### Debt, Bubbles, Booms, and Our Present Situation

In my last post on macroeconomics, I considered the possibility that a period of low interest rates could time-shift so much spending that in future periods it may be difficult to maintain adequate spending in order to achieve full employment. But I think it's important not to get too obsessed with debt levels in isolation. Debt can be a problem, but only in some contexts. What is crucially important is who holds the debt, who incurs it, and for what purpose. (This is a point Krugman has made many times, I will try to find some links later. As always, this is not original to me, though any mistakes in the analysis are highly likely to be mine.)

The first thing to recognize is that financial debt is really a relationship between two parties, and not only a burden on one party. To the extent debt is a liability for one party, it is also an asset for another. (It's true that a country might be a net debtor, but let's ignore this for now.)

The next thing to recognize is that debt is very helpful for time-shifting spending. The capital markets are meeting real human needs when, for instance, they allow someone to save for retirement. You technically don't need a capital market for that: you could just accumulate a bunch of canned food and hope to barter it to meet your other needs. But that would obviously be a vastly inferior way of accumulating assets for retirement. Much better to lend money to someone and then count on using the future payments to support myself in retirement.

So when does debt become problematic? Well, in macroeconomic terms, if a segment of the population is highly indebted, then it won't have much additional spending capacity, no matter how low interest rates go. But if you think about it, the problem is actually that the people who hold the debt aren't spending more. After all, we always knew that the borrowers weren't going to spend much at time T2. They did their spending at time T1. But the savers were supposed to be doing the opposite, spending less at time T1 but spending more at time T2. What we tend to see is an asymmetric situation in which the borrowers spend amply in T1 but then the savers don't ramp up their spending in T2, for whatever reason. Counter-intuitively, the debt is problematic because of the behavior of savers, not so much the behavior of borrowers.

Now let's consider how financial assets factor into macroeconomic policy. To start, let's consider the relationship between financial assets and interest rates. This can be confusing, and I don't entirely understand it, so I'll try to keep it as simple as possible. Take, for instance, a standard fixed-income asset (that is, debt in the form of a bank loan or a bond or something like that). One of the first things you learn in finance is that bond prices are inversely related to interest rates. There's a sense in which this is just a statistical relationship, but there is also a deeper point here.

Consider two different interest rates, the interest rate on a bond and the market interest rate. The inverse correlation of bond prices to market interest rates is simply statistical. But the inverse correlation between the bond's interest rate and its price is exact. This is because the two are simply different ways of expressing the same thing. A bond's price is how much you have to pay now to obtain a known stream of payments in the future. A bond's yield is how much you get in the future if you pay a specified amount now.

Here's another way to think of it. Picture a graph with time on the x axis and dollars on the y axis. Now draw a point at time T2 reflecting the payment in full of the bond. (For simplicity we will assume there is only one payment remaining.) Now draw another point at time T1, reflecting the current price of the bond. This point should be lower than the point at time T2, indicating a positive interest rate. Now connect the dots with a line. The slope of that line is (roughly) the bond's yield. (I think ideally you would use a slightly curved line or something - just ignore the mathematical niceties.) You can see that as you change the bond's yield, it pivots around its price at time T2, and its price at time T1 changes. In fact, as you can see, if someone tells you the slope of the line, it's easy to calculate the value of the bond at time T1. Alternatively, if someone tells you the value of the bond at time T1, it's easy to calculate the bond's yield (the slope of the line connecting the two points).

Was that fun? I hope so. Now, a bond's yield is not necessarily the same as the market rate of interest. But they tend to be strongly correlated, because investors buy and sell bonds to bring their yields into alignment with current interest rates.

So here we have another way of thinking about low interest rates: they tend to increase the value of debt while reducing its future expected yield. So if you hold a fixed-income asset, and the central bank lowers the interest rate, two things will happen. First, your existing portfolio will increase in value, making you richer and enabling you to spend more, if you choose. Second, on a forward-looking basis fixed-income assets become less attractive (relative to current consumption) because their yield is lower. So the people who saved in the first period are now induced and enabled to spend, and balance is restored.

