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A frightening figure
Paul Krugman presents a frightening figure.
The figure [below] shows the real interest rates on corporate bonds, with the expected rate of inflation from the spread between 20-year TIPS and 20-year Treasury rates. All data monthly, from St. Louis Fed.
I've been saying for some time that one of the signs of a credit crunch has got to be rapidly rising real rates - in very recent weeks, that appears to be happening. The timing suggests to me that this is more of a deflation problem than a banking-credit problem per se but at this point who cares - we can probably all agree it's more bad news.
Addendum: Greg Mankiw is also troubled by what this figure means.
Posted by Alex Tabarrok on November 20, 2008 at 07:05 AM in Economics | Permalink
Comments
Why isn't the answer to deflation simply printing more money?
Posted by: Ted at Nov 20, 2008 7:31:51 AM
"Why isn't the answer to deflation simply printing more money?"
Because the real problem right now isn't that there is too little money. It's that interest rates were set below market for a very long time. That was possible without a rise in prices because of the Reagan/Thatcher revolution.
All price controls cause distortions in the free market. When you set a price below market you get over consumption and under production. Consumers are willing to consume more at the lower price and producers want to produce less With interest rates consumption is borrowing, and production is savings.
A price control in one area of the economy will cause effects in other areas. If you put a price ceiling on say corn then the production of ethanol looks more profitable and it will be overproduced.
Interest rates are, in part, the time cost of money. Interest rates also have an inflation premium, and risk reward but let's ignore those. So interest rates are a price. The price people are willing to be paid to wait to consume. Like all prices interest rates send a signal between producers and consumers on "how much".
With below market interest rates it appears if the producers, the savers, are willing to wait a long time for their money. This causes the producers to change their plans based on this information. In the case of below market interest rates, false information.
Because long term projects like investing in for example, housing or an internet company, are more profitable with low interest rates you will get more of that activity than is economically viable.
Because interest rates and money are transactional goods in the market they effect all the prices and plans for all other goods. So there are other effects, like trade deficits and asset bubbles that will occur.
Now in the case of a ceiling on corn prices what is going to happen is that as time progresses and the corn producers react to the lower prices by lowering production. Meanwhile the ethanol producers will have set up new factories to increase production.
Both industries start suffering and they call on the government to help. If the corn producers politically accept the ceiling they will ask for subsidies to increase production. So the government will start paying them via taxes taken from other industries.
Meanwhile corn requires resources to grow and farmland and fertilizer (produced by other fuels) will be diverted from other industries to produce more corn. Food prices go up in general. While all the ethanol being dumped on the market will cause other fuel prices to drop.
But it is totally unproductive to do this. It was much more efficient to just leave the market alone. Furthermore the disruption and intervention has set a precedent and other people start railing for subsidies.
The exact wrong answer is to provide more subsidies. If you give to bean farmers then they will bid up the price of farmland, and you will then have to repeat the process with corn farmers because their production costs go up.
In the case of the interest rates we have already distorted the market by being too "loose" with money and essentially setting a price ceiling on interest rates.
Your suggestion to print more money is again, essentially a scheme to keep interest rates low. It however bypasses the saver completely. The saver will not be encouraged to produce more goods, and consume less, a.k.a. save for the future. Instead, you will hand money directly to the consumer of goods.
It's as if in order to solve the price ceiling on corn you suggest we hand money directly to the ethanol producers. Not only will that not cause more corn production, but it will allow the ethanol producers to consume more of other goods without actually producing any goods in trade for them.
Total production will go down.
Posted by: at Nov 20, 2008 8:30:01 AM
>> "Paul Krugman presents a frightening figure."
That statement is true all by itself. ;-)
Posted by: Speedmaster at Nov 20, 2008 8:36:32 AM
I have been worried for a little while about the crowding out effect of all this government borrowing. If the government is hogging the interest bearing capital market this should inevitably push up corporate bond rates. Could this also be affecting equity investment as well?
Posted by: Brian Shelley at Nov 20, 2008 8:46:04 AM
Isn't the problem not that there is to little money, rather, that there's too little money being put to work, so to speak? The treasury and Fed have so far pumped an additional $2t into the economy that's mostly just sitting around. I have little doubt this will continue. I guess I am just surprised no one is concerned about the potential for hyperinflation and the decimation of the dollar in a couple years. Can anyone tell me why I might be crazy?
