America is getting sued by a number of investors who are seeking to have BoA repurchase soured mortgages that were packaged into bonds by Countrywide Financial (Bank of America bought them in 2008). Do you know why we’re not hearing anything about J.P. Morgan getting sued for the deals that Washington Mutual (or why nobody’s suing Lehman Brothers)? Because when WaMu (and Lehman) went through bankruptcy, the unliquidated claims are trapped there and thus have no impact on JP Morgan. Therein lies the beauty of bankruptcy for the system -- clean assets with which to regenerate things!