February 1, 2013 Leave a Comment
In 1752, Prime Minister Henry Pelham converted the entire outstanding stock of British debt into consolidated annuities that would become known as consols. The consols paid interest on an annual basis just like regular bonds, but with no requirement that the government ever redeem them by repaying the face value. Pelham created the bonds in order to reduce the government’s annual debt service costs. That isn’t our problem today. Instead, a modern-day consol would target another problem: political reluctance to take advantage of record-low interest rates.
As of Friday, the inflation-adjusted yield on 10-year Treasury bonds was negative 0.56 percent. Savers, in other words, want to pay the American government for the privilege of safeguarding their money. For the longest-dated bonds we sell, the 30-year Treasury bond, rates were 0.51 percent. That’s higher than zero, but far below the long-term average economic growth level. A sensible country would be taking advantage of that fact to finance some valuable public undertakings. Alternatively, if we think there’s nothing worth spending money on we could enact a big temporary tax cut aimed at reducing the unemployment rate and boosting the population’s skill level. Prolonged long-term unemployment, after all, has lasting effects that reduce the efficiency of the labor market and make it much harder to grow in the long term.
The first reason problem with Yglesias’s idea is that he thinks we should borrow money. We’ve been borrowing over a trillion dollars a year and the economy is still in the basement. We just had a quarter with negative GDP. If borrowing and spending worked it would have worked by now. As it is, we’re getting a negative return on government spending and the ratings agencies have already downgraded our credit rating once.
Then there’s the finance issue. There’s a yield curve on Treasuries. You can buy Treasuries in durations ranging from short term (1 month, 2 month, etc.) to long term (10 and 30 years). Treasuries with longer durations pay higher interest rates.
Yglesias glosses over that by expressing 10 and 30 year Treasury prices in terms of real interest rates – interest rates minus inflation. While real interest rates are a meaningful number, they also obscure the difference in interest rates. Currently the 10 year pays 2.03% and the 30 year pays 3.18%, or about 50 percent higher. If the yield curve went to infinity, investors would expect returns much, much higher than on the 30 year.
Third, does Yglesias think he’s the first person to notice that yields are at historic lows? Investors are still buying short- and medium duration Treasuries at low interest rates because they’re a safe haven. They’re not enthusiastic about long-dated Treasuries with pitiful returns. In fact, it’s the Federal Reserve buying those long-dated Treasuries as part of Operation Twist to mop up the excess in long-dated Treasuries and drive down interest rates.
Finally, there’s a huge, huge difference that Yglesias overlooks. If investors aren’t getting their original principal back, they will have to charge much, much higher interest rates.
Here’s why. Imagine I borrow $1,000 from you. If I promise to pay back the money in a year you might charge me 5% interest. Within one year you’ll get the original $1,000 principal back plus the $50 in interest. Now imagine I say I’ll never pay back the principal, but will just pay interest perpetually. Under the first plan you’ll get $1,050 from me in 1 year. Under the second plan with interest only it will be 21 years before I repay the same $1,050.
It’s pretty darned obvious that under the second plan you’ll have to charge a lot more vig. Besides the time value of money, you have to factor in the erosion of the real value of payments due to inflation over 21 years. Too, the longer I keep your money the greater the risk I’ll duck out on the payments. The fact that banks don’t offer interest-only loans for the life of the loan (as opposed to a brief introductory period) is a clue that interest-only loans are a bad idea for investors.
A consul-like debt instrument would also incentivize the government to foster inflation, which would make the government’s debt payments easier while diminishing the investor’s real returns.