Market discipline for fiscal imprudence and the term structure of interest rates

Let’s talk about bond market vigilantes and the term structure of interest rates in a fiat currency system! That’s a mouthful, but I’ll explain what I mean.

Bootstrapping the yield curve

When I was in business school, we learned about bootstrapping the yield curve. Basically, long-term interest rates can be expressed as a series of short-term interest rates, such that if you know long-term rates, you can calculate expected future short-term interest rates. This is important because it tells you what people believe the Federal Reserve is likely to do with interest rates in the future.

For example, say you know the 5-year rate by looking at the current on-the-run 5-year interest rate on Bloomberg. Then, all you need to calculate all the expected future expected 3-month rates are quotes on U.S. zero-coupon bonds known as Treasury STRIPS. They are quoted in the Wall Street Journal daily.

Here’s what the Journal says:

U.S. zero-coupon STRIPS allow investors to hold the interest and principal components of eligible Treasury notes and bonds as separate securities. STRIPS offer no interest payment; investors receive payment only at maturity. Quotes are as of 3 p.m. Eastern time based on transactions of $1 million or more. Yields calculated on the ask quote.


Bootstrapping the yield curve is simply the math used to translate these three-month zero-coupon prices into a series of expected future 3-month interest rates. Doing this would mean we have a full term structure of interest rates every three-months out to five years.

The Fed controls short-term rates

Here’s the thing though. In our monetary system, the Federal Reserve controls short-term interest rates through open market operations. Bank reserves normally serve this purpose. If the Fed wants a higher Fed Funds rate, it drains reserves by selling financial assets and buying up reserves. If the Fed wants a lower rate, it adds reserves by buying up financial assets – usually Treasury bonds, but more recently it has taken to buying other assets. The quantity of reserves, of course, is irrelevant; the interest rate is what counts for the economy.

Now, if the Federal Reserve has absolute control over short-term rates, why isn’t it reasonable to assume it also has absolute control over long-term rates too? After all, I just showed you how long-term interest rates are really a series of short-term rates smashed together. The real reason that the Federal Reserve would lose control over short-term interest rates is because the economy was operating at full capacity and creating inflation which provoked an increase in rates.

My point is, unless the U.S. economy starts operating at full capacity, consumer price inflation isn’t going to create interest rate pressure for the Fed. A central bank issuing debt in its own currency controls short-term rates. So, absent inflationary pressure when there isn’t significant slack in the economy, rates remain low.

I think this is significant when thinking about bond market vigilantes and the like. But the key takeaway from the Japanese experience is the one I just outlined: sovereign central banks control short-term rates in the currency they issue and through the term structure, they also have some control over longer-term rates. When there is slack in the economy, there is only so far the bond market vigilantes can go. I’m not saying rates can’t rise. I’m saying that that rise is capped if an economy is in a balance sheet recession.

Running out of buyers

But, of course, people worry that the federal government won’t be able to sell its bonds. The thing is there can never be a problem for the federal government in selling bonds in a currency it creates.

As Jamie Galbraith recently said:

The government’s spending creates the bank’s demand for bonds, because they want a higher return on the money that the government is putting into the economy.

This comment sounds insane in isolation but you have to remember that bonds and currency are really the same thing – claims on the federal government. A quote from a November article of mine might make this a bit more clear:

From the government’s perspective, there is no functional difference between any of its obligations like bank notes, electronic credits, or treasury bills and bonds. As the Ten pound note says, “I promise to pay the bearer on demand the sum of [fill in the blank sum][fill in the blank fiat currency].”

So, the U.S. government could legitimately stop issuing bonds altogether if it wanted to. When people complain about the admittedly enormous government debt, they don’t think of the mechanics of the issue. As I see it, in a fiat money environment, the first function of the Treasury bonds is to serve as a vehicle to add or subtract reserves in the system to help the Federal Reserve hit a target Fed Funds rate. The second is to give holders of government obligations a return on their investment. After all, bank notes or bank reserves don’t pay much if anything.

If the U.S. stopped issuing treasuries, would it go broke?

So, since I expect significant slack in the economy for some time to come, it seems reasonable to me to expect Treasury bond yields to stay low during that period. U.S. citizens can buy gold as currency revulsion takes hold. But, what else are banks going to do with their excess reserves? Speculate and bid up asset prices, creating malinvestment. And of course, pension funds and fund managers will reach for yield by investing in high risk assets, further distorting the allocation of investment capital and creating asset bubbles. But, of course that’s the Austrian in me saying that!

At some point I am going to get back to Austrian school posts. I have been thinking a lot about the actual ability of government to withdraw demand from the economy by increasing taxes – a key assumption in Modern Monetary Theory (MMT) with which that I have an issue and critical to containing eventual inflation. But for now, I am on an MMT kick and their analyses demonstrate that sustained consumer price inflation is a long way off.

Update 18 May 2010 1120 ET:

I received the following corrections about my post from Scott Fullwiler, a Professor of Economics at Wartburg College and one of the leading scholars on Modern Monetary Theory

Two minor corrections:

  1. The Fed and other central banks actually don’t change the qty of rbs when they want to change the interest rate target. Under pre-Lehmann operating procedures (that set the target rate above the rate paid on rbs) the demand for rbs is VERY interest inelastic at the qty banks desire to hold to settle payments and meet rr. The Fed essentially just announces a new target, and stands ready to "defend" the target via repos/reverse repos if the mkt doesn’t move to the new rate. Under current operating procedures, with a large qty of excess rbs and the target rate set at the remuneration rate, the Fed just changes the remuneration rate (or could). Finally, in other countries that set the target rate in a narrow corridor b/n the remuneration rate and the cbs lending rate, all the cb really needs to do is announce a new target and new levels for remuneration and lending rates–that is, just set new bid/ask rates, and the overnight rate will necessarily trade in that range.
  2. MMT’ers don’t necessarily argue for a fiscal policy rule that alters tax rates to manage the macroeconomy. In fact, I’ve never seen such a rule proposed. The statement that "govt can alter taxes to stabilize aggregate demand at full employment" should be understood as a metaphor for adjusting the deficit. The preferred prescription is to have very strong automatic stabilizers, like a job guarantee that countercyclically provides employment at at minimum wage. I would also index most govt spending and taxes currently indexed to inflation instead to an inflation target. When these and similar measures are insufficient (like now), then we might consider proactive adjustment of, say, taxes or tax rates, but the goal would be to have automatic stabilizers strong enough that this would rarely be necessary. Of course, that’s theory, and fashioning effective stabilizers is easier said than done, particularly once you add the complexities of political economy. We fully recognize that. But I would just conclude by saying that aside from the job guarantee, there’s not much published theory by MMT’ers on specific fiscal policy rules–my point again being that "adjustment of taxes" is more of a metaphor than an actual policy suggestion.

I hope that helps explain some of the nuances I could not.


Edward Harrison is the founder of Credit Writedowns and a former career diplomat, investment banker and technology executive with over twenty years of business experience. He is also a regular economic and financial commentator on BBC World News, CNBC Television, Business News Network, CBC, Fox Television and RT Television. He speaks six languages and reads another five, skills he uses to provide a more global perspective. Edward holds an MBA in Finance from Columbia University and a BA in Economics from Dartmouth College. Edward also writes a premium financial newsletter. Sign up here for a free trial.