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Source link: http://archive.mises.org/12613/what-next-for-treasury-bonds/

What Next for Treasury Bonds?

May 3, 2010 by

The government is not a wealth generator — it is completely at the mercy of the wealth generators in the private sector. This, of course, means that the US government must drastically cut its expenditures to prevent a serious economic disaster. FULL ARTICLE by Frank Shostak


newson May 3, 2010 at 6:46 pm

a huge head-and-shoulders top on the us long-bonds would seem to corroborate shostak’s scenario (for those who believe in technical analysis).

Andrew Chance June 4, 2010 at 2:38 pm

This is a great discussion on the future of treasury bonds, but in an economy where investors proclaim an exorbitant future hike in inflation, it would be most relevant to include TIPS bonds in the discussion.

Jeff Borack from Kerrisdale Capital provides an insightful analysis, providing the differences between the two bonds and how they relate to the current economy. I have provided the link to Kerrisdale’s blog here:


Anonymous May 4, 2010 at 2:42 am

“In the money economy, individuals’ time preferences are realized through the supply and the demand for money.”

Frank Shostak is brilliant, but in this case he is incorrect. Individuals’ time preferences are not realized through the supply and demand for money. Individual’s time preferences are realized through consumption and savings decisions. In other words, interest rates are a real phenomenon, not a monetary phenomenon. This simple truth can be understood by realizing that interest would still exist in a pure barter economy with no money. Furthermore, there would be no demand for cash balances in the Evenly Rotating Economy, but interest would still exist.

Otherwise, I completely agree that treasury yields will start rising sometime in the near future. See this article: http://www.moneyandmarkets.com/the-great-interest-rate-explosion-of-2010-2011-how-to-protect-your-wealth-and-profit-38957

Dick Fox May 4, 2010 at 7:18 am


You need to understand Wicksell concerning real and nominal interest rates. In the Classical barter economy real interest rates are determined by time preference, but Wicksell demonstrated that the introduction of indirect exchange can distort the interest rate from its real time preference level. This distorts both interest rates and prices.

I would refer you to Chapter XX of Human Action.


“The final state of the rate of originary interest to the establishment of which the system tends after the appearance of changes in the money relation, is no longer that final state toward which it had tended before. Thus, the driving force of money has the power to bring about lasting changes in the final rate of originary interest and neutral interest.”

Anonymous May 5, 2010 at 3:21 am

Dick Fox,

You must distinguish between cash and loanable funds. The supply and demand for money determines the purchasing power of money, not the interest rate. I suggest you examine chapter 11 of Man, Economy, and State. Robert Murphy states:

“The PPM and the rate of interest are not inherently connected. For example, the demand for money could increase (raising the PPM), yet if time preferences remain the same, this will not affect the (real) rate of interest” (MES Study guide, pg. 140).

Dick Fox May 5, 2010 at 8:47 am


Note that Murphy states clearly that he is talking about the real rate of interest not the nominal rate. Shostak’s analysis of why an increase in the money supply impacts interest rates is spot on. His weakness is in the decrease in the money supply.

Rothbard in chapter 11 of Man, Economy, and State is locked into an equilibrium economy, what Mises calls “the imaginary constuct of the evenly rotating economy.” The ABCT of Hayek-Mises is based not an equilibrium but on a dynamic economy where changes in the money supply give false prices and create “forced savings.” There is no change in the time preference per se but the false prices create errors because of the relation between time preference and money supply are distorted. It is this that Shostak is talking about when he talks of an increase in excess money. If time preference and money supply were coordinated there would be no change in the originary interest rate but they are not especially in an economy with a floating currency.

Anonymous May 5, 2010 at 6:35 pm

Dick Fox,

The supply and demand for money in the narrow sense (cash) does not affect the gross interest rate. Changes in the supply and demand for loanable funds affects the gross interest rate. If the Fed expands credit, then there is an increase in the supply of loanable funds. This will drive the gross market rate of interest below the originary rate of interest.

The gross market rate of interest only falls if the money enters through the loan market. Simple changes in the supply and demand for cash (money in the narrow sense) do not cause changes in the gross interest rate.

In short, you fail to grasp the difference between money inflation and credit expansion: “It is important to pay heed to these facts in order not to confuse the consequences of credit expansion proper and those of government-made fiat money inflation” (Human Action, pg. 568)

Also, see pg. 526 of “The Theory of Money and Credit” to better understand the distinction between money in the broader sense and money in the narrower sense.

Dick Fox May 4, 2010 at 7:08 am

“From this we can infer that anything that leads to an expansion in the real wealth of individuals gives rise to a decline in the interest rate, i.e., a lowering of the premium of present goods versus future goods. Conversely, factors that undermine real-wealth expansion lead to a higher rate of interest.” This is a very important point that Shostak makes because it takes into account both the nature of capital and the nature of money, but then Shostak begans to move in the wrong direction. “Consequently, an increase in the supply of money coupled with a fall in the demand for money raises the excess supply of money, which in turn bids the prices of assets higher and lowers their yields.

This lowers individuals’ tendency for investments and lending, i.e., raises the demand for money and works to lower the excess-money-supply rate of growth — this puts an upward pressure on interest rates.”

Bidding assets higher does not necessarily lower yields if the monetary authorities are continuing to increase the supply of money, rather when the monetary authorities continue to increase the money supply the value of money falls and there is a “flight to quality.” There is a reduced demand for money increasing the supply of excess money and continuing the lowering of interest rates, all things equal.

