The Fiat Solution
My essential claim is that an economy using fiat money can only find a stable equilibrium at short term rates at or near zero, and that the last 40 or so years have been the period during which the economy, led by the markets – not the monetary authorities – has moved itself in that direction from the unstable starting point (a fiat regime with significantly high nominal interest rates). I call this hypothetical zero interest rate equilibrium for fiat money economies the fiat solution.
The common wisdom is that central bankers have been blowing bubbles and deliberately inflating asset prices by lowering interest rates.
In contrast, my view is that a monetary asset that is costlessly and instantly created in any quantity and which the issuing authority ensures will never become scarce cannot by definition attract a yield or rate of interest in any equilibrium situation.
Contrast this with a gold standard money which is a natural restriction of the amount money relative to everything else – providing a clear case for a rate of interest on money to exist. Although attempts have been made by the monetary authorities over the last 40 years to restrain the natural movement toward a zero interest fiat solution I’m going to show how these measures have essentially attempted to impose a fiat arbitrage, e.g. ‘let there be yield’ and how markets have systematically acted to remove these arbitrages, lowering long term rates thus forcing the monetary authorities to lower short term rates to avoid recession and therefore move the whole economy in the direction of the only solution (e.g. equilibrium attractor) that exists for the fiat money economy.
Cause and Effect
The way the economy as a whole achieved the fiat solution was to move quickly to a situation of maximum leverage (e.g. peak debt) at which the zero rate of interest is more or less the correct rate of interest, which is of course more or less where we are today.
Money For Nothing
Unless we live in a risk free reality, which we don’t, then a nominal return on a genuinely risk free security is unwarranted regardless of what the real return is. Government bonds issued in a fiat economy fall into this category.
To illustrate this point lets do a little thought experiment.
Consider the case in which there is one money, gold, which is accepted everywhere for payment. Its supply varies against the supply of goods and services meaning the real return on holding it fluctuates. This is a nice, uncontroversial scenario which holds for much of human history. If you wish to be pedantic, you can read gold and silver where I have written just gold.
In this simple simple case of a money economy, we see there is nothing which gives a guaranteed risk free real return above zero, not even gold. To underline that point, here’s a graph  of the nominal and real rates of return over the last couple of centuries:
The Golden Goose
Now imagine that the government offers for sale special geese. The geese cost 1000 ounces of gold and are guaranteed to produce 10 8-ounce gold eggs each year. Furthermore, there is a well established market for golden egg laying geese, as one might expect. Lastly, there are no upkeep costs since the government has its own goose cages where they will keep your goose and feed it on your behalf.
There are other geese on the market but they are of an inferior kind which sometimes lay golden eggs to an unknown schedule but quite often just die, or remain barren. These geese are sold as seen and one never knows for sure whether the goose is good or not.
Everyone believes the tale about the superior type of golden goose, and they have been laying golden eggs for many a year right in front of peoples eyes, and one can see these golden eggs in the marketplace every day where they are a common form of payment.
Laughing at Alchemy
What is the value, in gold, of this goose? In Victorian or Edwardian times, such an asset would have been regarded as a philosopher’s stone.
Alchemy, turning base metal into gold …
The goose is priced in these modern, rational times using Net Present Value , in which we simply discount the value of future golden eggs by the prevailing interest rate at which gold can be lent in the market. If that rate is positive, then the goose has a finite value. If that rate is zero, then the value of the goose is infinite according to NPV, regardless of how many eggs it lays and over what timeframe.
Never Believe an Alchemist
The objections to the above that will be offered by those claiming to be Alchemists, and the obvious dismissals of those objections can be summarised as follows:
Alchemist: The price of the goose is determined by the real rate of return on holding golden eggs, not the nominal rate (e.g. The rate at which our gander lays eggs).
The Other: As shown above, the real rate of return on gold has been positive and negative throughout history, but nevertheless, a golden goose would be considered alchemy in those times. And if the alchemist is right, then the price of the goose would decline if the real rate of return to gold goes up, but that is not what happens, the goose goes on laying regardless.
Alchemist: A government bond goose is not risk free. The government bond might default goose might die. Everything has risk.
The Other: Both government bonds and geese expire. But if one can easily buy another the alchemy can continue (*1). Also, if enough people believe in the risk free nature of the asset you will always be able to sell it for its risk free value.
Alchemist: A goose that lays 1 egg a year is less valuable than a goose that lays 10 eggs a year, so how can both have infinite value
The Other: Both geese are individually valued using NPV at a discount rate of zero and found to have infinite value. This does not prove that geese always have finite value, it proves that a golden goose can only ever be a figment of the imagination.
Killing the Golden Goose
Its gotta be done.
And its gonna hurt a bit.
The Ibbotson data from 1926 to present show that T-bills returned about 3.7% compounded annually, while inflation was around 3.5% compounded. If the inflation figure was slightly understated due to errors in measuring the CPI, then the real return on T-bills was indistinguishable from zero.
Thus I'd propose substituting 'real' for 'nominal' in the quoted statement, and vice versa. Evidence doesn't support the claim of no nominal return on the risk-free asset, but the real return has been essentially zero for T-bills.
Longer-term bonds have exhibited a real return of about 2.0% (5.5% nominal) compounded annually, because they do present duration risk in the form of price volatility, for which investors demand compensation.
data from 1926 to present show that T-bills returned about 3.7% compounded annually, while inflation was around 3.5% compounded. If the inflation figure was slightly understated due to errors in measuring the CPI, then the real return on T-bills was indistinguishable from zero.
I would say that the only valid return accruing to long nominal bonds is the interest rate risk. This is because they have no duration risk (i.e. they have a very liquid market and the average holding period for a government bond is about 1.7 months). Obviously long bonds will be held longer on average but we are talking an extra few months here not 25 years. Likewise there is no nominal risk.
So a government bond is just cash with an enhanced interest rate swap.
They should be priced accordingly, and we are at long last converging on this process of price discovery for so called 'nominal' securities.
Here then is the force behind your bond bubble. It has nothing to do with bernanke and everything to do with the natural mechanics of a fiat unit of account.
" A monetary asset that is costlessly and instantly created in any quantity and which the issuing authority ensures will never become scarce......"
Sounds like a counterfeit operation. The medium of exchange for goods must be acceptable to actual producers of goods and their consumers, not issued by some entity that does not produce anything but redirects production activities by issuing claim checks on the peoples livelihoods. In order to solve some equation in a blackboard.
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