In a previous post I described the theoretical implausibility as well as the empirical rarity of governments inflating away their debt. I concluded that a deficit-driven buyer’s strike was unlikely, by itself, to pop the bond bubble.
Does this mean that “deficits don’t matter”? Oh no, quite the contrary. Deficits do matter, but it’s important to understand the mechanism. Deficits don’t operate via a buyer’s strike unless you go into hyperinflation. Instead the channel is monetary policy.
The Treasury issues bonds. The Fed buys them. As far as I’m concerned, that’s just an internal transfer. The external effect is not bond supply; the bonds never hit the street. Instead, the external effect is government expenditure. Essentially the Treasury is spending dollars that have been newly printed by the Fed.
In the short run this policy will boost private sector consumption and employment, as indeed it is designed to do. But in the long run it will lead to inflation; seigniorage always does.
Note that this inflation will not necessarily manifest itself in the form of rising interest rates, at least not immediately. If the Fed is willing to buy 75% of each Treasury auction (matching China at its peak) then sure, bond yields will stay low.
But the increase in money supply has to be reflected somewhere. Two obvious candidates are the dollar and real assets. Sure enough, in the last year or so these two instruments have fallen and risen, respectively. Policymakers who look only at bond yields to determine inflation pressures are missing the point.
Ultimately of course rates will have to go up. If something cannot last forever, it will not.
Tampilkan postingan dengan label Macro Musings. Tampilkan semua postingan
Tampilkan postingan dengan label Macro Musings. Tampilkan semua postingan
Kamis, 17 Desember 2009
Kamis, 03 Desember 2009
Buyers' Strikes and the Debt Treadmill
Here’s what I wrote last week:
And here’s progressive economist Paul Krugman:
Both Ferguson and Krugman seem to think that the danger is that of a “buyers’ strike” in the bond market. Both Ferguson and Krugman are wrong.
The way a buyers’ strike works is this: bond investors fear that huge deficits could lead to inflation down the road as the government tries to print its way out of debt. Hence they demand higher interest rates (lower bond prices) today to compensate for this risk.
Ferguson fears that a buyers’ strike could easily happen in the near future, and hence deficits are something to worry about. Krugman inverts this line of reasoning: he argues that low interest rates are prima facie evidence that a buyers’ strike is unlikely, and so deficits are nothing to worry about1.
They both miss the point. The notion of a buyers’ strike caused by fears of deficit-driven inflation is conceptually flawed, for the simple reason that the government cannot inflate away its debt.
It’s all a question of loan duration. Sure, if the entire government debt were in the form of a single loan of very long duration, with no payments before the maturity date of the loan, then yes, the government could foster inflation / debase the currency over the lifetime of the loan, and thus gyp the lenders.
But in actual fact, the majority of the US government’s debt is in the form of short duration loans – bonds with 2 years or less to maturity. This debt has to be rolled over. If lenders suspect that the government is planning to inflate the currency, then at the time of rollover they will demand higher nominal interest rates on the rolled debt, to compensate for this expected inflation. They will also demand higher real interest rates, to compensate for the additional uncertainty. And so the cost of servicing the debt will actually increase, by an amount greater than the amount of inflation. It’s like running on a treadmill: the government cannot get ahead2.
The facts bear this out. Here’s a chart from UBS showing that changes in government debt / GDP are broadly uncorrelated with the level of inflation.
(Source: UBS, via FT Alphaville; more here)
Note the strong element of feedback (a favorite topic on this blog) at work here. The possibility of a buyers’ strike in the future implies that inflation cannot work as a strategy for debt-reduction; the futility of an inflationary strategy suggests that a buyers strike will not occur in the present. A buyers’ strike is thus a self-negating prophecy; the present (no-strike) equilibrium is maintained; and market yields have nothing to do with the probability of such a strike occurring.
But wait. Does this mean that deficits don’t matter? Not quite. I’ll return to this question in my next post.
Footnotes
# 1Their respective stances would be more credible if it weren’t for the fact that six years ago, Krugman and Ferguson were on the opposite sides of the deficit debate. Back then, Krugman was a vocal deficit hawk, raising the prospect that tax cuts, entitlement commitments and military spending could ‘drive interest rates sky-high’. Meanwhile, Ferguson claimed that deficits were necessary and desirable if that was what it took to maintain the level of military spending required for purposes of US hegemony.
Of course both sides claim to have switched allegiance for the best of reasons. But the cynic in me will perhaps be forgiven for concluding that whether one is a deficit hawk or not depends greatly on what type of spending the deficit is being used to finance.
# 2As a general principle, the only way a government can inflate its way out of debt is to print money so fast that the real value of the debt falls significantly before the debt comes due. For a short-duration debt portfolio (like that of the US), this means hyperinflation.
Believing or disbelieving in the bond bubble seems to have become a political choice, at least in the United States. I can’t recall such a degree of partisan frenzy in the debate over previous bubbles such as housing, tech stocks or commodities. And for good reason: any discussion of bond prices and interest rates leads inevitably to a discussion of budget deficits and Fed/Treasury policy, which – unlike say dotcom valuations – is ideologically fraught territory.Sure enough, and with dreary predictability, commentators from left and right have divided along partisan lines in their analysis of the deficits. Here’s conservative historian Niall Ferguson:
There is no end in sight to the borrowing binge. Unless entitlements are cut or taxes are raised, there will never be another balanced budget. By 2039, when I shuffle off this mortal coil, the federal debt held by the public will have reached 91 percent of GDP, according to the CBO’s extended baseline projections.
...
Of course, our friends in Beijing could ride to the rescue by increasing their already vast holdings of U.S. government debt ... [But] the Chinese keep grumbling that they have far too many Treasuries already.
And here’s progressive economist Paul Krugman:
Right now, however, the bond market seems notably unworried by deficits. Long-term interest rates are low; inflation expectations are contained (too well contained, actually, since higher expected inflation would be helpful) ... This is truly amazing. It’s one thing to be intimidated by bond market vigilantes. It’s another to be intimidated by the fear that bond market vigilantes might show up one of these days, even though you’re currently able to sell long-term bonds at an interest rate of less than 3.5%.
Both Ferguson and Krugman seem to think that the danger is that of a “buyers’ strike” in the bond market. Both Ferguson and Krugman are wrong.
The way a buyers’ strike works is this: bond investors fear that huge deficits could lead to inflation down the road as the government tries to print its way out of debt. Hence they demand higher interest rates (lower bond prices) today to compensate for this risk.
Ferguson fears that a buyers’ strike could easily happen in the near future, and hence deficits are something to worry about. Krugman inverts this line of reasoning: he argues that low interest rates are prima facie evidence that a buyers’ strike is unlikely, and so deficits are nothing to worry about1.
They both miss the point. The notion of a buyers’ strike caused by fears of deficit-driven inflation is conceptually flawed, for the simple reason that the government cannot inflate away its debt.
It’s all a question of loan duration. Sure, if the entire government debt were in the form of a single loan of very long duration, with no payments before the maturity date of the loan, then yes, the government could foster inflation / debase the currency over the lifetime of the loan, and thus gyp the lenders.
But in actual fact, the majority of the US government’s debt is in the form of short duration loans – bonds with 2 years or less to maturity. This debt has to be rolled over. If lenders suspect that the government is planning to inflate the currency, then at the time of rollover they will demand higher nominal interest rates on the rolled debt, to compensate for this expected inflation. They will also demand higher real interest rates, to compensate for the additional uncertainty. And so the cost of servicing the debt will actually increase, by an amount greater than the amount of inflation. It’s like running on a treadmill: the government cannot get ahead2.
