Monthly Archives: June 2009

Quote of the Day

“In any event, it is not like the only alternatives available to us are a government-run health insurance plan or unregulated laissez faire.”

Greg Mankiw

More on Interest Rates

Frederic Mishkin on rising bond yields:

When the Federal Open Market Committee meets this Tuesday and Wednesday, the Federal Reserve will face a serious dilemma.

Since the last committee meeting six weeks ago, the 10-year U.S. Treasury yield has risen by around 70 basis points (0.70%), with the result that the interest rate on 30-year mortgages has risen by a similar amount. The rise in long-term interest rates is particularly worrisome, because it has the potential to choke off economic recovery and lead to further deterioration in the housing market. That would put an already weakened financial system under stress. Does the situation call for the Fed to expand its purchases of Treasury bonds to lower long-term interest rates?

To answer this question, we need to look at why long-term interest rates have risen. Here, there is good news and bad news. One cause of the rise in long-term rates is the more positive economic news of the past couple of months, particularly in financial markets. The bad news is that long-term interest rates are higher because of concerns about the deteriorating fiscal situation, with massive budget deficits expected for the indefinite future. To fund these budget deficits, the Treasury has to sell large quantities of bonds both now and in the future, causing bond prices to fall and interest rates to rise. The increased supply of Treasury debt puts pressure on the Fed to buy it up.

Note that he doesn’t point to rising inflation.

Similarly, Scott Sumner looks at the TIPS spread. You will notice that (1) the TIPS spread implies that expected inflation is around 1.47%, and (2) the TIPS spread largely follows the movements in the S&P 500. This provides more evidence against the hypothesis that yields are rising because of inflation concerns (as I previously discussed here).

What I’m Reading

  • Interest and Prices by Michael Woodford — again
  • Monetary Policy, Inflation, and the Business Cycle by Jordi Gali
  • Some Fiscal Calculus by Harald Uhlig
  • Street Fighters: The Last 72 Hours of Bear Stearns, the Toughest Firm on Wall Street by Kate Kelly

Can We Please Raise the Level of the Debate?

In all of our self-importance, economists and political pundits have seen the current recession as a time to argue about whether markets clear. Inevitably, the discussion on financial news networks always devolves into a debate about whether markets are efficient, etc.* (Incidentally, can I call cross-talk and yelling a discussion? I am talking to you CNBC.) A prime example of this type of discourse is found in a recent article by John Tamny and a subsequent post by Ezra Klein.

Tamny’s article essentially extols the virtues of free markets. He points out that recessions often lead to falling asset prices, which allow others to purchase these assets and use them more wisely. Tamny is correct that an important part of any recession is the reallocation of assets and capital. However, when making a larger point about the macroeconomy and the policy, it often doesn’t serve ones case to provide anecdotal examples of how markets clear.

Ezra Klein rightfully scoffs at using such examples to sell markets as well as articulating the left-of-center response that although markets might clear, the process can be painful. Unfortunately, Klein continues:

What would a “humble federal government” do, exactly? Shut down the stimulus projects so a couple million more people end up unemployed and a couple million other people can buy their possessions at fire sale prices? Shut down the system of financial supports which are currently sustaining a weakened lending market? Should they have held back from Detroit’s collapse so that the assets of the various companies were simply liquidated, along with what was left of the Rust Belt’s economy? Should they cut off economic aid to the states so infrastructure literally crumbles?

A course these are all loaded questions. For example, even if the stimulus were to save “a couple million” jobs, this would come at the expense of either current or future consumption due to the increase in future tax liabilities that was created thereby causing job losses where this money is no longer spent. (We have been through the literature on this before.) It is similarly questionable why the automakers would have to liquidate upon entering bankruptcy without government assistance.


At the end of the day, it will be a resuscitation of household spending and business expansion that restarts our economic growth. But for now, both have fallen through the floor, with terrible consequences for both individuals and businesses. What little demand exists is being substantially kept afloat by the massive intervention of the federal government.

Define “little”. I would describe several trillion as substantial. Furthermore, there must be a very large multiplier, especially considering much of the fiscal stimulus hasn’t even been spent.


…the idea that the economy will heal itself if the government only steps out of the way is exactly the thinking that led to the deep recession of 1937. What a pity those lessons haven’t been better learned.

I am struggling to understand how the year that FDR decided to raise taxes and the Federal Reserve decided to increase reserve requirements thereby leading to another monetary contraction strikes one as government getting out of the way. It is indeed a pity that those lessons haven’t been learned.

I don’t mean to pick on Klein or Tamny, but rather highlight the fact that this debate is rather silly. We did not live in a world of laissez faire prior to the financial crisis — nor prior to the Great Depression — and thus it seems more than a bit self-important to sit around and debate whether markets clear as though we are living through the quintessential moment in which this argument will be won. It is also important to realize that the fact that markets fail does not imply that government can perform any better.

