For the Duration

It was a shakedown cruise
I guess I just was born to lose
They tell you life is going cheap
I got myself in pretty deep
--Jay Ferguson

Seems to me that many folks don't understand the difference between printing 'paper money' and printing 'credit money.' Major inflationary events burned into people's heads involve the printing of paper money. The spectre of kids playing house with worthless Weimar marks, or the recent paper blizzard in Zimbabwe, seems to dominate current mindset.

In today's 'advanced' monetary monetary systems, however, money is created primarily in the form of credit. Central banks such as the Federal Reserve reduce borrowing costs in hopes that banks will pyramid credit money thru the system.

This adds, I think, a few counterintuitive dynamics to the system. One relates to the perverse behavior of interest rates during early periods of deflationary conditions. It goes something like this. People become risk averse in droves after a secular borrowing binge. Risk aversion leads to paying down debt and debt defaults. As debt-related projects are retired, folks pour into cash and short term fixed income because they are risk averse and trying to preserve capital. The Fed intervenes and drives interest rates to zero to encourage risk taking. As long as risk aversion has folks moving into fixed income as a 'flight to safety', then the Fed does not have to worry about market forces winning the upper hand and forcing interest rates higher. In fact, people will be willing to buy all the 0% yield paper offered by the Fed in return for the guarantee that it will be 'safe.' Therefore it can be posited that:

Proposition 1a: In early stages of deflationary periods, interest rates will decline and remain at low levels despite high levels of central bank stimulus.

Proposition 1b: In early stages of deflationary periods, demand will be high for near 0% yield paper that is 'guaranteed.'

These low interest rates facilitate government borrowing on the cheap for social programs to stem the pain from the deflationary decline (unemployment insurance, other safety nets). However, the government will be tempted to borrow at shorter durations, because short rates are subject to the greatest degree of central bank influence (longer term rates are subject to drift higher as some bond investor sense longer term inflationary consequences of all the stimulus). As government borrowing increases, a mismatch grows between the funds borrowed (e.g., at 0.1% for three month T-bills), and the obligations that they are supposed to fund (say, 12 months of unemployment payments or infrastructure projects with 5-10 yrs timelines). This creates a mismatch in duration--long term projects are being funded with short term debt.

Proposition 2a: Lower interest rates during deflationary periods, particularly on the short end of the yield curve, will drive governments to increase their borrowing for social programs.

Proposition 2b: Higher levels of government borrowing during deflationary periods will increase duration mismatch.

These actions could precipitate profound down-the-road consequences. For instance, what happens if/when market forces drive interest rates (a.k.a. borrowing costs) higher (kinda like what's happening in Greece now)?

position in SPX