Friday, June 10, 2005

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Economists are flummoxed

When Alan Greenspan can't explain the bond market, I start to get very, very nervous.

Among the biggest surprises of the past year has been the pronounced decline in long-term interest rates on U.S. Treasury securities despite a 2-percentage-point increase in the federal funds rate. This is clearly without recent precedent. The yield on ten-year Treasury notes, currently at about 4 percent, is 80 basis points less than its level of a year ago. Moreover, even after the recent backup in credit risk spreads, yields for both investment-grade and less-than-investment-grade corporate bonds have declined even more than Treasuries over the same period.

The unusual behavior of long-term interest rates first became apparent almost a year ago. In May and June of last year, market participants were behaving as expected. With a firming of monetary policy by the Federal Reserve widely expected, they built large short positions in long-term debt instruments in anticipation of the increase in bond yields that has been historically associated with a rising federal funds rate. But by summer, pressures emerged in the marketplace that drove long-term rates back down. In March of this year, market participants once again bid up long-term rates, but as occurred last year, forces came into play to make those increases short lived. There remains considerable conjecture among analysts as to the nature of those market forces.

Of course, what Greenspan is sure about doesn't make me feel any better:

Our household saving rate remains negligible. Moreover, modest, if any, progress is evident in addressing the challenges associated with the pending shift of the baby-boom generation into retirement that will begin in a very few years. And although prices of imports have accelerated, we are, at best, in only the earliest stages of a stabilization of our current account deficit--a deficit that now exceeds 6 percent of U.S. gross domestic product (GDP).

Now part of the reason savings is at a historic low is that asset prices have been rising so dramatically over the past ten years -- equities in the late nineties and housing now. So it's tough to say that the American consumer is behaving irrationally -- why save income when your assets are appreciating at a healthy clip?

Tyler Cowen speculates on whether this is true and is just as flummoxed as Greenspan is about the bond market:

So what is the problem? Does liquifying real assets somehow bring excess leverage to the economy? I don't see why. Or does borrowing against real assets lead to a later switch toward consumption, thereby necessitating transformation costs? Each individual thinks he has a more liquid savings position than is the case; borrowing is cheap but society as a whole must incur reallocation costs to convert the real capital into consumption. But how big a factor can this be?

All seems fine. Yet in my neo-Austrian gut I cannot bring myself to think as capital gains as analytically equivalent to abstinence out of income.

I file this one under the category of "macroeconomic problems I've been thinking about for twenty years but haven't made much progress on."

Now is normally the point in the post when I give you my take on things. Not this time -- I'm just as stumped as Cowen and Greenspan on these questions.

posted by Dan on 06.10.05 at 07:45 AM


China? Bonds? Is there a connection?

posted by: exclab on 06.10.05 at 07:45 AM [permalink]

What do people think about Richard Duncan's argument that the CA deficit puts a lot of dollars out there, the default use of them is Treasury debt, and as the fiscal deficit declines (and the CA def rises) you get downward pressure on UST debt rates plus knock-on effects in near-substitute markets (Bunds, agencies, etc)? (FinanceAsia, subscription link)

posted by: Jim M on 06.10.05 at 07:45 AM [permalink]

One possible explanation of the apparent paradox is that the market seems to be expecting a long period of slow growth; not surprising considering the long-term troubles facing the US economy. Another factor is that maybe the large CA deficit creates more demand for US debt than the Delphi thinks.

Since I graduated from your school, I tend to believe that the market is probably smarter than even Alan Greenspan.

posted by: Larry on 06.10.05 at 07:45 AM [permalink]

Now part of the reason savings is at a historic low is that asset prices have been rising so dramatically over the past ten years -- equities in the late nineties and housing now. So it's tough to say that the American consumer is behaving irrationally -- why save income when your assets are appreciating at a healthy clip?

Because its not real savings till you can sell it ? If housing jumps by 50% over 2 years, it could well remain stagnant or drop 10% over the next 5. Its happened before. We saw what happened in equities in 2000. At that time dividends were passe, now rents are.