The facts bear this out. Here’s a chart from UBS showing that changes in government debt / GDP are broadly uncorrelated with the level of inflation.
(Source: UBS, via FT Alphaville; more here)Note the strong element of feedback (a favorite topic on this blog) at work here. The possibility of a buyers’ strike in the future implies that inflation cannot work as a strategy for debt-reduction; the futility of an inflationary strategy suggests that a buyers strike will not occur in the present. A buyers’ strike is thus a self-negating prophecy; the present (no-strike) equilibrium is maintained; and market yields have nothing to do with the probability of such a strike occurring.
But wait. Does this mean that deficits don’t matter? Not quite. I’ll return to this question in my next post.
Footnotes
# 1Their respective stances would be more credible if it weren’t for the fact that six years ago, Krugman and Ferguson were on the opposite sides of the deficit debate. Back then, Krugman was a vocal deficit hawk, raising the prospect that tax cuts, entitlement commitments and military spending could ‘drive interest rates sky-high’. Meanwhile, Ferguson claimed that deficits were necessary and desirable if that was what it took to maintain the level of military spending required for purposes of US hegemony.
Of course both sides claim to have switched allegiance for the best of reasons. But the cynic in me will perhaps be forgiven for concluding that whether one is a deficit hawk or not depends greatly on what type of spending the deficit is being used to finance.
# 2As a general principle, the only way a government can inflate its way out of debt is to print money so fast that the real value of the debt falls significantly before the debt comes due. For a short-duration debt portfolio (like that of the US), this means hyperinflation.
Minggu, 29 November 2009
The Next Bubble: Are We There Yet?
My previous two posts make it clear that all the conditions are in place for a bond bubble: strong fundamentals, technical momentum, and a mechanism for positive feedback. But these conditions are merely necessary; they are not in themselves sufficient to generate or identify a bubble.
Nonetheless there are certain indicators that suggest we may be entering bubble territory.
Let’s start by looking at the fundamentals again. One sign that a market has transitioned from boom to bubble is when the fundamentals change from bullish to bearish, but prices keep rising. I believe that this is true for the bond market. Let’s consider each of the factors I identified in my earlier post, in order:
1. Monetary policy seems to have regressed in recent years. In particular, central banks are no longer strict inflation-targeters; they have become asset-price-targeters instead1. Central banks are also less independent than before2. Finally, central banks have explicitly moved from trying to head off crises, to merely reacting to them3. This reaction invariably takes the form of overly easy monetary policy, since policy-makers and politicians alike seem incapable of accepting short-term pain for long-term gain. Each of these is a backward step, in my opinion.
2. Since the fall of the Berlin wall and the ‘end of history’, the US has become embroiled in two expensive new wars, in Iraq and Afghanistan. In addition, entitlement spending (especially social security and health care for retiring baby boomers) will put a significant burden on the government’s fiscal position in the years to come. And a dysfunctional political process renders this trajectory very difficult to change.
3. The momentum towards lower global trade barriers seems to have turned; there are ugly signs everywhere of growing protectionism, higher tariffs, and incipient trade wars.
4. China may not export disinflation for much longer. Western politicians, pundits and plutocrats have been unanimous in calling for China to consume more and/or to revalue its currency upward, in order to reduce the global imbalances that (supposedly) lay behind the recent crisis. Either of these shifts (an increase in Chinese domestic consumption or an increase in the RMB/USD exchange rate) would be dramatically inflationary for the United States4.
5. The commodity supercycle is now in its bullish phase.
6. Increased regulation (for which there is plenty of momentum) could see a rollback of innovation, especially financial innovation.
Now, figuring out the impact of (changes in) fundamentals on asset prices is a tricky business. It’s very difficult to know how important any given factor is in determining bond yields; it’s also very difficult to know the extent to which any given factor has already been priced into the bond market.
Fortunately, my argument does not depend on my ability to perform either of these tricks. My point is much simpler. Every single fundamental factor that has driven the 30-year decline in bond yields has either weakened appreciably, or reversed direction. Yet bond yields continue to decline!
What’s going on here?
Well, for starters, many of the technical forces I identified earlier are still in play: Bretton Woods II (developing country exporters continue to finance the US twin deficits); baby boomer portfolio changes (stocks as a retirement haven are understandably less attractive now then they were a few years ago); and post-crisis risk aversion (unemployment and consumption data suggest we are still not out of the woods).
But in addition to these relatively ‘benign’ technicals, some rather more dangerous forces have come into effect.
First, ‘reflexive feedback’ has kicked in, as Wednesday’s post makes clear. Low long bond yields create the justification for the Fed to keep overnight rates low. And low overnight rates create the motivation for investment banks to buy long bonds.
Second, the ‘greater fool theory’ has kicked in: there’s certainly an element of it in foreign central bank purchases of US government debt. Various acronymic entities like the BOJ, SAFE, ADIA and so on know full well that if they don’t take down Treasury’s flood of new supply, their existing holdings will be mullered.
(As an aside, the fact that foreign CBs are price-insensitive buyers is often quoted as a justification for the low level of yields, whereas in fact it is a symptom that yields are in non-economic territory.)
Third, commentators have begun to emerge claiming that “this time it’s different”, most notably those whose belief in American exceptionalism blinds them to the parallels with Britain a century ago or Spain somewhat further back.
A fourth suggestive indicator is the level of supply. All true bubbles are characterized by dramatic increases in supply, which seem to have no impact on prices (until of course the bubble collapses). The Treasury market clearly embodies this dynamic: the August 10-year note, for example, had a float (after reopenings) of 67 billion. That’s more than the entire government of debt of say Switzerland or Australia. Just one single bond.
Put it all together, and the conclusion is obvious: we are entering a regime where fundamentals don’t matter any more; a regime in which technicals, feedback and short-term (institutional) considerations dominate the price action; a regime where supply has crossed the line from the impressive to the insane. In short, a bubble.
Footnotes
# 1 We used to have a Greenspan put; now we have a Bernanke put; but there was never a Volcker put. I explain the link between Fed policy and asset price bubbles here.
# 2 Witness the close cooperation between the Fed and the Treasury in rescuing Wall Street banks in 2008 – this could have come straight out of the Arthur Burns / Richard Nixon / Penn Central playbook. It’s not as if the Fed has much choice in the matter; see the last two paragraphs of this post for more.
# 3 A view reflected in ex-governor Mishkin’s recent comments on identifying bubbles, which I review here.
# 4 Actually, that’s sort of the point. Inflation is a monetary phenomenon; an increase in US inflation necessarily means a debasement of the currency, which is precisely what the US needs if it is to reduce its twin deficits.
Also, note that if China does boost domestic demand, revalue its currency or otherwise plug its trade surplus with the US, an immediate and necessary consequence would be a decline in Chinese buying of US Treasuries. And if China backs off, who will finance the US budget deficit? One more bearish indicator for bonds.
Nonetheless there are certain indicators that suggest we may be entering bubble territory.
Let’s start by looking at the fundamentals again. One sign that a market has transitioned from boom to bubble is when the fundamentals change from bullish to bearish, but prices keep rising. I believe that this is true for the bond market. Let’s consider each of the factors I identified in my earlier post, in order:
1. Monetary policy seems to have regressed in recent years. In particular, central banks are no longer strict inflation-targeters; they have become asset-price-targeters instead1. Central banks are also less independent than before2. Finally, central banks have explicitly moved from trying to head off crises, to merely reacting to them3. This reaction invariably takes the form of overly easy monetary policy, since policy-makers and politicians alike seem incapable of accepting short-term pain for long-term gain. Each of these is a backward step, in my opinion.