Now it's not just fixed-income assets that are subject to this phenomenon, it applies broadly to a lot of asset types. For instance, a rental property behaves a lot like a fixed-income asset, especially if there is a long-term lease that specifies what the future rent payments will be. But even shares of stock tend to follow this same pattern.

Hence the slut. I mean, hence the "Everything Boom, or Maybe the Everything Bubble," as Neil Irwin formulated it. Assets of almost every variety are expensive right now, because that is the flip side of market interest rates being low. And it is arguably a good thing, if it completes the process I described above, inducing people who have accumulated financial assets in the past to spend more in the present. (The other thing that is accomplished is that businesses can raise a lot of money in the financial markets, because financial assets command such a high price. This enables businesses to make investments that otherwise might be uneconomical. This is a phenomenon I have already pointed to, but now we are seeing it through the lens of high asset prices rather than cheap money - two sides of the same coin.)

Now here's a thought. Just as the central bank can draw spending from the future to the present, possibly depleting future spending, the central bank can also draw asset appreciation from the future to the present, creating a low-return environment in the future. That is, by lowering interest rates, financial assets appreciate massively in the present but appreciate much more slowly in the future. Their value goes up, their future yield goes down. (Recall our example of pivoting the line around the point at time T2. You can increase the value at time T1, but by definition this reduces the yield between time T1 and time T2.)

At this point I have said the same thing like 5 different ways. But anyway, that is the world we are living in: our assets have appreciated to dizzying heights, and now we have to hope that economic growth follows. Most people think that given how anemic the recovery has been, interest rates are going to be low for quite a while. This helps explain why housing is unaffordable in a lot of places, why hyper-luxury towers are shooting up like weeds in New York, why the stock market has surged, why most people think it can't keep surging, and why everyone feels a little uneasy about our current situation.

The first thing to recognize is that financial debt is really a relationship between two parties, and not only a burden on one party. To the extent debt is a liability for one party, it is also an asset for another. (It's true that a country might be a net debtor, but let's ignore this for now.)

The next thing to recognize is that debt is very helpful for time-shifting spending. The capital markets are meeting real human needs when, for instance, they allow someone to save for retirement. You technically don't need a capital market for that: you could just accumulate a bunch of canned food and hope to barter it to meet your other needs. But that would obviously be a vastly inferior way of accumulating assets for retirement. Much better to lend money to someone and then count on using the future payments to support myself in retirement.

So when does debt become problematic? Well, in macroeconomic terms, if a segment of the population is highly indebted, then it won't have much additional spending capacity, no matter how low interest rates go. But if you think about it, the problem is actually that the people who hold the debt aren't spending more. After all, we always knew that the borrowers weren't going to spend much at time T2. They did their spending at time T1. But the savers were supposed to be doing the opposite, spending less at time T1 but spending more at time T2. What we tend to see is an asymmetric situation in which the borrowers spend amply in T1 but then the savers don't ramp up their spending in T2, for whatever reason. Counter-intuitively, the debt is problematic because of the behavior of savers, not so much the behavior of borrowers.

Now let's consider how financial assets factor into macroeconomic policy. To start, let's consider the relationship between financial assets and interest rates. This can be confusing, and I don't entirely understand it, so I'll try to keep it as simple as possible. Take, for instance, a standard fixed-income asset (that is, debt in the form of a bank loan or a bond or something like that). One of the first things you learn in finance is that bond prices are inversely related to interest rates. There's a sense in which this is just a statistical relationship, but there is also a deeper point here.

