27
Aug
10

Bond bubbles and fundamental value

(I wonder what kind of batshit-insane Google hits I’m going to get from “fundamental value”.)

So lately there’s been a bit of talk in the econ blogs I read about a bubble in U.S. government bonds.  A lot of posts have been like this one from Marginal Revolution — basically collections of rather technical links.  Most of the rest have been more like this one from Arnold Kling — disconcerting analysis of long-term indicators and obligations.  I’m going to cherry-pick a quotation from a different Arnold Kling post, because I think it’s insightful:

[C]urrent debt/GDP ratios are not the problem. It is when you add in the unfunded liabilities of governments, primarily pension and health care promises, that things get ugly.

(Kling attributes that point to Arnaud Mares.)

Anyway, most of my reasoning ability is devoted to The Fucking Dissertation, so there’s rather little left over for sorting out this “bond bubble” crap beyond a sense of frustrated resignation and looming dread.  (If anyone would care to help me out in the comments, I’d very much appreciate it. Update: Oh look!)  But Nick Rowe takes a swing at what seems like a smaller question, and breaks it down into terms that even I can (for the most part) understand:

First of all, he defines his terms (always a good start):

If we define the “fundamental” value of an asset as the price that asset would have if all markets, not just the market for that asset, were in long-run equilibrium (and with inflation at target), then bond prices are above their fundamental values. And if we define “bubble” as a price above that fundamental value, then bond prices are a bubble.

Then he makes his point:

A bubble in house prices is a bad thing. It will cause over-investment in building new houses, under-investment in other things, and under-consumption. A bubble in bond prices is a much worse thing. It will cause under-investment in everything, and under-consumption in everything, because it causes under-employment of everything. That’s because bonds and money are close substitutes. A bubble in bonds causes a bubble in money. And a bubble in money can cause a bubble in bonds. Or perhaps they are just different aspects of the same bubble, in both money and bonds.

It’s not the bubble in bonds per se that is the big problem. If there were only a bubble in bonds, and no bubble in money, it would be no worse than a bubble in houses. It might lead to the wrong mix of real investment and consumption (presumably too little real investment and too much consumption, due to a wealth effect). It’s when a bubble in bonds spills over into a bubble in money, the medium of exchange, that we get a big problem. An excess demand for the medium of exchange is what causes, and is the only thing that can cause, a general glut of all goods. And that causes employment and output to fall, and both consumption and investment to fall.

What I don’t grok — at least not at first glance — are (first) how a bubble in government bonds necessarily leads to a bubble in money, and (second) how a bubble in money leads to “a general glut of all goods”.  On the first, I’m guessing that higher bond prices lead to lower inflation (and thus money that’s “above its fundamental value”), because governments can get the currency they “need” without resorting to inflation.  On the second, I’m guessing that a bubble in money doesn’t so much increase supply above demand (or increase supply at all) as it simply lowers demand (by increasing the value of each dollar and making people less likely to spend it).  But those seem technical to the point of artificiality, especially in combination.

This is probably the sort of thing that would be straightforward (if not transparent) if I’d only taken a macro course or three, and that I ought to be able to muddle through in an afternoon with enough spare energy, focus, and time.  But it’s a Friday night at the end of a long week, and I’m severely beer-deficient.

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2 Responses to “Bond bubbles and fundamental value”


  1. August 27, 2010 at 23:53

    First point. Assume, just to keep it simple, that all “money” is paper currency, and doesn’t pay any interest. Bonds pay interest, and money doesn’t, but having money makes it a lot easier to do the shopping, because nobody takes bonds at the supermarket. So you hold some of each. Now suppose there’s a bond bubble, and everyone wants bonds. So the price of bonds rises, which means the rate of return (interest) on bonds falls. So now people want to start holding more money too, because the loss of interest, from holding money instead of bonds, isn’t such a big deal now the interest rate is lower.

    Second point. We don’t do barter. We always buy and sell things for money (assume). Suppose everyone suddenly decides they want to hold more money. How do you get more money? You sell more stuff, or you buy less stuff, or both. So everybody is trying to sell more stuff and/or trying to buy less stuff. So there’s an excess supply of everything. And because nobody else will buy your stuff, you have to buy even less of their stuff. Which is where we are today.

    Now, stop reading this, and finish your bloody dissertation!


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