2. Since the fall of the Berlin wall and the ‘end of history’, the US has become embroiled in two expensive new wars, in Iraq and Afghanistan. In addition, entitlement spending (especially social security and health care for retiring baby boomers) will put a significant burden on the government’s fiscal position in the years to come. And a dysfunctional political process renders this trajectory very difficult to change.
3. The momentum towards lower global trade barriers seems to have turned; there are ugly signs everywhere of growing protectionism, higher tariffs, and incipient trade wars.
4. China may not export disinflation for much longer. Western politicians, pundits and plutocrats have been unanimous in calling for China to consume more and/or to revalue its currency upward, in order to reduce the global imbalances that (supposedly) lay behind the recent crisis. Either of these shifts (an increase in Chinese domestic consumption or an increase in the RMB/USD exchange rate) would be dramatically inflationary for the United States4.
5. The commodity supercycle is now in its bullish phase.
6. Increased regulation (for which there is plenty of momentum) could see a rollback of innovation, especially financial innovation.
Now, figuring out the impact of (changes in) fundamentals on asset prices is a tricky business. It’s very difficult to know how important any given factor is in determining bond yields; it’s also very difficult to know the extent to which any given factor has already been priced into the bond market.
Fortunately, my argument does not depend on my ability to perform either of these tricks. My point is much simpler. Every single fundamental factor that has driven the 30-year decline in bond yields has either weakened appreciably, or reversed direction. Yet bond yields continue to decline!
What’s going on here?
Well, for starters, many of the technical forces I identified earlier are still in play: Bretton Woods II (developing country exporters continue to finance the US twin deficits); baby boomer portfolio changes (stocks as a retirement haven are understandably less attractive now then they were a few years ago); and post-crisis risk aversion (unemployment and consumption data suggest we are still not out of the woods).
But in addition to these relatively ‘benign’ technicals, some rather more dangerous forces have come into effect.
First, ‘reflexive feedback’ has kicked in, as Wednesday’s post makes clear. Low long bond yields create the justification for the Fed to keep overnight rates low. And low overnight rates create the motivation for investment banks to buy long bonds.
Second, the ‘greater fool theory’ has kicked in: there’s certainly an element of it in foreign central bank purchases of US government debt. Various acronymic entities like the BOJ, SAFE, ADIA and so on know full well that if they don’t take down Treasury’s flood of new supply, their existing holdings will be mullered.
(As an aside, the fact that foreign CBs are price-insensitive buyers is often quoted as a justification for the low level of yields, whereas in fact it is a symptom that yields are in non-economic territory.)
Third, commentators have begun to emerge claiming that “this time it’s different”, most notably those whose belief in American exceptionalism blinds them to the parallels with Britain a century ago or Spain somewhat further back.
A fourth suggestive indicator is the level of supply. All true bubbles are characterized by dramatic increases in supply, which seem to have no impact on prices (until of course the bubble collapses). The Treasury market clearly embodies this dynamic: the August 10-year note, for example, had a float (after reopenings) of 67 billion. That’s more than the entire government of debt of say Switzerland or Australia. Just one single bond.
Put it all together, and the conclusion is obvious: we are entering a regime where fundamentals don’t matter any more; a regime in which technicals, feedback and short-term (institutional) considerations dominate the price action; a regime where supply has crossed the line from the impressive to the insane. In short, a bubble.
Footnotes
# 1 We used to have a Greenspan put; now we have a Bernanke put; but there was never a Volcker put. I explain the link between Fed policy and asset price bubbles here.
# 2 Witness the close cooperation between the Fed and the Treasury in rescuing Wall Street banks in 2008 – this could have come straight out of the Arthur Burns / Richard Nixon / Penn Central playbook. It’s not as if the Fed has much choice in the matter; see the last two paragraphs of this post for more.
# 3 A view reflected in ex-governor Mishkin’s recent comments on identifying bubbles, which I review here.
# 4 Actually, that’s sort of the point. Inflation is a monetary phenomenon; an increase in US inflation necessarily means a debasement of the currency, which is precisely what the US needs if it is to reduce its twin deficits.
Also, note that if China does boost domestic demand, revalue its currency or otherwise plug its trade surplus with the US, an immediate and necessary consequence would be a decline in Chinese buying of US Treasuries. And if China backs off, who will finance the US budget deficit? One more bearish indicator for bonds.
Rabu, 25 November 2009
The Next Bubble: Positive Feedback
There are three types of positive feedback in the market: irrational feedback, rational feedback, and reflexive feedback. To distinguish between these, let me quote a previous post at length:
So, which kinds of feedback are at work in the bond market today? Well, for starters, I don’t think irrational feedback applies. There’s certainly no groundswell of investors clamoring to jump aboard the bond bandwagon, and I don’t expect this to change for some time yet (if at all).
As for rational feedback, there is certainly an element of it driving bond purchases by foreign central banks, pension fund managers and carry traders. But in my experience, rational feedback tends to be a reaction to (or symptom of) a bubble, not a precursor to it; at any rate it is not sufficient to inflate a bubble on its own.
Finally, let us consider reflexive feedback. This is the subtlest case of the three, and the most interesting. Is there a mechanism for reflexive feedback in the bond market today?
I believe so. It works like this:
The Fed lends money to banks at 0%, hoping that the banks will turn around and lend to businesses and consumers. But why should the banks do this? They'd much rather buy bonds at 4% and make the carry. Of course some amount of funds does in fact go to businesses and consumers, and some amount goes into riskier assets (this year, for example, these riskier assets have included commodities and emerging market stocks). But as a proportion of the whole, these amounts are minuscule.
Meanwhile the Treasury issues gigantic amounts of debt and that's where the bank money goes. And it creates a self-reinforcing dynamic: banks buy bonds and keep long rates low; the Fed sees low long rates as evidence that the market does not anticipate inflation, and so keeps short rates low; the Treasury sees strong demand for government paper and weak third-party lending and concludes that more issuance is both acceptable and required; and the cycle continues.
Note that it is precisely the fact of low overnight rates that makes buying long bonds attractive for banks. And it is precisely the fact of healthy demand for long bonds that encourages the Fed to keep overnight rates low. That’s positive feedback in its cleanest form.
Again, this is not (yet) proof either way that a bond bubble exists. It is merely suggestive evidence that a necessary condition – reflexive feedback – is in place for such a bubble to inflate. I will review some other pieces of suggestive evidence in my next post.
In a bubble, the dominant mechanism is positive feedback; the key to understanding bubbles is understanding this positive feedback. How, then, does positive feedback arise?It is the third kind of feedback – reflexive feedback, wherein a rise in the price of an asset positively impacts the fundamentals underlying that asset – that drives the most extreme bubbles.
The most obvious explanation is the conventional one: positive feedback is a consequence of irrationality in the market. And there’s certainly an element of truth in this explanation. Greed, self-delusion, unjustified extrapolation, caring more about relative returns than absolute profits (a.k.a. “keeping up with the Joneses”), conformism (a.k.a. “if everybody else is doing it why can’t we?”), confusing the improbable with the impossible (“house prices will never go down nation-wide”) and other persistent behavioral flaws lead inevitably to bubbles. This has been true throughout the history of speculation.
But one doesn’t have to invoke irrationality to explain positive feedback. Positive feedback can arise quite naturally when rational traders encounter flawed institutional mechanisms, as my previous post makes clear. Short-term incentives, asymmetric outcomes, incomplete information and firm-wide pay structures could all lead to perfectly rational actors taking actions which lead to positive feedback and hence bubbles.
Both of these are what I would call ‘technical’ explanations, in that they depend on trader behavior (which has various causes) to move market prices away from some underlying fundamental value. But there is another, and to my mind more interesting, form of positive feedback in which the fundamental values themselves change.