* I find this entire debate to be quite a bit tiresome as well considering that banks are one of the most heavily regulated industries in the country (by this I mean the actual regulation that is supposed to be enforced, not what actually is enforced) as well as the fact that the Federal Reserve, whose power is derived from the government, plays such a central role in this entire fiasco.

Quote of the Day

“In modern teaching an “A” is the grade you get when you have done nothing wrong. So I give the Fed an A for predicting the crisis, because they did nothing wrong there, and a D for adopting a monetary policy far too contractionary for the needs of the economy in September and October 2008, when things obviously starting getting much worse. I’d be happy if they simply did their job by keeping expected NGDP growing on a 5% track, I don’t expect them to be some sort of Nostradamus.”

Scott Sumner

Becker on the Pay Czar

Gary Becker on the pay czar:

The title of my post, “The Fatal Conceit”, is taken from the title of a book published in 1988 by Friedrich Hayek. In this book Hayek attacks socialists for “the fatal conceit” that government officials can effectively determine prices and production through various forms of central planning without having the incentives and information available to firms in competitive markets. A closely related conceit is behind the belief that someone sitting in Washington can determine the pay to hundreds of executives and other employees.

The social purpose of competition and private enterprise is to provide quick responses to constantly changing market conditions. These responses include determining and changing the salaries, bonuses, and stock options of employees and top executives. Companies get into trouble and even fail when their decisions, including decisions on the quality of employees and their compensation, are less effective than decisions of their competitors.


The background of the Czar, Kenneth Feinberg, is not reassuring in these respects. A lawyer, he first worked for the federal government, and then during the past several decades headed a law firm based in Washington. Since he apparently has never been an employee of any company other than the government and Washington law firms, how can this background prepare him to set the pay of large companies, such as AIG or GM, that are in highly competitive industries?

Read the whole thing.

Was Keynes Correct?

My answer is going to be much more nuanced than the title might imply, but I think it is something that a discussion of this type requires. For example, it would be quite natural to answer the question in the title with another question (“Was he correct about what?”). The impetus behind this post was inspired by two unrelated, but thought-provoking blog posts by Casey Mulligan and Roger Farmer, each of whom answer the question in the affirmative for entirely different reasons. As someone who both appreciates Keynes and is skeptical of the effects of fiscal policy I thought that I might weigh in to provide my unique perspective.

Casey Mulligan asserts that Keynes was correct when he wrote, The Economic Consequences of the Peace regarding government spending and inflation. Indeed, I think that many would agree that this might have been Keynes’s greatest text. However, Mulligan notes on his own blog that the General Theory is “incorrect or at best unintelligible.” I have always had trouble with this type of statement as it begs the question “incorrect about what?” while simultaneously giving the impression that the GT is somehow impossible to understand — a point which I do not believe to be true. If Mulligan is referring to fiscal policy, which is somewhat indirectly implied by the context of his statement, then I think that he is correct. However, fiscal policy is not a primary theme in the GT. I would similarly argue that Keynes’s consumption function is incorrect in that consumption is not given by a stable relationship with current income, but rather permanent income as Friedman’s 1957 text demonstrated.

Ultimately, however, I think that the most important theme throughout the GT is the role of expectations and uncertainty. This is the topic of Roger Farmer’s post:

In the FT’s Economists’ Forum, Benn Steil wrote a stimulating piece in which he argued that Keynes was wrong. His argument is that interpretations of Keynesian economics are all based on the assumption that wages and prices are sticky. But wages and prices are not sticky. Ergo – Keynes was wrong. Mr. Steil and I are in complete agreement that the Keynesians, interpreted in this way are, to use a technical term, out to lunch. But that does not imply that Keynes was wrong. At least not entirely wrong. Far from it.


Keynes said three things in the General Theory. First: the labour market is not cleared by demand and supply and, as a consequence, very high unemployment can persist forever. Second: the beliefs of market participants independently influence the unemployment rate. Third: It is the responsibility of government to maintain full employment.

I have already stated my skepticism about the third point, but I think that Farmer is correct that these are the important themes of the GT.

Much of Farmer’s work has been dedicated to these ideas. He has demonstrated using reasonable models that a continuum of equilibria can exist. In such a case, the realized equilibrium can be a function of “sunspots”, or beliefs that are uncorrelated with fundamentals. Thus, changes in beliefs can have an impact on business cycle dynamics.

Whether or not you agree with Farmer’s research agenda or his particular methodology, I think that he is the closest of nearly anyone in modern macro to understanding the truly important themes of Keynes’s GT. The idea that beliefs about things that are uncorrelated with market fundamentals might have an impact on the business cycle was certainly a theme drive home by Keynes in the GT.