Posted by: Steve at Nov 20, 2008 8:53:24 AM
"I guess I am just surprised no one is concerned about the potential for hyperinflation and the decimation of the dollar in a couple years."
That's because they are under the mistaken belief that they can "just mop it up later".
It's as if they believe that disruptions to the market by setting price ceilings now can be corrected by setting price floors in the future.
If you set a ceiling on the price of corn below market now it will cause a shortage. Seeing the shortage you may think, hey, we need to raise prices. You can then set a price floor which will certainly move prices in the direction the market would. You can know that, what you can't know is where the price floor should be and if you set it too high you then get overproduction.
Why mess with a system that is automatically self correcting?
Meanwhile you missed years of productivity while the price ceiling was in effect, have a transient period where prices are proper, and then get over production while the price floor is in effect until that again becomes enough of a crisis to cause action.
That's not free markets. That's a planned economy.
Posted by: Brian Macker at Nov 20, 2008 9:12:13 AM
@8:30 -- if what you're saying is true, then "deflation" isn't a problem, but a symptom of the problem, so you're challenging the premise of the question.
I'm asking the people who think deflation is a problem in and of itself, which would seem to include Alex.
Posted by: Ted at Nov 20, 2008 9:12:53 AM
It's not that frightening, if we consider that:
a) high real interest rates stem from fears of debt repudiation and that such fears may prove self-fulfilling;
b)market trades lower inflation in the short run for higher inflation in the long run;
c) contrary to Walras’ law, which states that the bond market always clears, that is not obviously happening at present;
d) it means less investment projects are financially viable;
e) it reveals the collapse of the marginal efficiency of capital and the rise of liquidity preference (only cash and not highly illiquid financial assets of some corporates...).
When figures are not frightening anymore
Posted by: Massimo GIANNINI at Nov 20, 2008 9:13:33 AM
It's not that frightening, if we consider that:
a) high real interest rates stem from fears of debt repudiation and that such fears may prove self-fulfilling;
b)market trades lower inflation in the short run for higher inflation in the long run;
c) contrary to Walras’ law, which states that the bond market always clears, that is not obviously happening at present;
d) it means less investment projects are financially viable;
e) it reveals the collapse of the marginal efficiency of capital and the rise of liquidity preference (only cash and not highly illiquid financial assets of some corporates...).
When figures are not frightening anymore
Posted by: Massimo GIANNINI at Nov 20, 2008 9:14:58 AM
A high real cost of borrowing it's not that frightening , if we consider that:
a) high real interest rates stem from fears of debt repudiation and that such fears may prove self-fulfilling;
b)market trades lower inflation in the short run for higher inflation in the long run;
c) contrary to Walras’ law, which states that the bond market always clears, that is not obviously happening at present;
d) it means less investment projects are financially viable;
e) it reveals the Keynesian collapse of the marginal efficiency of capital and the rise of liquidity preference that is only cash and not highly illiquid financial assets of some corporates...
When figures are not frightening anymore
Posted by: Massimo GIANNINI at Nov 20, 2008 9:20:57 AM
That's some hockey-stick lookin' chart right there. Can we see the plot of the inflation correction value? Deflation expectations should show up in that data alone, without including corporate rates. Can we go back earlier than 2004? What's the 20 year mean real AAA borrowing rate? I bet it's more than 5%.
Posted by: David at Nov 20, 2008 9:24:04 AM
I don't think this question:
"Why isn't the answer to deflation simply printing more money?"
has been adequately answered. The recitation of Austrian business cycle theory is not an answer. Real interest rates and price level trends are logically independent. If real interest rates have been too low and need to rise, fine. Let nominal interest rates rise but keep the price level steady. Or, if that's not possible, why not? The following seems to be evidence-- far from conclusive, however-- that you can't stop deflation by printing money:
"The treasury and Fed have so far pumped an additional $2t into the economy that's mostly just sitting around."