Consider this example from the FX markets. A currency strengthens. This acts like a tightening of monetary policy. Hence inflation expectations diminish. Hence the currency strengthens further. The initial move has thus changed the underlying fundamentals so as to justify itself; it has become a self-fulfilling prophecy.
So, which kinds of feedback are at work in the bond market today? Well, for starters, I don’t think irrational feedback applies. There’s certainly no groundswell of investors clamoring to jump aboard the bond bandwagon, and I don’t expect this to change for some time yet (if at all).
As for rational feedback, there is certainly an element of it driving bond purchases by foreign central banks, pension fund managers and carry traders. But in my experience, rational feedback tends to be a reaction to (or symptom of) a bubble, not a precursor to it; at any rate it is not sufficient to inflate a bubble on its own.
Finally, let us consider reflexive feedback. This is the subtlest case of the three, and the most interesting. Is there a mechanism for reflexive feedback in the bond market today?
I believe so. It works like this:
The Fed lends money to banks at 0%, hoping that the banks will turn around and lend to businesses and consumers. But why should the banks do this? They'd much rather buy bonds at 4% and make the carry. Of course some amount of funds does in fact go to businesses and consumers, and some amount goes into riskier assets (this year, for example, these riskier assets have included commodities and emerging market stocks). But as a proportion of the whole, these amounts are minuscule.
Meanwhile the Treasury issues gigantic amounts of debt and that's where the bank money goes. And it creates a self-reinforcing dynamic: banks buy bonds and keep long rates low; the Fed sees low long rates as evidence that the market does not anticipate inflation, and so keeps short rates low; the Treasury sees strong demand for government paper and weak third-party lending and concludes that more issuance is both acceptable and required; and the cycle continues.
Note that it is precisely the fact of low overnight rates that makes buying long bonds attractive for banks. And it is precisely the fact of healthy demand for long bonds that encourages the Fed to keep overnight rates low. That’s positive feedback in its cleanest form.
Again, this is not (yet) proof either way that a bond bubble exists. It is merely suggestive evidence that a necessary condition – reflexive feedback – is in place for such a bubble to inflate. I will review some other pieces of suggestive evidence in my next post.
Selasa, 24 November 2009
The Next Bubble: Fundamentals and Technicals
In my opinion there are three necessary conditions that have to be in place for a bubble to inflate: fundamentals, technicals, and feedback. Let’s look at each of these in turn.
Preceding every bubble there is a boom: a justified increase in prices driven by positive fundamentals. In the aftermath of a bubble, it’s easy to mock the excesses that marked the bubble’s apogee (boo.com! ninja loans!) but all too often people forget the backstory. In fact there were very good macro and micro reasons why the tech sector boomed in the early 90s, and why real estate boomed in the early 00s; it wasn’t all froth.
So, have the fundamentals been positive for bonds? I think the answer is yes, they undoubtedly have. Here are some of the factors that have led to lower and more stable interest rates over the last few decades, in no particular order:
1. Improved monetary policy – specifically, central bank independence and inflation targeting – starting with the Volcker Fed
2. The end of the cold war; reduced military spending; the peace dividend
3. The lowering of global trade barriers and tariffs
4. China’s entry into world commerce and its export of wage and retail disinflation
5. The bear leg of the commodity supercycle
6. Improvements in business technology, especially in inventory management1
But fundamentals alone are not the entire story. A number of technical factors have also supported bonds in recent years2:
1. The Bretton-Woods II equilibrium, in which countries on the periphery (Asia and the Middle East) lend money to (buy bonds from) countries in the center (North America and Europe) to finance the latter’s imports.
2. Aging baby boomers transferring capital from stocks to bonds as per life-cycle investment theory
3. Risk aversion in the aftermath of the crash
4. The dollar carry trade
Fundamentals and technicals working in tandem have driven 30-year yields from 15.5% in 1981 to 2.5% in 2008. That’s a boom in anyone’s book.
But is it a bubble? For a bubble to inflate, there’s a third, crucial element: positive feedback. I shall investigate this topic in my next post.
Footnotes
# 1Paul Krugman puts it nicely: "Businesses spent two decades figuring out what to do with information technology, then found the answer: big box stores!"
# 2Note that these are just some of the technicals that are currently in play; at other times in the bull run, other technicals have applied.
Preceding every bubble there is a boom: a justified increase in prices driven by positive fundamentals. In the aftermath of a bubble, it’s easy to mock the excesses that marked the bubble’s apogee (boo.com! ninja loans!) but all too often people forget the backstory. In fact there were very good macro and micro reasons why the tech sector boomed in the early 90s, and why real estate boomed in the early 00s; it wasn’t all froth.
So, have the fundamentals been positive for bonds? I think the answer is yes, they undoubtedly have. Here are some of the factors that have led to lower and more stable interest rates over the last few decades, in no particular order:
1. Improved monetary policy – specifically, central bank independence and inflation targeting – starting with the Volcker Fed
2. The end of the cold war; reduced military spending; the peace dividend
3. The lowering of global trade barriers and tariffs
4. China’s entry into world commerce and its export of wage and retail disinflation
5. The bear leg of the commodity supercycle
6. Improvements in business technology, especially in inventory management1
But fundamentals alone are not the entire story. A number of technical factors have also supported bonds in recent years2:
1. The Bretton-Woods II equilibrium, in which countries on the periphery (Asia and the Middle East) lend money to (buy bonds from) countries in the center (North America and Europe) to finance the latter’s imports.
2. Aging baby boomers transferring capital from stocks to bonds as per life-cycle investment theory
3. Risk aversion in the aftermath of the crash
4. The dollar carry trade
Fundamentals and technicals working in tandem have driven 30-year yields from 15.5% in 1981 to 2.5% in 2008. That’s a boom in anyone’s book.
But is it a bubble? For a bubble to inflate, there’s a third, crucial element: positive feedback. I shall investigate this topic in my next post.
Footnotes
# 1Paul Krugman puts it nicely: "Businesses spent two decades figuring out what to do with information technology, then found the answer: big box stores!"
# 2Note that these are just some of the technicals that are currently in play; at other times in the bull run, other technicals have applied.
Senin, 23 November 2009
The Next Bubble: Disclaimer and Disclosure
Believing or disbelieving in the bond bubble seems to have become a political choice, at least in the United States. I can’t recall such a degree of partisan frenzy in the debate over previous bubbles such as housing, tech stocks or commodities. And for good reason: any discussion of bond prices and interest rates leads inevitably to a discussion of budget deficits and Fed/Treasury policy, which – unlike say dotcom valuations – is ideologically fraught territory.
So, in the interests of full disclosure, and for what it’s worth: I am not a US citizen or resident, I do not pay US taxes or receive US benefits, I am not currently connected with the US financial industry (except as an external observer and generic investor), and I do not support any US political party. In short, I have no dog in this race.
All I want to do is understand what has happened, what is happening, and what will happen, insofar as (and no further than!) it helps me as a trader and investor. And my current understanding, based I hope on unbiased analysis, is that we are in the middle of a bond bubble. I think that interest rates may go lower over the short term, but that they will go higher – significantly higher! – over the medium to long term. My portfolio is positioned accordingly. If I get my predictions correct, I will make money; if I get them wrong, I will lose money. It’s as simple as that.
So, in the interests of full disclosure, and for what it’s worth: I am not a US citizen or resident, I do not pay US taxes or receive US benefits, I am not currently connected with the US financial industry (except as an external observer and generic investor), and I do not support any US political party. In short, I have no dog in this race.
