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SUMMARY
Paul Krugman and Ricardo Caballero discuss the diminishing safety premium on U.S. government debt, exploring the factors driving increased borrowing costs. Their conversation addresses the evolving role of U.S. Treasuries as a safe asset and the implications for fiscal policy and aggregate demand.
MAIN POINTS
- Caballero outlines his method for measuring the elimination of the safety premium on U.S. government debt, focusing on the marginal cost of debt issuance.
- The discussion clarifies the concept of the Treasury basis trade and the convenience yield, emphasizing the historical advantages of holding Treasury bonds.
- Caballero explains the shift in marginal holders of U.S. Treasuries from central banks to leveraged agents, impacting the spread and premium.
- The conversation turns to the rising interest rates for long-term U.S. government bonds and the implications for the real cost of debt.
- They discuss the surge in bond issuance by both governments and corporations, increasing competition and affecting perceptions of safety.
- Caballero concludes that while U.S. Treasuries remain the ultimate safe asset, the increased cost of issuing such debt could eventually dampen aggregate demand.
DETAILED ANALYSIS
Ricardo Caballero presents a framework for understanding the recent elimination of the safety premium on U.S. government debt, focusing on the marginal cost of debt issuance. This cost is split between the spread over a safe interest rate and the expense of rolling over existing debt at higher premiums. Caballero estimates that the total increase in cost is approximately 110 basis points, with about half attributable to the premium spread and the remainder to rollover costs.
The spread, often referred to as the convenience yield, historically reflected the willingness of investors to accept lower yields on Treasuries due to their unique advantages, such as use as collateral and liquidity. However, this convenience yield has diminished, with the spread moving from negative values before the COVID-19 pandemic to around zero today.
A significant factor in this shift is the change in the marginal holders of U.S. Treasuries. Previously, central banks like the Bank of Japan prioritized holding Treasuries for their stability and utility, but now leveraged financial agents play a larger role, making balance sheet considerations more prominent.
Additionally, the duration component of bond yields has increased, with investors demanding higher compensation for holding long-term debt. This is reflected in the fact that the U.S. government now faces much higher interest rates when issuing 30-year bonds compared to several years ago, moving from near-zero or negative real rates to positive rates around 2% to 2.5%.
The conversation also highlights the broader context of increased bond issuance, both by governments in response to COVID-19 and by corporations amid an investment boom. The resulting competition has narrowed the perceived safety gap between U.S. Treasuries and high-quality corporate bonds, with instances where corporate bonds like those from Apple briefly traded at higher prices than Treasuries.
Despite these changes, Caballero maintains that U.S. Treasuries remain unmatched as a safe asset, with no real substitute in the event of a crisis. The primary concern is not default risk but the growing fiscal burden of issuing safe debt, which could eventually constrain aggregate demand.