But just because the banks are too spooked to put the money out there doesn't mean ordinary people would be. Why not give every American $2,000 cash (or debit-card points, whatever) no strings attached? Even if they only spend 20% of it-- like people say they did with the stimulus last year-- that's $120 billion of new spending, just under 1% of GDP. And if they save it, doesn't that shore up banks' balance sheets?
People might have better ideas of what to do with the money than scared banks or government bureaucrats.
Posted by: Nathan Smith at Nov 20, 2008 9:58:53 AM
OK, let's ask another basic, naive question.
If the best thing for business planning is to have stable, predictable policies, then could we imagine policies more likely to disrupt business planning than those adopted by the US government this year?
Bear vs Lehman. Save AIG, but other insurance companies become banks. $600 stimulus checks. Maybe people who hold underwater mortgages will be helped, maybe not. $700 billion to buy securities at auction -- no, wait, let's not hold that auction.
Posted by: ZBicyclist at Nov 20, 2008 9:59:46 AM
I guess my problem Alex is that I didn't believe when you said (a year ago?) that high consumer borrowing was a good thing. I didn't believe you (months ago?) when you said there was no credit crisis. And now I wonder if this observation about "very recent weeks" is an attempt to square your earlier beliefs with .... the body on the floor in the library.
Posted by: odograph at Nov 20, 2008 10:01:42 AM
high real interest rates stem from fears of debt repudiation and that such fears may prove self-fulfilling;
High real interest rates are not merely a result of the incorporation of risk; they can also reflect the time preference of savers in general. The fact that the Boomers are leaving the workforce and beginning to draw down their retirement savings (and that many more of them will begin to do so in the next ten years) means that the time preference of the American Saver, at least, is undergoing a sea change.
Posted by: bbartlog at Nov 20, 2008 10:33:36 AM
Yes, lending to corporations is really risky now. That's not a surprise given the economic meltdown in housing, finances, manufacturing. Compounding it all is the institutional meltdown--Bush obviates the 'rule of law' for the 'rule of Paulson' and the President-Elect promises a 21st century version of socialism.
But, the President-Elect does have a chance to turn things around. He could simply say, "No, you've got me wrong. Yes, of course I want a health care safety net. Yes, a middle class tax cut is important. But, most clearly no, I want neither socialism, nor more trillions in corporate welfare. I want to restore the institutions of our free enterprize economy. I want to encourage our entrepreneurs and our most productive workers. I want to bring out the creative genious of a free and bold people. They are the great ones who built our country. They are the ones who will rebuild it, now and in the future. To provide this encouragement, I want Congress to act now to eliminate the capital gains tax on new investment and to reduce the corporate tax rate to a maximum of 25%. That, my dear compatriots, will move us into the future."
The stock market would jump 4000 points and interest rates would subside. Maybe it's too much to hope for, but the President-Elect could do it. It would be a historical moment.
Adam
Posted by: Adam at Nov 20, 2008 10:56:49 AM
Yeah, it's so risky it's almost 5%.
Posted by: David at Nov 20, 2008 11:26:06 AM
Richard Russell, an 84-year-old financial advisor, points out we are not in a credit crisis, we're in an income crisis. This seems right to me.
http://home.comcast.net/~munsrat/2008/11/income-crisis.html
Posted by: Floyd Waterson at Nov 20, 2008 11:27:55 AM
The graph uses the TIPS vs. Treasury spread to account for inflation/deflation. One commenter had the theory that the TIPS spread may underestimate inflation due to the possibility the government, down the line, underestimating inflation to reduce their rate increase.
All the new Fed bonds issued the last few months, by the way, will not seriously affect inflation because they're likely to just be sitting around in company faults until banks have to repay the Fed with super-low interest. True hyperinflation would be caused by the government monetizing a lot of its costs, which Nouriel Rubini (sp?) has said would not be worth the short-term stimulus to the economy.
Interesting times we live in.
Posted by: MW at Nov 20, 2008 11:46:14 AM
Also, here's the raw AAA yield curve from the St. Louis Fed.
http://research.stlouisfed.org/fred2/fredgraph?chart_type=line&s[1][id]=AAA&s[1][range]=5yrs
Nominal yields are not quite as horrifying, with a similar average yield now as parts of 2004 and 2006. Those yields, though, had a much higher expected inflation rate, even if the TIPS spread underestimates inflation. We really need a sustained productivity gain...somewhere...to give us a market which actually makes investors profits and makes them want to invest again instead of holding their money in T-bills or vaults. And by profits I mean real ones from increased productivity, not the imaginary high yields given by the subprime boom of 2002-05.
