Treasuries: A New Kind Of Giffen Good

In introductory economics one usually learns about Giffen goods, where people paradoxically consume more of it as the price rises, violating the law of demand. 

Your demand for an item is influenced by its relative value, and your over all wealth: substitution and income effects. This is formalized in the Slutsky equation (as with ‘homoskedasticity’ and ‘fat tails’, guaranteed to make the class snicker), but the bottom line is that the effects go in different directions. For normal goods, the income effect is positive, higher income leads to more demand, but for some inferior goods like Ramen noodles and American cars, the demand decreases with greater income. For a select few inferior goods the income effect is so large it can overwhelm the substitution effect, making it a Giffen good. 

In practice economists have used Irish potatos circa 1850 as the prototypical Giffen good, but this example has pretty much been discounted as apocryphal. The best example now is wheat in China

But what about US Treasuries? Over the weekend, their value certainly declined, as the S&P downgrade may have been wrong, but it didn’t decrease anyone’s default probability. Yet after a full day of trading the 10 year US T-Bond fell 25 basis points (ie, the price rose)! On a relative basis, the decline in US interest rates was greater than for the Australia, Great Britain, Canada, Germany, Japan, or Switzerland. Meanwhile, the US equity market tanked, which suggests the markets were not rebounding from a built-in expectations of an even larger downgrade. 

So, the value of the US Treasury falls, which lowers it relative price via the substitution effect relative to other assets. But everyone is now poorer, as with $60T or so in present valued unfunded promises, the AA+ downgrade is about a 0.1% increase in our discount rate, and that’s about a $1T drop in our net worth. This income effect is so large, the relative price of Treasuries actually increases because now other financial assets actually decline by even more. 

Today’s Treasury move didn’t work directly via the income effect, but indirectly via the income effect’s effect on the substitution effect, so it’s not a traditional Giffen good, rather, a ‘Geithner good.’