Cochrane on the Term Structure of Government Debt

11/17/2012 05:52:00 PM
Cochrane has a long post here telling the Treasury how to run its books. A quick summary of part of his argument: Interest rates on US federal government debt are unusually low right now, so the treasury should refinance all of its long-term debt in order to lock in at these low rates. The current system of rolling over the debt every two years leaves us vulnerable to a crisis if interest rates rise faster than revenues.

Taken to the furthest extreme, Cochrane proposes that we turn all of the federal debt into what he calls "perpetuities" which are government bonds that entitle the owner to a fixed interest payment--say $1-- each period for all periods in the future, but never repays the principle amount. These are then auctioned off to the highest bidder. Instead of holding the bond until they mature to get the principle back and the interest payment, the owner can hold the bond as long as they want, or sell it at anytime at the market price. This is not a novel idea--European governments used to use perpetuities as the main source of financing debts. The UK, for example, financed the Seven Years War primarily by issuing perpetuities (though they did try to buy them back by taxing our tea!).

The reason we don't take Cochrane's suggestion is that the maturity structure of US debts have macroeconomic consequences beyond those on the federal budget. In particular, the maturity structure affects the availability of liquidity in financial markets. If the treasury issues a 30 year bond, then it is taking liquidity away from an investor who would otherwise have invested in productive private sector projects, something that is not a big problem with, say, a one-month bond where investors know they will have their money back and ready to invest within a month. This is quite different from typical crowding out--the problem is not that the government is taking money away from private investment per se, but that by issuing long-term bonds the treasury is exposing private investors to greater risks from unexpected expenses and fluctuations in prices or interest rates.

Cochrane argues that we can have our cake and eat it too. That is, he claims that we can both provide the liquidity we would get by issuing short term bonds, while still locking the government debt in at low fixed interest rates. All we need to do, he says, is to use interest rate swaps. Here's how it works: the Treasury pays for the deficit by selling one-month bonds. Secretary Geithner then goes to Goldman Sachs and make a deal to exchange interest payments with Goldman--the Treasury would pay a fixed 30 year interest rate to Goldman, and Goldman would pay the floating one-month rate to the treasury (and by extension, to the people who bought the treasury bonds). This will probably be modestly more expensive for the Treasury, since we will have to pay a premium to Goldman in exchange for the fact that they are insuring the Treasury against the risk of unexpected changes in interest rates.

Cochrane is right that this would, at least in principle, preserve much of the liquidity advantage of short-term debt since the interest rate swap only requires that the interest payments, but never the whole principle amount, has to change hands. That is, liquidity is still reduced to the extent that Goldman still has a 30-year obligation to pay interest each month, but no one is obligated to hold the principle amount on their books for more than 30 days.

But does this really make anything better off? What Cochrane overlooks is the fact that while, in principle, this scheme absolves the federal government of short-term interest rate risks, it does so only by pushing them onto the private sector. Lets look at what he lists as the potential risks of short-term treasury bonds:
"What if the 4% growth underlying our already depressing deficit forecasts turns into another 4 years of sclerotic 1.5% growth, the CBOs static revenue forecasts from higher tax rates fail to materialize, inflation picks up, budget chaos raises the risk premium of US debt, and China7 stops buying?"
In the first point, he worries that future revenues may not rise as much as we expect, meaning that (if interest rates rise) the interest payments would gobble up a larger share of our revenues, causing the deficit to rise even further. Does interest rate swapping absolve us of this risk? No. In finance there are diversifiable and non-diversifiable risks. The former are firm-specific risks that an investor can eliminate by investing in a large number of diverse firms. The idea is that if some firms underperform, others will overperform, so on average you bear no risk. But there are some types of risks that affect all firms more or less equally, such as macroeconomic recessions, and there is no way to insure against this risk in the aggregate. The slow growth Cochrane worries about is an example of non-diversifiable risk, and it will inevitably hurt Goldman Sach's income just as much as it hurts the US treasury's income. Cochrane's scheme limits the treasury's exposure to this risk by having Goldman insure against it, but all this means is that Goldman has even more exposure to this risk. The result is that the federal government is still at risk whether or not it insures--if interest rates rise enough to cause the US to go bankrupt, then it is surely high enough to cause any of the private banks insuring the US to go bankrupt. In bankruptcy court, those interest rate swaps will be absolved, and the US government will once again be exposed directly to the interest rate risk and go bankrupt anyway.

Inflation is the same story. The idea is that higher inflation rates implies higher nominal interest rates (in the long run, once the liquidity effect wears off), and this is a risk to the government's finances. But, as with economic growth, this is a macroeconomic risk that cannot be diversified. So the interest rate swap does not protect us from this risk.

And ditto to the comment about China stopping purchases of treasury debt. The idea is that it would cause interest rates in the US to rise, but as in the previous examples this is a non-diversifiable macroeconomic risk.

The only valid point Cochrane actually makes is the one about congress and the budget chaos, because this is the only risk that is specific to the US government. There is potential that Congress would prove unable to raise taxes or the debt ceiling to pay for the interest on the debt in the event that interest rates rise, which is not a problem that Goldman Sachs would encounter with the rest of its portfolio of investments. In such an event, the insurance against an interest rate spike could prove to be the difference between Federal bankruptcy and solvency.

So Cochrane's actual argument--whether he realizes it or not--is that the treasury should buy insurance against the risk that we continue to elect total idiots to congress.