But all things are not equal. Lenders experience a decline in the value of their money and so build this in to their demand for interest to recover the loss. The interest rate does not increase in an inflationary period because of lower yields on assets but because of lower yields on holding money. Now this could be what Shostak means because he states in a following sentence, “It is loose monetary policy that undermines the stock of real wealth and the purchasing power of money,” so he does recognize the decline in the value of money, but his earlier phrasing is somewhat misleading.

However, as seems to be common in Austrian circles, Shostak makes his most serious mistake when he addresses deflation. Rather than engage in a serious analysis of deflation as he did with inflation we get a quick assumption that deflation will simply have the opposite effect of inflation. Mises assures us that they are very different phenomenon. Contrary to Shostak’s assertion price deflation also leads to higher interest rates.

Any alteration of the value of money leads to higher interest rates.

As Shostak correctly observes a decline in wealth reduces the tendency to lend, leading to an increase in the interest rate, but, where in an inflation lenders increase interest rates to offset the loss of value of money, you do not have the opposite reaction in deflation. As money becomes scarce during a deflation, the demand for money increases and interest rates rise. While lenders can recover a loss of monetary value in an inflation by increasing interest rates, there is no comparable pressure for lenders to lower interest rates due to an appreciation of assets, because the scarcity of money overwhelms any tendency to lower interest rates because of asset appreciation.

Austrians spend much time with the ABCT discussing and debating inflation, but they have a very poor understanding of deflation. In our current world of fiat currencies both deflation and inflation are critical events to understand because the monetary authorities create both with great frequency. When monetary authorities increase the money supply rapidly they watch inflation closely. When inflation becomes manifest in their indicators, inflation has been actually roaring for 6 months or more. To end the inflation the monetary authorities throw the economy into reverse and actually create deflation. Because the monetary indicators have a 6 months lag time, they tend to keep the economy in deflation for 6 months or longer. Once the indicators turn again the monetary authorities begin a new inflation under the illusion that increasing the money supply will stimulate the economy.

I am on a crusade because I believe that Austrians are stuck in the past because of their inattention and lazy attitude toward deflation. If Austrian theory is going to be taken seriously, Austrian academics must seriously begin to study and understand deflation and root out the deflation fallacies in modern Austrian theory. The writings of Mises and Hayek are a good place to start.

Nathan Mayer May 4, 2010 at 12:58 pm


I think you are misunderstanding what Shostak says.

“Consequently, an increase in the supply of money coupled with a fall in the demand for money raises the excess supply of money, which in turn bids the prices of assets higher and lowers their yields.

This lowers individuals’ tendency for investments and lending, i.e., raises the demand for money and works to lower the excess-money-supply rate of growth — this puts an upward pressure on interest rates.”

Bidding assets higher – by definition – reduces yields. Shostak assumes that this is a one off increase in the money suppy, and what he says is true. If individuals reduce their demand for money (reduce their demand for goods & services), they will trade the money in their possession for interest / dividend bearing securities. Now if central banks continue to increase the money supply and the excess money goes into goods and services rather than assets (increase in the demand for money), then the CPI will go up and you could assume that investors would sell bonds – especially long term bonds – and invest in inflation protected assets such as gold.

Also, if you read some of Shostaks other stuff on deflation I would challenge you to find an economist who understands and can explain the concept more eloquently.

In a nutshell, he says that loose monetary policy gives rise to wealth – consuming (or false) activities. When the loose money policy tighens (or when the pool of funding comes under pressure), it puts pressure on the false activities. Just a simple, logical explanation.

Dick Fox May 4, 2010 at 2:32 pm


You and Shostak are correct that loose monetary policy does give the illusion of wealth and so the pool of excess funds is expanded, but it does not follow that tight monetary policy is then the opposite. Tight monetary policy (deflation) leads to all of the problems with deflationary policy. Mises in The Theory of Money and Credit urges not tightening of monetary policy or a deflationary policy but to stop the inflation, allow the economy to adjust to the new equilibrium, then fix the currency to the new parity. Mises specifically mentions the risk of deflation leading to economic problems when curing inflation.

The reform thus consists of two measures. The first is to end inflation by setting an insurmountable barrier to any further increase in the supply of domestic money. The second is to prevent the relative deflation that the first measure will, after a certain time, bring about in terms of other currencies the supply of which is not rigidly limited in the same way.

Read more: The Theory of Money and Credit by Ludwig von Mises http://mises.org/books/Theory_Money_Credit/Part4_Ch23.aspx#_sec5#ixzz0mzUBx1JQ

The great Roosevelt-Truman inflation has, apart from depriving all creditors of a considerable part of principal and interest, gravely hurt the material concerns of a great number of Americans. But one cannot repair the evil done by bringing about a deflation. Those favored by the uneven course of the deflation will only in rare cases be the same people who were hurt by the uneven course of the inflation. Those losing on account of the uneven course of the deflation will only in rare cases be the same people whom the inflation has benefited. The effects of a deflation produced by the choice of the new gold parity at $35 per ounce would not heal the wounds inflicted by the inflation of the two last decades. They would merely open new sores.

Read more: The Theory of Money and Credit by Ludwig von Mises http://mises.org/books/Theory_Money_Credit/Part4_Ch23.aspx#_sec5#ixzz0mzSukt4R

I believe that Mises understand deflation better and is much more eloquent than Shostak.

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