My prediction for a likely scenario: in the overheated areas of the market (Cal, Washington area, NYC area, parts of Florida) the real estate bubble deflates. But in other regions like Texas the market picks up a little. SoCal is going to get hit, and so is the Bay area. There really hasn't been much job growth in the Bay area since 2000, and there really is no justification other than the greater fool theory for asset prices. SoCAl -- the economy is better, but again the affordability index is way down and so many new jobs are housing related. Florida and the NYC metro area are on slightly better ground overall, but expect towns and areas there to get hit as well. When ? Aha, if only I knew. We know SoCal went though a 12 year bust, and so did Texas. It can happen.

Ultimately, you cannot sustain an economy based largely on rising prices for financial assets.

And the yield curve is close to flat now. Normally, that indicates a cooling economy, but maybe not now ?

posted by: erg on 06.10.05 at 07:45 AM [permalink]

That a lot of investors believe we are driving through a pleasant countryside at the moment, but that the road ends in 2000' cliff a little way ahead?

Might there possibly be a connection to a seemingly unwinnable war in Iraq for which taxes are being lowered, not raised?

Of course not. Sorry for mentioning either of those foolish suggestions.


posted by: Cranky Observer on 06.10.05 at 07:45 AM [permalink]

I actually find Brad DeLong's related remarks to be rather insightful. It's worth checking out.

posted by: Robert Tagorda on 06.10.05 at 07:45 AM [permalink]

For once I have to agree with erg. We have seen this movie before, with equities in the 1990s. The wonder then was why stock prices continued to rise when profits didn't seem to justify this.

The point is that while this may have been a wonder it is not the relevant issue. Asset prices not justified by profits could in the end not be sustained. Rapidly rising values for residential property cannot be sustained either. Alan Greenspan does not want to credit the worst-case scenario, among other reasons because he fears the impact his doing so might have on the economy. But even if the worst case scenario -- a collapse of the real estate bubble -- does not pan out, deflation of the bubble is likely sooner or later. Economists can argue about why it happens later instead of sooner, but for the rest of us the issue is that it will happen and we need to prepare ourselves for the consequences.

posted by: Zathras on 06.10.05 at 07:45 AM [permalink]

many years ago the CEO of our NYSE corp asked at a special meeting why our stock price had gone down despite our good earnings.he announced it was an unresolvable puzzle.our (then CFO) said he could solve then puzzle.he knew exactly what was going on"there were more sellers than buyers:.While he nailed it,he was the ex cfo the following week.Our high trade deficit converts almost exactly every year to $available to foreign holders to invest somewhere and treasurers hate the sight of indolent cash.better highly liquid US bonds. No mystery at all,except whatever is A Greenspan thinking

posted by: john morrissey on 06.10.05 at 07:45 AM [permalink]

OK, so we should call it the Duncan-Morrissey position. But John, why is it so obvious? There are lots of liquid bonds that don't face such high currency risk. Laziness trumps fear? Help me out here.

posted by: Jim M on 06.10.05 at 07:45 AM [permalink]

The wars in Iraq and Afghanistan have cost us an additional $300 billion total over the past three years.

In a $13 trillion econonmy over those three years, that is less than 1% of GDP annually.



posted by: SteveMG on 06.10.05 at 07:45 AM [permalink]

I think CO's argument was that investors are skittish, that rising expenses plus lowered income looks like a bad omen, not that the 300B$ represented any actual weight on the GDP.

I tend to agree while adding that I don't think there has been an economic recovery at all, despite all the indicators. In the vein of the Scottish enlightenment thinker David Hume: "If I can't see it, it doesn't exist."

posted by: Jamie on 06.10.05 at 07:45 AM [permalink]

Not only are economists flummoxed, but so also do the Red Sox appear to be.

Go Cubs!

posted by: Andrew Steele on 06.10.05 at 07:45 AM [permalink]

Tom Petruno in a front-page article in today's L.A. Times ( provides a good first-cut explanation for the drop in long-term yields. Entitled "Long Term Interest Rates Buck Conventional Wisdom," Petruno cites the global decline of interest rates, in such economies as Germany and Japan (where in the latter the 10-year bond yield is currently at 1.23%), as well as in smaller economies (with Lithuania and Estonia listed as examples). With yields down, investors continue to move into the U.S. bond market, sending rates in the opposite direction of Fed policy. China's currency recycling is cited as well, with the Chinese needing to find markets to stash the huge cash surpluses resulting from their trade surplus. See also the Greg Ip and G. Thomas Sims, "Bond Yields Plunge Amid Falling Rates Worldwide," W.S.J. (June 2, 2005, p. A1).

posted by: Donald Douglas on 06.10.05 at 07:45 AM [permalink]

One piece of the puzzle has to be the artificially low prices on a broad range of consumer goods sourced in China. Free cash is finding its way to the only hard asset investment that is available to average people -- housing. It's more pronounced in high wage states (Florida is essentially a part of the Northeast) because you can only buy so much Chinese-made stuff.