All I want to do is understand what has happened, what is happening, and what will happen, insofar as (and no further than!) it helps me as a trader and investor. And my current understanding, based I hope on unbiased analysis, is that we are in the middle of a bond bubble. I think that interest rates may go lower over the short term, but that they will go higher – significantly higher! – over the medium to long term. My portfolio is positioned accordingly. If I get my predictions correct, I will make money; if I get them wrong, I will lose money. It’s as simple as that.
The Next Bubble: Introduction
Bubbles fascinate me. Nowhere else will you find such a variegated proving ground for the vagaries of human psychology, nor such a vivid illustration of the wondrous complexity that is the market. The various tensions on display – between individuals and institutions; between incentives and emotions; between rationality and greed; between the short term and the long run; between macro economics and micro behavior; between fundamentals and technicals – offer limitless scope to the curious observer.
If the study of markets is the study of human nature, then the study of bubbles is the study of markets in microcosm.
My fascination with bubbles will come as no surprise to regular readers of this blog, as evidenced by my choice of subject matter. In recent weeks I have written about bubbles and the rational trader; scale invariance in bubbles; feedback effects in bubbles; the link between asset price bubbles and jobless recoveries; the identification of bubbles; and the stages in the evolution of bubble.
But these essays have been, for the most part, abstract and analytical; they say little about the state of the world today. Not so the next few posts. In the coming week I would like to talk about a bubble that I fear is developing before our eyes. And it’s not a bubble in emerging market stocks or in raw materials; it’s in something much closer to home.
Again, regular readers of this blog will know or have guessed what I’m talking about: I believe that we have recently completed the transition from a boom to bubble in the market for long term US government bonds.
Extraordinary claims require extraordinary evidence. Hence I will take a break from the usual ‘weekly column’ format of this blog, and instead provide a sequence of shorter posts in which I will expound on my thesis in greater detail. Coming up first: background information and necessary conditions.
If the study of markets is the study of human nature, then the study of bubbles is the study of markets in microcosm.
My fascination with bubbles will come as no surprise to regular readers of this blog, as evidenced by my choice of subject matter. In recent weeks I have written about bubbles and the rational trader; scale invariance in bubbles; feedback effects in bubbles; the link between asset price bubbles and jobless recoveries; the identification of bubbles; and the stages in the evolution of bubble.
But these essays have been, for the most part, abstract and analytical; they say little about the state of the world today. Not so the next few posts. In the coming week I would like to talk about a bubble that I fear is developing before our eyes. And it’s not a bubble in emerging market stocks or in raw materials; it’s in something much closer to home.
Again, regular readers of this blog will know or have guessed what I’m talking about: I believe that we have recently completed the transition from a boom to bubble in the market for long term US government bonds.
Extraordinary claims require extraordinary evidence. Hence I will take a break from the usual ‘weekly column’ format of this blog, and instead provide a sequence of shorter posts in which I will expound on my thesis in greater detail. Coming up first: background information and necessary conditions.
Kamis, 12 November 2009
Identifying Bubbles: It's Really Not That Hard
In an opinion piece written for the Financial Times on Monday, former Fed governor (and current Columbia professor) Frederic Mishkin argues that central bankers cannot reliably identify asset-price bubbles; that certain types of bubbles – specifically, those without a credit element, which Mishkin calls ‘pure irrational exuberance bubbles’ (sic) – do not do much harm when they pop; that central bankers should not, in fact, try to pop the latter type of bubble; and that when in doubt a central banker should err on the side of benign inaction.
Implicit in all these arguments is the Greenspanist view that policy is better suited to mitigating the painful after-effects of a popped bubble, than it is to spotting and deflating the bubble in the first place. I was under the impression that this particular stance had been discredited along with the rest of Alan Greenspan’s philosophy of central banking, but evidently not. Here are the relevant quotes from Mishkin’s piece:
I find these arguments deeply unconvincing, and not just because it is precisely this line of reasoning that has led us to crisis after crisis in the financial markets. Let us leave aside for the moment the contentious question of what action (if any) a central bank should take to restrain a developing bubble, or to ameliorate the consequences of its collapse. (I do have an opinion on this question but will save it for a later post). Instead let us ask a simpler question: Is it in fact credible to claim, as Mishkin does, that central bankers cannot identify a bubble in the process of expansion?
I think not. I think it is fairly obvious that Mishkin is being disingenuous. The problem is not that the Fed is unable to spot bubbles, but that it is unwilling to do so1.
Because the truth is, identifying bubbles is easy. When speculators use post-dated checks to buy stocks and sellers accept these checks because they assume the market can only go up: that’s a bubble. When an obscure fishmeal manufacturer offers a billion dollars to buy an internet portal: that’s a bubble. When people with no income and no assets are offered their choice of loans with which to buy million-dollar homes: that’s a bubble.
I repeat: identifying full-blown bubbles is easy. What’s not so easy is identifying the transitions that bookend a bubble. It’s not easy to know precisely when a rational, fundamentals-driven boom will morph into an irrational, sell-to-the-greater-fool frenzy. It’s not easy to know precisely when an irrational frenzy will reverse into an equally irrational stampede for the exits.
But here’s the thing: nobody is asking central bankers to do this. Central bankers do not need to time bubbles perfectly (that particular cross is solely for contrarian traders to bear). Central bankers merely need to recognize when they’re in a bubble, and take action accordingly. This is a much easier task.
Mishkin elides this distinction. When he implies that recognizing a bubble is equivalent to timing it (“If policymakers were that smart, why aren’t they rich?”), Mishkin is pulling an ingenious (and underhanded!) bait-and-switch on his readers. I can only hope that his views do not reflect either the prevailing wisdom at the Fed, or its attitude towards the taxpaying public.
Footnotes
# 1Why might this be the case? For a host of political, institutional and structural reasons, most of which boil down to one simple fact: bursting a bubble is unpopular and painful. And ever since Paul Volcker retired, the Fed has consistently shied away from any course of action that involves exchanging short-term pain for long-term gain.
Implicit in all these arguments is the Greenspanist view that policy is better suited to mitigating the painful after-effects of a popped bubble, than it is to spotting and deflating the bubble in the first place. I was under the impression that this particular stance had been discredited along with the rest of Alan Greenspan’s philosophy of central banking, but evidently not. Here are the relevant quotes from Mishkin’s piece:
Because the second category of bubble does not present the same dangers to the economy as a credit boom bubble, the case for tightening monetary policy to restrain a pure irrational exuberance bubble is much weaker. Asset-price bubbles of this type are hard to identify: after the fact is easy, but beforehand is not. (If policymakers were that smart, why aren’t they rich?) Tightening monetary policy to restrain a bubble that does not materialize will lead to much weaker economic growth than is warranted.
I find these arguments deeply unconvincing, and not just because it is precisely this line of reasoning that has led us to crisis after crisis in the financial markets. Let us leave aside for the moment the contentious question of what action (if any) a central bank should take to restrain a developing bubble, or to ameliorate the consequences of its collapse. (I do have an opinion on this question but will save it for a later post). Instead let us ask a simpler question: Is it in fact credible to claim, as Mishkin does, that central bankers cannot identify a bubble in the process of expansion?
I think not. I think it is fairly obvious that Mishkin is being disingenuous. The problem is not that the Fed is unable to spot bubbles, but that it is unwilling to do so1.
Because the truth is, identifying bubbles is easy. When speculators use post-dated checks to buy stocks and sellers accept these checks because they assume the market can only go up: that’s a bubble. When an obscure fishmeal manufacturer offers a billion dollars to buy an internet portal: that’s a bubble. When people with no income and no assets are offered their choice of loans with which to buy million-dollar homes: that’s a bubble.
