Monday, August 08, 2011

Treasuries a New Kind of Giffen Good

In introductory economics one usually learns about Giffen goods, where people paradoxically consume more of it as the price rises, violating the law of demand.

Your demand for an item is influenced by its relative value, and your over all wealth: substitution and income effects. This is formalized in the Slutsky equation (as with 'homoskedasticity' and 'fat tails', guaranteed to make the class snicker), but the bottom line is that the effects can go in different directions under very unusual circumstances. For normal goods, the income effect is positive, higher income leads to more demand, but for some inferior goods like Ramen noodles and American cars, the demand decreases with greater income. For a select few inferior goods the income effect is so large it overwhelms the substitution effect, making it a Giffen good. I suppose it's a similar model to how burning coal causes global cooling in standard models.

In practice economists have used Irish potatos circa 1850 as prototypical Giffen goods, but this example has pretty much been discounted as apocryphal. The best example now is wheat in China, and that's basically the only one.

But what about US Treasuries? Over the weekend, their value certainly declined, as the S&P downgrade may have been wrong, but it didn't decrease anyone's default probability. Yet after a full day of trading the 10 year US T-Bond fell 25 basis points (ie, the price rose)! On a relative basis, the decline in US interest rates was greater than for the Australia, Great Britain, Canada, Germany, Japan, or Switzerland. Meanwhile, the US equity market tanked, which suggests the Treasury markets were not rebounding from prior expectations of an even larger downgrade.

So, the value of the US Treasury falls, which lowers it relative price via the substitution effect relative to other assets. But everyone is now poorer, as with $60T or so in present valued unfunded promises, the AA+ downgrade is about a 0.1% increase in our discount rate, and that's about a $1T drop in our net worth. This income effect is so large, the relative value of Treasuries increases because now other financial assets actually decline by even more, so much so the absolute value of Treasuries increase after a fall in their 'quality'.

Today's Treasury move didn't work directly via the income effect, but indirectly via the income effect's effect on the substitution effect, so it's not a traditional Giffen good, rather, a 'Geithner good.'


travis said...

It's an interesting hypothesis, but a bit tortured. There are other things to buy than treasuries. I think it's more plausible to say that growth expectations are dropping. People tried to come up with plausible economic explanations for the 87 crash. There really weren't any, except that prices got extended relative to plausible growth paths. In this situation, we obviously don't have as good an economy as in 87, but we are just slogging along. The Fed is going to stand pat unless inflation expectations fall below 1%. We need higher inflation than 2% in order to get decent growth, so the market is in a blue mood.

r2d2 said...

yields are lower, the PV of all your debt is higher by 1T. OK, does it mean you have to go in the market and buy your own bonds at current prices to realize this loss? if you consider the fact that you can roll maturing debt into new one at lower yields, you are actually better off, because you will pay less interest in the future. to me the $1T drop in net worth only means anything if you have to close the position at that level. similar with a gain, if there is a way to close the position and lock the gain, it really means something, if not, it's just mathematical fantasy that accountants take too seriously.

apologies if I missed your point completely.

Anonymous #5 said...

It's hard to reconcile S&P having a major impact on the markets with any idea of market efficiency (unless you think their observation that there are a lot of clowns in Washington is some sort of profound insight that was not previously available to ordinary investors living in caves without electricity). Much simpler hypothesis: the stock market is tanking, people are fleeing to Treasuries, S&P is irrelevant, maybe even self-destructive (MHP down 8.6% yesterday).

Majorajam said...

That's not new at all though- that's Soros' reflexivity, isn't it? Bubbling asset catches more bids begets more bubbling assets and catches more bids, (mortgage paper and condos last time round, dot com ipos in the 90s, etc.). Until it pops.

Treasuries are just the latest in the sequence of these bubbles, which is to say, the only one that has yet to pop.

All the policy moves that have led us to here were tactical withdrawals meant to mitigate losses. But it's been a losing strategy the whole time. And the endgame is neigh.

David Merkel said...

Thanks for posting this, I was thinking about writing something similar but I could not quite get there.

Anonymous said...

On the Equity Premium's non-existence, what say you?

Gaston said...

FT Alphaville
Think the same 3 days latter... strange..

haha.. go get your copyright haha