Posted by: mw at Nov 20, 2008 11:58:24 AM
I concur with the lack of income being the problem. When you look at MEW over the last few years and realize that it has gone from being a MEW to being something that needs to be replaced. It is a huge problem that essentially all of our growth was financed by income gains at the top and MEW for the middle class. We need to rectify this problem and stimulate the economy.
There is a simple solution that is easier than issuing a debit card that disappears at the end of the month. Suspend payroll taxes and have the treasury pay for those taxes for the next 6 months.
Doing this is about $20B a week in stimulus, so 20 weeks is only about $400B in stimulus. We could do if for a year for about a trillion dollars. It would then be spent by people and divert future resources into improving the low to middle-end consumer part of our economy. The people that this would largely impact are people that live paycheck to paycheck. They won't save it- they will spend it either to reduce their existing debt or to upgrade something within their lives.
Trickle up economics.
Posted by: mickslam at Nov 20, 2008 12:19:38 PM
I would like to make two quick points, and I apologize that I will be linking to my own blog to do so, but I really have made some "contributions" I think to this stuff. (At the very least, I am raising possibilities that need to be ruled out before deciding Krugman is right.)
(1) Rather than transforming the data, look at the absolute values of the Aaa and Baa bonds. What has happened during the "credit crunch" is that they returned to pre-housing-bubble levels. Isn't that exactly what we want to happen? In particular, even after the recent spike, Aaa bonds are at the lowest level since the late 1960s, if we exclude the housing bubble years.
(2) It's true that my point (1) refers to nominal yields, and you want to correct for expected inflation, which Krugman/Alex attempt to do in the chart they show above. But that chart relies on backing out the "expected inflation rate" by subtracting TIPS from nominal yields. Yet without looking at the data, if what has happened is that inflation expectations have collapsed recently, then you'd expect nominal yields to have fallen down to the TIPS yield.
But that's not what has driven (most of) the collapse in the nominal/TIPS spread on Treasurys, as I explain in this post.
Posted by: Bob Murphy at Nov 20, 2008 12:26:12 PM
"I want to encourage our entrepreneurs and our most productive workers. I want to bring out the creative genious of a free and bold people. They are the great ones who built our country. They are the ones who will rebuild it, now and in the future."
The creative genious has been encouraged over the last 8 years with cheap money and tax cuts . . . it came up with a smorg of CDS, SIV, CDO etc etc to leverage the economy to the hilt with little transparency and unbridled "enthusiasm" that way too many bought into (school boards "gambling" on derivatives GMAB!). The consumer consumed to the max on Mcmansions that made no economic sense (prices @ 10x income!) and all kinds of other doodads and thingamajings.
Time for a rest, re-evaluation, re-pricing here. Not re-ignition.
Posted by: at Nov 20, 2008 12:33:52 PM
This graph is silly. The yields in the graph are adjusted from nominal yields to real yields via "the expected rate of inflation from the spread between 20-year TIPS and 20-year Treasury rates." However, this "expected rate of inflation" is not a very reliable prediction of inflation expectations under the current trading environment. The TIPS market has suffered from serious illiquidity and forced selling from deleveraging. The prices signal a drop in inflation expectations to proposterously low levels; the high bid-ask spread shows us this information is not really reliable as other market signals.
When the liquidity to TIPS markets normalizes (which we will see with an improved bid-ask spread), then we can use this information and apply it to more liquid markets (such as generic AAA swap rates, etc). Until then we have no basis for using poor information when we have better information available. A better indicator of stress would be in the short-dated swap spreads or eurodollar/Treasury futures.
Posted by: Alex at Nov 20, 2008 2:06:56 PM
Another way to look at the figure is this:
"The markets do not believe current credit ratings. They are pricing AAA bonds the way that they used to price BAA bonds."
Posted by: Robert Ayers at Nov 20, 2008 3:20:09 PM