Consider two different interest rates, the interest rate on a bond and the market interest rate. The inverse correlation of bond prices to market interest rates is simply statistical. But the inverse correlation between the bond's interest rate and its price is exact. This is because the two are simply different ways of expressing the same thing. A bond's price is how much you have to pay now to obtain a known stream of payments in the future. A bond's yield is how much you get in the future if you pay a specified amount now.

Here's another way to think of it. Picture a graph with time on the x axis and dollars on the y axis. Now draw a point at time T2 reflecting the payment in full of the bond. (For simplicity we will assume there is only one payment remaining.) Now draw another point at time T1, reflecting the current price of the bond. This point should be lower than the point at time T2, indicating a positive interest rate. Now connect the dots with a line. The slope of that line is (roughly) the bond's yield. (I think ideally you would use a slightly curved line or something - just ignore the mathematical niceties.) You can see that as you change the bond's yield, it pivots around its price at time T2, and its price at time T1 changes. In fact, as you can see, if someone tells you the slope of the line, it's easy to calculate the value of the bond at time T1. Alternatively, if someone tells you the value of the bond at time T1, it's easy to calculate the bond's yield (the slope of the line connecting the two points).

Was that fun? I hope so. Now, a bond's yield is not necessarily the same as the market rate of interest. But they tend to be strongly correlated, because investors buy and sell bonds to bring their yields into alignment with current interest rates.

So here we have another way of thinking about low interest rates: they tend to increase the value of debt while reducing its future expected yield. So if you hold a fixed-income asset, and the central bank lowers the interest rate, two things will happen. First, your existing portfolio will increase in value, making you richer and enabling you to spend more, if you choose. Second, on a forward-looking basis fixed-income assets become less attractive (relative to current consumption) because their yield is lower. So the people who saved in the first period are now induced and enabled to spend, and balance is restored.

Now it's not just fixed-income assets that are subject to this phenomenon, it applies broadly to a lot of asset types. For instance, a rental property behaves a lot like a fixed-income asset, especially if there is a long-term lease that specifies what the future rent payments will be. But even shares of stock tend to follow this same pattern.

Hence the slut. I mean, hence the "Everything Boom, or Maybe the Everything Bubble," as Neil Irwin formulated it. Assets of almost every variety are expensive right now, because that is the flip side of market interest rates being low. And it is arguably a good thing, if it completes the process I described above, inducing people who have accumulated financial assets in the past to spend more in the present. (The other thing that is accomplished is that businesses can raise a lot of money in the financial markets, because financial assets command such a high price. This enables businesses to make investments that otherwise might be uneconomical. This is a phenomenon I have already pointed to, but now we are seeing it through the lens of high asset prices rather than cheap money - two sides of the same coin.)

Now here's a thought. Just as the central bank can draw spending from the future to the present, possibly depleting future spending, the central bank can also draw asset appreciation from the future to the present, creating a low-return environment in the future. That is, by lowering interest rates, financial assets appreciate massively in the present but appreciate much more slowly in the future. Their value goes up, their future yield goes down. (Recall our example of pivoting the line around the point at time T2. You can increase the value at time T1, but by definition this reduces the yield between time T1 and time T2.)

At this point I have said the same thing like 5 different ways. But anyway, that is the world we are living in: our assets have appreciated to dizzying heights, and now we have to hope that economic growth follows. Most people think that given how anemic the recovery has been, interest rates are going to be low for quite a while. This helps explain why housing is unaffordable in a lot of places, why hyper-luxury towers are shooting up like weeds in New York, why the stock market has surged, why most people think it can't keep surging, and why everyone feels a little uneasy about our current situation.

## 1 Comments:

Note this is not distribution neutral. By drawing savings from the future to the present (ie financial assets go up now and returns will be low in the future) this benefits those who are wealthy now over those who will become wealthy in the future. If you wanted to adjust the time shift in a distributional neutral way you might need a “change in wealth” tax that was inversely related to the change in interest rates over a given period. I’m not sure how you could do this in practice though… capitals gains doesn’t quite capture what I’m thinking

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