I repeat: identifying full-blown bubbles is easy. What’s not so easy is identifying the transitions that bookend a bubble. It’s not easy to know precisely when a rational, fundamentals-driven boom will morph into an irrational, sell-to-the-greater-fool frenzy. It’s not easy to know precisely when an irrational frenzy will reverse into an equally irrational stampede for the exits.
But here’s the thing: nobody is asking central bankers to do this. Central bankers do not need to time bubbles perfectly (that particular cross is solely for contrarian traders to bear). Central bankers merely need to recognize when they’re in a bubble, and take action accordingly. This is a much easier task.
Mishkin elides this distinction. When he implies that recognizing a bubble is equivalent to timing it (“If policymakers were that smart, why aren’t they rich?”), Mishkin is pulling an ingenious (and underhanded!) bait-and-switch on his readers. I can only hope that his views do not reflect either the prevailing wisdom at the Fed, or its attitude towards the taxpaying public.
Footnotes
# 1Why might this be the case? For a host of political, institutional and structural reasons, most of which boil down to one simple fact: bursting a bubble is unpopular and painful. And ever since Paul Volcker retired, the Fed has consistently shied away from any course of action that involves exchanging short-term pain for long-term gain.
Jumat, 23 Oktober 2009
Some Thoughts on Buttonwood's Trifecta
Buttonwood’s column this week is typically thought-provoking. She starts with the observation that three major asset classes – stocks, bonds and gold – have all produced double-digit returns in the last three months. She then points out that this is not usual: indeed, it has only happened thrice in the past fifty years 1. And for good reason: the three asset classes have very different exposures to risk (equities are risky, bonds and gold are canonical safe havens) and to inflation (gold is a good inflation hedge, bonds are not, and equities lie somewhere in between). She describes various fundamental explanations (divisions in investor opinion; inefficient markets; central bank intervention; increasing risk appetites). And finally, she lays out her own explanation: liquidity.
The second question is the easiest to answer. Under Arthur Burns and then William Miller, realized inflation was very high and inflation expectations were well-entrenched. Asset prices reflected these fundamentals. Gold confirmed its status as an inflation hedge, rising from $35 (its pre-float peg) to over $800 over the course of the 1970s. In contrast, the fixed cashflows offered by bonds are very unattractive under inflation, hence bonds did horribly: 30-year yields rose from around 7.5% in 1970 to 15.5% in 1981. Equities merely treaded water, with higher nominal earnings cancelled out by higher discount rates.
The 1980s saw exactly the opposite dynamic. The Fed under Paul Volcker committed itself to fighting inflation no matter what the cost in terms of temporary economic pain. As a result financial assets enjoyed a golden run: stocks entered a 20-year bull market (to 2000) while the bull market in bonds lasted even longer (to 2008 – and counting). Meanwhile gold was pummeled, dropping all the way to $250 in 1999.
So far so good; all these are precisely what you would expect when changes in (Fed-sponsored) liquidity drive asset prices, first one way and then the other. And as theory dictates, the three asset classes never moved strongly in the same direction, throughout this lengthy period.
With one exception: the last quarter of 1982. Gold, stocks and bonds all rallied very sharply into the end of the year. What happened?
Here’s my theory, propounded as always with the benefit of hindsight. 1982 was the year that the markets finally ‘got’ Volcker’s plan. Tight monetary policy had already caused a short, sharp recession in 1980. 1981 saw a partial recovery, but then the economy entered a crippling double dip in 1982. Nonetheless Volcker kept policy relatively tight (certainly tighter than his predecessors would have done in the same situation). Gold rallied in expectation that this tight policy would hurt the economy and force Volcker to capitulate and ease rates 2. But Volcker stood firm. This gave stock- and bond-markets confidence that inflation was truly going to be beaten, and so it proved. Stocks and bonds continued to rally, while gold gave back its gains within a matter of months. And so it continued, for the next 20-odd years.
Which brings us to 2009. I agree with Buttonwood that the ‘Bernanke put’ (in the form of easy liquidity) is supporting all asset prices. But why don’t Treasury prices reflect this? Where are the bond market vigilantes?
I suspect the answer is that these days, bond traders, like the Fed, care more about wage and retail inflation than about asset inflation 3. And wage and retail inflation has been kept quiescent by the entry of Chinese labor into global commercial flows (a point I have made before, at length). That’s why the current flood of Fed-sponsored liquidity hasn’t entered the official figures yet; and that’s why bonds continue to be bid up.
Will it last? Or will bonds be the next great bubble to burst? We shall see.
Footnotes
# 1 Try as I might, I cannot replicate Buttonwood’s numbers for government bonds. The high in yields over the past 4 months was on 7 August; the subsequent low was on 7 October. Between those two (cherry-picked) dates, 10-year Treasury notes rallied by about 70 basis points, which corresponds to a return of roughly 6% in price terms. The price gains for 2-year, 5-year and 30-year Treasuries over the same period were 1%, 3% and 8% respectively. Given that Treasury issuance is overwhelming skewed to the short end of the yield curve, there is simply no way that bonds have returned double digits in the last quarter. Also, Buttonwood talks of a fifty year sample; this is actually meaningless, since the dollar was pegged to gold until 1971. But I digress; this is mere quibbling over numbers, and the arguments made elsewhere in Buttonwood’s column remain valid.
# 2There was also a large technical element to gold’s 35% rally, coming as it did on the heels of a 65% selloff.
# 3FX traders are not so accommodating; witness the continuing weakness in the dollar versus pretty much every other currency in the world.
Low interest rates are driving investors out of cash and into anything that offers either the prospect of capital gain or a yield that is higher than zero. Investors used to talk about a ‘Greenspan put’ that supported the stockmarket. This time there is a ‘Bernanke put’ supporting all asset prices.I think that this is exactly correct, as far as it goes. But it doesn’t go far enough. Buttonwood leaves unanswered a host of interesting questions, such as: if there so much liquidity in the market today, why hasn’t it manifested itself in the inflation data? And why, on previous occasions when there was a lot of liquidity available (under, for instance, the Miller Fed), didn’t all three asset classes rally in tandem? Conversely, why did all three asset classes rally together in late 1982, a time when nobody could plausibly claim a surfeit of liquidity in the market?
The second question is the easiest to answer. Under Arthur Burns and then William Miller, realized inflation was very high and inflation expectations were well-entrenched. Asset prices reflected these fundamentals. Gold confirmed its status as an inflation hedge, rising from $35 (its pre-float peg) to over $800 over the course of the 1970s. In contrast, the fixed cashflows offered by bonds are very unattractive under inflation, hence bonds did horribly: 30-year yields rose from around 7.5% in 1970 to 15.5% in 1981. Equities merely treaded water, with higher nominal earnings cancelled out by higher discount rates.
The 1980s saw exactly the opposite dynamic. The Fed under Paul Volcker committed itself to fighting inflation no matter what the cost in terms of temporary economic pain. As a result financial assets enjoyed a golden run: stocks entered a 20-year bull market (to 2000) while the bull market in bonds lasted even longer (to 2008 – and counting). Meanwhile gold was pummeled, dropping all the way to $250 in 1999.
So far so good; all these are precisely what you would expect when changes in (Fed-sponsored) liquidity drive asset prices, first one way and then the other. And as theory dictates, the three asset classes never moved strongly in the same direction, throughout this lengthy period.
With one exception: the last quarter of 1982. Gold, stocks and bonds all rallied very sharply into the end of the year. What happened?
