Home > Finance, Government, macro, Money > Gov’t debt is the safest dollar valued asset

Gov’t debt is the safest dollar valued asset

Karl Smith had an interesting post up this morning suggesting that government debt is in a bubble. I think this is one of those rare examples in which he is confused. The problem I have is this: although there may be bond buyers with heterogeneous valuations of the stream of (nominal) payments from government bonds, there is no state of the world in which government bonds are less safe than other (nominal) streams of payment. The government prints the money behind all these nominal transactions. Even with the possibility of voluntary default, I don’t see how you could see it any other way… if the US gov’t doesn’t have enough money to pay its debts (or choses not to print more to do so) then why on Earth would you expect GE to have the money to repay its debts?

I left the following long comment:

…A bubble is a deviation from fundamental values, not a situation in which “prices must eventually fall”.

The problem that I have, really, is that this sort of bubble talk really just leads to confusion. Otherwise, you can call anything you want a bubble and I wouldn’t care. Nothing in your analysis suggests that the US is headed for an imminent fiscal crisis if it doesn’t balance its budget, but that is exactly how some people will take it.

… the fact that the current price of gov’t bonds exceeds flow value of the expected payments does not mean that gov’t bonds are in a bubble …: they also have value as collateral. More importantly, they have value as collateral precisely because their fundamentals are so well anchored. The collateral value itself would be expected to fall as the economy recovers if we just presume (correctly) that a healthy economy generates collateral faster than an unhealthy one. …, I would argue that the current term structure could in principle be sustained in perpetuity–it is just unlikely that that would be the case…

[The] point that asset bubbles are the new normal… is actually something I myself worry a great deal about. It does seem that the supply growth of new assets has fallen behind the demand growth of assets, which makes sense in an aging world, and also that such a situation tend to produce bubbles. …this danger…, is lessened in a world with enough safe assets and therefore printing government bonds would generally reduce the risk of bubbles both by restraining excessive savings and giving what savings there are a place to go less prone to bubble generation–gov’t bonds have an easily calculated fundamental value contingent on the path of interest rates.

The point is that understanding that gov’t debt is safe and why is important if the rest of Karl Smith’s hypothesis turns out to be correct. Bubbles are not just something that “happen” when prices rise, you need some reason that agents might expect prices to continue to rise. A world in which new assets are not being produced quickly enough satisfies this condition. Gov’t debt does not; I can’t earn a profit (in expectation) by buying gov’t bonds, holding them and then selling them before maturity. Actually right now I will almost certainly lose money, as the yield has to rise sometime, but it is generally true that the price can’t exceed the PDV of the bond by too much–a sort of “soft” ceiling on the price.

Categories: Finance, Government, macro, Money
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