If the Yuan was priced fairly, we wouldn't be seeing the persistent rise in housing prices. If China decides to float their currency, consumer goods prices will rise dramatically, but housing prices will be flat -- they won't drop significantly. We will see bond prices rise, because value will start to flow back into our currency. And it will stop the long, slow devaulation of the Dollar that Greenspan has presided over during his tenure.

Or something like that. :)

China's Yuan policy is hollowing out the United States' manufacturing infrastructure. At Target yesterday, they had stand fans branded by Holmes, Honeywell, and Black & Decker. All were made in China. That sucks.

posted by: gruffbear on 06.10.05 at 07:45 AM [permalink]

I don't understand why people confused. The reason long term Treasury rates are low

is that they are not being purchased by rational

but rather are being purchased by stealing roughly $5 Trillion from the Trust Funds
for Social Security and Medicare. Bush's own budget for 2006 shows that by 2010, Social Security's "assets" will consist of $5 Trillion of worthless Bush IOUs (or ,as Bush's late Economic Advisor Lawrence Lindsay called them "not real assets").

Ref: , Table S-14 at bottom,
entry "Debt, Outstanding at End of Year", subentry
"Debt held by the Public"

That being the
case, the thieves (Bush and the Republican Congresses) can set the interest rates at whatever
rate they want.

Greenspan, of course, realizes this. His expression of puzzlement is ,in my opinion,
mere dissimulation and two-faced hypocrisy.

The public, on the other hand, does not realize they're being robbed.

All of which brings back to mind an earlier query re the social value of academic tenure. Why do we tolerate an educational system which receives billions of dollars and yet graduates
some of the most ignorant people on the planet?

posted by: Don the Greater on 06.10.05 at 07:45 AM [permalink]

I appreciate that amplification, and I will go with it ;-)

But that isn't exactly what I was saying, either. As I learned in intro to reactor control, you can have a 1,000,000 gallon water tank (or 12 trillion gallon) with inflow and outflow of 50,000 gal/hr, yet control the level of the tank with a 10 gal/hr input and drain. So the fact that 300 billion is a small fraction of GDP (although - shouldn't that be compared to government budget and tax revenue, not the private sector?) isn't the deciding factor IMHO.

I have to say it is an interesting day when those I suspect are Republicans start arguing that a $300 BILLION sink (and I don't believe the $100B/yr figure either by the way; just a quick scan of the public trade publications will tell you that the Pentagon is diverting enormous portions of its budget to Iraq operations using all the bureaucratic tricks at its command) is "trivial" - I thought that was supposed to be what tax-and-spend Democrats did.

But I also think that the investment community is a bit concerned about that minimum $100 billion/year dead loss to the US economy, and the fact that there is no increase in Iraqi oil production to help pay for it anywhere in sight. In fact, the entire Iraqi economy is just about destroyed, which means 40 million more educated Iraqi citizens looking for either new jobs, new countries, or revenge. All of which will cost the world somewhere down the road.


posted by: Cranky Observer on 06.10.05 at 07:45 AM [permalink]

On a global basis, it seems like there may be more available capital than there are high-return places to put it. Isn't this kind of strange, particularly given the rapid growth in places like China and India? Shouldn't China, at its present stage of economic development, be a net *importer* of capital, rather than have zillions to put in US Treasuries?

posted by: David Foster on 06.10.05 at 07:45 AM [permalink]

This thread is probably dead, but anyway:

Are economists really flummoxed Dan? A aren't one, and don't hang out with them any more, but I suspect 95% of all academic and business economists have a fairly good idea of what is going on, be their leanings left or right. They just aren't talking about it, those on the left because they cannot and those on the right because they are gobsmacked (or terrified).


posted by: Cranky Observer on 06.10.05 at 07:45 AM [permalink]

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