Here’s my theory, propounded as always with the benefit of hindsight. 1982 was the year that the markets finally ‘got’ Volcker’s plan. Tight monetary policy had already caused a short, sharp recession in 1980. 1981 saw a partial recovery, but then the economy entered a crippling double dip in 1982. Nonetheless Volcker kept policy relatively tight (certainly tighter than his predecessors would have done in the same situation). Gold rallied in expectation that this tight policy would hurt the economy and force Volcker to capitulate and ease rates 2. But Volcker stood firm. This gave stock- and bond-markets confidence that inflation was truly going to be beaten, and so it proved. Stocks and bonds continued to rally, while gold gave back its gains within a matter of months. And so it continued, for the next 20-odd years.
Which brings us to 2009. I agree with Buttonwood that the ‘Bernanke put’ (in the form of easy liquidity) is supporting all asset prices. But why don’t Treasury prices reflect this? Where are the bond market vigilantes?
I suspect the answer is that these days, bond traders, like the Fed, care more about wage and retail inflation than about asset inflation 3. And wage and retail inflation has been kept quiescent by the entry of Chinese labor into global commercial flows (a point I have made before, at length). That’s why the current flood of Fed-sponsored liquidity hasn’t entered the official figures yet; and that’s why bonds continue to be bid up.
Will it last? Or will bonds be the next great bubble to burst? We shall see.
Footnotes
# 1 Try as I might, I cannot replicate Buttonwood’s numbers for government bonds. The high in yields over the past 4 months was on 7 August; the subsequent low was on 7 October. Between those two (cherry-picked) dates, 10-year Treasury notes rallied by about 70 basis points, which corresponds to a return of roughly 6% in price terms. The price gains for 2-year, 5-year and 30-year Treasuries over the same period were 1%, 3% and 8% respectively. Given that Treasury issuance is overwhelming skewed to the short end of the yield curve, there is simply no way that bonds have returned double digits in the last quarter. Also, Buttonwood talks of a fifty year sample; this is actually meaningless, since the dollar was pegged to gold until 1971. But I digress; this is mere quibbling over numbers, and the arguments made elsewhere in Buttonwood’s column remain valid.
# 2There was also a large technical element to gold’s 35% rally, coming as it did on the heels of a 65% selloff.
# 3FX traders are not so accommodating; witness the continuing weakness in the dollar versus pretty much every other currency in the world.
Rabu, 21 Oktober 2009
Some Thoughts on the Phillips Curve
Of all the economists, journalists and assorted financial industry participants who comment on the web – and there’s certainly no shortage of them – the one whose views align most closely with my own is James Hamilton of UC San Diego and Econbrowser. I find that I rarely disagree with him, whether it’s on macroeconomics, oil, securitization, financial markets, or anything else. So I was interested to see him make the case that ‘high levels of unemployment are a factor that will put downward pressure over the next two years’.
His argument is straightforward: he regresses historically realized inflation against unemployment, and also against lagged inflation (the latter is to account for expectations of inflation). He finds a statistically significant negative coefficient for the period from 1948 to 2007, validating the classical Phillips Curve relationship. Since unemployment is currently very high, inflation is (ceteris paribus) likely to be contained over the next few years.
My quibble with this analysis is that I just don’t think historical data, aggregated like this, is a very useful guide to the future. For instance, the period from 1948 to 2007 had several very distinct macroeconomic regimes. Let’s go decade by decade:
1940s: World War II has massive effects on consumption, production, resource allocation and labor markets, effects which do not end with the end of the war. The Fed buys long bonds to finance government spending, but reduces the money supply to pre-empt post-war inflation of the kind seen in 1919-20.
1950s: A boom in capital goods and in consumer credit (think: demobilization and reconstruction) leads to a sustained period of strong employment and benign inflation; the misery index will never be this low again. But a balance of payments deficit hints at trouble to come.
1960s: Operation Twist. The Great Society. Tax cuts combined with spending increases bring about the first persistent, large budget deficits. Congress eliminates the gold reserve requirement for the Fed. Inflation rises. The draft reduces unemployment.
1970s: The US leaves the gold standard in 1971. Nixon imposes wage and price controls from 1971 to 1974. OPEC embargos oil. Arthur Burns argues that it’s okay to countenance ‘temporarily’ higher inflation if that can alleviate economic shocks. He is succeeded by William Miller who thinks Burns kept policy too tight (!).
1980s: Paul Volcker breaks the back of inflation. The Reagan recessions are followed by the Plaza Accord and the devaluation of the dollar.
1990s: China. See my previous post for details.
I think it’s fairly clear that at different times over the last 60 years, very different factors have driven inflation and employment in the US. Certain drivers remain important to this day, but others have changed utterly. (For instance: every decade has seen a different role for the Federal Reserve, from financing government debt in the 1940s, to twisting the yield curve in the 1960s, to fostering stagflation in the 1970s, to satisfying the bond market vigilantes in the 1980s). If causation has changed so much, how can we expect correlations from the past to apply today?
In fairness, I don’t think Prof. Hamilton himself fully believes the case he presents. He merely makes the observation that a forecast for low inflation going forward is not ‘crazy’, while pointing out that other factors (the dollar, commodities) may pull the other way. I can’t disagree with that ... so I guess I’m back to agreeing with him on everything.
Postscript: I’m embarrassed to admit that I only found out recently that the James Hamilton who co-writes Econbrowser is the same James Hamilton who wrote Time Series Analysis, a text which I used a fair bit in my professional career.
His argument is straightforward: he regresses historically realized inflation against unemployment, and also against lagged inflation (the latter is to account for expectations of inflation). He finds a statistically significant negative coefficient for the period from 1948 to 2007, validating the classical Phillips Curve relationship. Since unemployment is currently very high, inflation is (ceteris paribus) likely to be contained over the next few years.
My quibble with this analysis is that I just don’t think historical data, aggregated like this, is a very useful guide to the future. For instance, the period from 1948 to 2007 had several very distinct macroeconomic regimes. Let’s go decade by decade:
1940s: World War II has massive effects on consumption, production, resource allocation and labor markets, effects which do not end with the end of the war. The Fed buys long bonds to finance government spending, but reduces the money supply to pre-empt post-war inflation of the kind seen in 1919-20.
1950s: A boom in capital goods and in consumer credit (think: demobilization and reconstruction) leads to a sustained period of strong employment and benign inflation; the misery index will never be this low again. But a balance of payments deficit hints at trouble to come.
1960s: Operation Twist. The Great Society. Tax cuts combined with spending increases bring about the first persistent, large budget deficits. Congress eliminates the gold reserve requirement for the Fed. Inflation rises. The draft reduces unemployment.
1970s: The US leaves the gold standard in 1971. Nixon imposes wage and price controls from 1971 to 1974. OPEC embargos oil. Arthur Burns argues that it’s okay to countenance ‘temporarily’ higher inflation if that can alleviate economic shocks. He is succeeded by William Miller who thinks Burns kept policy too tight (!).
1980s: Paul Volcker breaks the back of inflation. The Reagan recessions are followed by the Plaza Accord and the devaluation of the dollar.
1990s: China. See my previous post for details.
I think it’s fairly clear that at different times over the last 60 years, very different factors have driven inflation and employment in the US. Certain drivers remain important to this day, but others have changed utterly. (For instance: every decade has seen a different role for the Federal Reserve, from financing government debt in the 1940s, to twisting the yield curve in the 1960s, to fostering stagflation in the 1970s, to satisfying the bond market vigilantes in the 1980s). If causation has changed so much, how can we expect correlations from the past to apply today?
In fairness, I don’t think Prof. Hamilton himself fully believes the case he presents. He merely makes the observation that a forecast for low inflation going forward is not ‘crazy’, while pointing out that other factors (the dollar, commodities) may pull the other way. I can’t disagree with that ... so I guess I’m back to agreeing with him on everything.