In short, I think that whether Keynes was correct requires a much more nuanced perspective than is generally presented. As I have expressed, I think that Keynes was incorrect about the consumption function and overly optimistic about the role of fiscal policy. However, I think that he was correct in asserting that expectations and confidence, which need not always be consistent with fundamentals in a world of uncertainty, can have a significant impact on economic fluctuations.

Should We Fear Rising Bond Yields?

There seems to be some concern as to the rising yields on long-term bonds. Our friend Jimmy P. (now of Reuters) quotes Scott Grannis, who writes:

The Fed is trying to fight a force of nature—the bond market—and they are bound to lose. Purchasing long-maturity Treasuries, mortgage-backed securities or corporate bonds in an to keep their yields low is a self-defeating strategy … Ultimately, inflation and inflation expectations are what drive bond yields. If the Fed buys too many bonds, rising inflation expectations will kill the world’s demand to own bonds, and yields will rise. … So far this year, the yield on 10-year Treasuries has risen from 2.05% to 3.4%, and that is just a down payment on the eventual rise.

This presents two interesting questions:

1. Is the Fed trying to lower long-term rates?

2. Are rising long-term rates a bad thing?

I think that the answer to (1) is ‘no’. Counter to what seems to be the conventional wisdom, I believe that the Fed is buying long-term bonds because because short-term bonds and cash having largely been near perfect substitutes for quite some time. Thus replacing an asset that banks are gladly holding at near zero yield for an asset that earns zero yield isn’t likely to create the proper incentive to expand the money supply and stimulate economic activity. Buying the longer term debt, on the other hand, serves the purpose of creating the incentive to replace said debt with something that earns a return, thereby promoting lending and monetary expansion. What’s more this monetary expansion, if successful (or, more appropriately, credible) will begin to create an increase in inflation expectations, reduce the real interest, and therefore create demand for investment.

This latter point brings us to question number 2.

I similarly think that the answer to (2) is ‘no’ as well (or at least ‘not yet’). The creation of inflation expectations will temporarily lower the real interest rate, but as these expectations become more widespread the nominal interest rates will start to creep up. The recent increase in nominal rates is seen by some (including Scott Grannis, above) to be a sign that investors are worried about inflation. I am not convinced that this is the case for two reasons.

First, the nominal rates on bonds have been at historically low levels for some time. These low rates are largely the result of expectations of deflation and, more importantly, the flight to quality. Given this diagnosis, it is not surprising that these longer term bond yields have started to rise. Indeed, Martin Wolf (HT: David Beckworth) notes:

The jump in bond rates is a desirable normalisation after a panic. Investors rushed into the dollar and government bonds. Now they are rushing out again. Welcome to the giddy world of financial markets.

At the end of December 2008, US 10-year Treasury yields fell to the frighteningly low level of 2.1 per cent from close to 4 per cent in October (see chart). Partly as a result of this fall and partly because of a surprising rise in the yield on inflation-protected bonds (Tips), implied expected inflation reached a low of close to zero. The deflation scare had become all too real.

What has happened is a sudden return to normality: after some turmoil, the yield on conventional US government bonds closed at 3.5 per cent last week, while the yield on Tips fell to 1.9 per cent. So expected inflation went to a level in keeping with Federal Reserve objectives, at close to 1.6 per cent. Much the same has happened in the UK, with a rise in expected inflation from a low of 1.3 per cent in March to 2.3 per cent. Fear of deflationary meltdown has gone.

The most important point to take away from this is that inflation expectations are in line with rates in which the Federal Reserve is quite comfortable. Thus, I am not trying to argue that rising inflation expectations have played no role in the rising bond yields, but rather than these increases are the result of a return to normal conditions (hence my reason for offering the qualification ‘not yet’).

The second reason that I remain unconcerned about the rising yields is that the phenomenon is not unique to the United States. One of the main points underlying the inflation expectation concerns is that the Federal Reserve will monetize some of the growing debt (or similarly about the risk of default). However, if increases in bond yields were the result of the growing budget deficit and debt, then one would expect to see such increases in the United States, but not countries with relatively small deficits. With that being said, Stephen Gordon’s recent comparison of the yields on Canadian and U.S. bonds throws a wet blanket on this hypothesis. He notes:

As we all know, Canada’s deficit and debt picture resembles in no way that of the US. But a US recovery is a sufficient (although perhaps not necessary) condition for a Canadian recovery.

If investors were suddenly concerned about default, it’s hard to see why Canadian bond yields should be affected in the same way that US yields would be. But if investors are anticipating a US recovery that would spill over to Canada, then we would expect long-term interest rates in both countries to increase.

Thus, like Gordon, I would argue that the rising yields are a good thing as they seem to indicate a return to normalcy rather than runaway inflation expectations. This is also a sign that the Fed’s policy of quantitative easing is working (at least in terms of what I believe to be the Fed’s goals).