Turns out bonds are risky

The world wakes up to our new reality and freaks out

Photo by Robert Nyman on Unsplash

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Welcome to Known Unknowns, a newsletter that never claimed to be risk-free.

Maybe We Shouldn’t Try to Be China

I participated in a lively debate on Trump’s first 100 days for Open to Debate. As always, I learned a lot from my fellow debaters. One thing that struck me was how similar the far left and right are beginning to sound. The center-right and center-left are also starting to converge—it’s a strange sort of realignment. It’s less right versus left these days, and more moderate versus non-moderate.

In a better world, that could even be somewhat healthy—leading to better policy and more compromise. Alas, both parties seem to be governing from their extreme wings. Based on my panel, the emerging conventional wisdom among this crowd is that the American economy has failed and we need tariffs to fix it. And if they don’t work, that’s because we didn’t implement enough industrial policy.

Sigh.

The argument, essentially, is that we should be more like China, since they appear to be winning at… something—maybe global trade, though I’m not sure. I wrote for Bloomberg last week about how insane it is that so many people think China has it right and that we should manage our economy that way. I can almost see the appeal. Over the last few decades, China experienced high and steady growth as it opened up and liberalized some things, while also carefully managing its economy. The result was all upside (growth-wise) without the downside of free markets—no financial crises, recessions, or mass job loss. Meanwhile, America experienced all those things and lost even more manufacturing jobs. We don’t control our markets, but China does. Control is compelling. Even the best economists of the day once thought the Soviet Union had it right.

But the Chinese model won’t work in America. First of all, it’s not working so well in China either. Between investments in real estate, infrastructure, and overseas ventures, China has built up a massive debt problem that even they may not be able to manage. There have been huge distortions in how capital is allocated and which industries grow (not in a good way), not to mention demographic issues—also a result of bad policy choices. It’s worth noting that the threat of tariffs has been very bad for them and is exposing many of their weaknesses. For all our problems, the American economy is much more resilient. As bad as a trade war might be, it won’t break us in the same way.

Central planning also just won’t work here. As I argued in the debate: we’re not Singapore. Our forays into industrial policy under Biden suggest our results would look more like Latin America’s than East Asia’s. And we’re not China either. Our institutions require more freedom and are quite good at holding people accountable. Freedom and creativity are how we innovate, and government direction tends to be less successful. Our capital markets are also pretty good at allocating capital—why they’re the envy of the world—and why we’re still the leader in innovation.

It’s also much easier to direct an emerging economy than a mature one.

We keep hearing scare stories about other countries cozying up to China. Maybe that’s true. But I think countries that go all in with China will come to regret it. China remains unpredictable, and there are many reasons to believe the economic model so admired by the far left and right is heading for trouble—as most planned economies eventually do. Unless, of course, we’re planning to resurrect Lee Kuan Yew and make him king.

Since When Was the 10-Year Treasury Risk-Free?

No one hates tariffs more than I do, but some of the commentary about how bad they’ll be them is starting to sound a little unhinged. Many aspects of the American economy are still exceptional. We are not an emerging market, and we still issue the world’s “risk-free asset.”

I agree it was concerning that the 10-year yield went up while the stock market fell and the dollar depreciated. But that doesn’t mean it’s now a risky asset. It was never entirely safe to begin with. There has always been risk in American bonds. We’ve been spending like crazy, inflation returned even before the trade war, and bonds tend to mean-revert—we were at historic lows.

Since when was a 10-year bond safe? I suppose it could be, if you have an American liability with the same duration—but that’s a discussion for another day.

The yield spike last month may have simply been an unwinding—not the end of King Dollar or the Treasury market, at least for now. But make no mistake, bonds were never risk-free. And if Trump does succeed in reducing the current account deficit significantly, bond prices will fall further. That’s just basic math. But that’s not what makes them risky. If you ever thought they were safe—you weren’t paying attention.

Still, U.S. bonds remain safer than the alternatives. Even with more German bunds in circulation, nothing matches Treasuries in liquidity and relative stability. Europe still has structural issues, and China remains less predictable than we are.

What worries me is how poorly people—especially those who should know better—understand what a risk-free asset actually is. Bad things tend to happen when people think something is risk-free and it isn’t.

We may not be the best option forever, and that may give us too much rope to hang ourselves with.

Price Transparency for the Win

Every European I know hates shopping in America. They think it’s nuts that the price on the tag isn’t the price you pay at the register once sales tax is added. I’ve heard them warn each other to be prepared. Americans, of course, find it totally normal.

I’m not a fan of surprise bills. But I am a big fan of transparent pricing and more awareness of tax incidence.

It may be annoying to pay extra for a better airline seat, resort fees, or state taxes—but that annoyance is healthy. We should know what increases prices and be annoyed by it.

So yes, I’m also all for a tariff premium on our price tags. It may be hard to calculate because tariffs are partly absorbed by governments, exchange rates, and corporate profits—but consumers will pay, too. How much will vary by the size of the business and the origin of the good. Still, if this could be broken out, we should know what portion is being passed on to us.

And while we’re at it, let’s show how much we bear the burden of corporate taxes too. That would supercharge tax reform!

Other News

Some good thoughts on currency from Rich Clarida.
And Ken Rogoff—also on the dollar—on my favorite podcast.

Until next time, Pension Geeks!
Allison