Postscript: I’m embarrassed to admit that I only found out recently that the James Hamilton who co-writes Econbrowser is the same James Hamilton who wrote Time Series Analysis, a text which I used a fair bit in my professional career.
Rabu, 14 Oktober 2009
Jobless Recoveries and Asset Market Bubbles
Asset markets around the world have rebounded quite substantially from their lows of earlier this year. As a result, attention has increasingly become focused on the Federal Reserve’s ‘exit strategy’1. Can the Fed raise interest rates, or even credibly threaten to do so, given the bleak state of the labor market? Some central bankers think so; here’s the Philly Fed’s Charles Plosser:
Thanks to a lowering of international trade barriers, thanks to outsourcing and off-shoring, and thanks above all to Chinese labor’s entry into the global marketplace, workers in the first world have no bargaining power any more2. Gone are the days of strong unions and collective wage agreements.
It is no coincidence that the last few recessions – specifically, those after China’s entry to world commerce – have been followed by jobless recoveries.
Source: Calculated Risk
Indeed, the shape of the world’s labor market today is such that ‘jobful’ recoveries are guaranteed not to happen. A policymaker who waits to see such a recovery before raising rates will have waited too long.
If the flood of liquidity provided by central bankers does not go into the labor market, then where does it go? Into asset markets. It is also no coincidence that the last few recessions and jobless recoveries have been followed by asset market bubbles, first in technology stocks, then in housing.
Thus the conventional wisdom, that China ‘exports deflation’ to the world, is only partly true. Over the last twenty-odd years, China has indeed exported deflation, but this has been concentrated in very specific segments of the economy: in the prices of retail goods, and in worker salaries. It so happens that these segments are precisely the ones captured in standard measures of consumer inflation. Central bankers, lulled by this quiescence in measured inflation, have time and again erred on the side of loose monetary policy, leading directly to the asset price bubbles that have done so much harm in recent years.
Of course, there is no guarantee that the Federal Reserve will go down the same path this time around. Policymakers today are very sensitive to the charge that they kept rates too low for too long in the early 2000s, and thus inflated the housing bubble; they will be keen to avoid repeating this mistake. But policy is inseparable from politics, and it will be difficult if not impossible for the Fed to completely ignore labor market conditions when making its next few interest rate decisions3. These will be interesting times indeed.
Footnotes
# 1‘Exit strategy’ is the currently fashionable euphemism for the painful process of raising interest rates. In the 2004 hiking cycle, the euphemism of choice was a ‘measured removal of policy accommodation’.
# 2If anything, this lack of bargaining power is even more obvious, and its effects even more pronounced, during economic downturns. Corporations increasingly take advantage of recessions to make dramatic cuts to payrolls, cuts that they would find politically inexpedient to make in good times. When the recovery comes (as it eventually must), the replacement hires are, more often than not, made overseas. Thus cross-border labor arbitrage – the gradual replacement of first-world workers with their cheaper third-world counterparts – is not a smooth process but a step function.
# 3Personal opinion: while I sympathize with the intent of those seeking to alleviate the condition of the working middle class, who have been hammered hard in recent years, I can’t help but feel that monetary policy is absolutely the wrong tool for the job. If you want to improve the employment data, implement deep-structural changes (investments in education, infrastructure, research and technology; a better tax code; incentives to save and invest rather than consume; and so on – all easier said than done, of course) designed to bring about that outcome; don’t count on the Federal Reserve to come to the rescue. In any case the Fed can, at best, merely buy a few years of breathing space; it cannot change the underlying fundamentals, and it would be foolish to expect otherwise.
As the economy and financial markets improve, the Fed will need to exit from this period of extraordinarily low interest rates and large amounts of liquidity. We recognize the costs that significantly higher inflation and the ensuing loss of credibility will impose on the economy if we fail to act promptly, and perhaps aggressively, when the time comes to do so. The Fed will need courage because I believe we will need to act well before unemployment rates and other measures of resource utilization have returned to acceptable levels.Others are more cautious, and would like to see a rebound in employment data before removing policy accommodation. Here’s the St Louis Fed’s James Bullard:
We’ve got this short term deflation risk; if we get into that trap it’s going to be hard to get out of, and that’s why we want to avoid the Japanese style outcome right now.This entire debate misses the point. In my opinion the emphasis on labor markets is overdone, simply because we are not likely to see a rebound in the employment data – payroll expansions or wage increases – any time soon. The mechanisms for robust and rapid growth in payrolls and wages just do not exist any more.
...
We know labor markets are going to lag, but we’d at least like to see them go in the right direction and start to improve. We’d like to see positive results in labor markets.
...
You want some jobs growth and you want to see unemployment coming down. That’s a prerequisite [for an increase in interest rates].
Thanks to a lowering of international trade barriers, thanks to outsourcing and off-shoring, and thanks above all to Chinese labor’s entry into the global marketplace, workers in the first world have no bargaining power any more2. Gone are the days of strong unions and collective wage agreements.
It is no coincidence that the last few recessions – specifically, those after China’s entry to world commerce – have been followed by jobless recoveries.
Source: Calculated Risk
Indeed, the shape of the world’s labor market today is such that ‘jobful’ recoveries are guaranteed not to happen. A policymaker who waits to see such a recovery before raising rates will have waited too long.
If the flood of liquidity provided by central bankers does not go into the labor market, then where does it go? Into asset markets. It is also no coincidence that the last few recessions and jobless recoveries have been followed by asset market bubbles, first in technology stocks, then in housing.
Thus the conventional wisdom, that China ‘exports deflation’ to the world, is only partly true. Over the last twenty-odd years, China has indeed exported deflation, but this has been concentrated in very specific segments of the economy: in the prices of retail goods, and in worker salaries. It so happens that these segments are precisely the ones captured in standard measures of consumer inflation. Central bankers, lulled by this quiescence in measured inflation, have time and again erred on the side of loose monetary policy, leading directly to the asset price bubbles that have done so much harm in recent years.
Of course, there is no guarantee that the Federal Reserve will go down the same path this time around. Policymakers today are very sensitive to the charge that they kept rates too low for too long in the early 2000s, and thus inflated the housing bubble; they will be keen to avoid repeating this mistake. But policy is inseparable from politics, and it will be difficult if not impossible for the Fed to completely ignore labor market conditions when making its next few interest rate decisions3. These will be interesting times indeed.
Footnotes
# 1‘Exit strategy’ is the currently fashionable euphemism for the painful process of raising interest rates. In the 2004 hiking cycle, the euphemism of choice was a ‘measured removal of policy accommodation’.
# 2If anything, this lack of bargaining power is even more obvious, and its effects even more pronounced, during economic downturns. Corporations increasingly take advantage of recessions to make dramatic cuts to payrolls, cuts that they would find politically inexpedient to make in good times. When the recovery comes (as it eventually must), the replacement hires are, more often than not, made overseas. Thus cross-border labor arbitrage – the gradual replacement of first-world workers with their cheaper third-world counterparts – is not a smooth process but a step function.
# 3Personal opinion: while I sympathize with the intent of those seeking to alleviate the condition of the working middle class, who have been hammered hard in recent years, I can’t help but feel that monetary policy is absolutely the wrong tool for the job. If you want to improve the employment data, implement deep-structural changes (investments in education, infrastructure, research and technology; a better tax code; incentives to save and invest rather than consume; and so on – all easier said than done, of course) designed to bring about that outcome; don’t count on the Federal Reserve to come to the rescue. In any case the Fed can, at best, merely buy a few years of breathing space; it cannot change the underlying fundamentals, and it would be foolish to expect otherwise.
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