Niall Ferguson Says "Bring It On!"

... and refuses to back down.

Why Did the Yield Curve Invert Before This Recession?

Over at Free Exchange the inversion of the Treasury yield curve prior to this current recession is being interpreted as the result of a decline in the term premium, not a change in the expectation of future short-term interest rates. Specifically, the term premium allegedly declined for the following reasons:

Implicit inflation targeting appeared to be working; high and unpredictable inflation was relegated to emerging markets. That decreased the premium on long-dated government bonds. The savings glut also lowered long-term yields by increasing the demand for long-term governments, lowering their yields.

There are studies supporting this interpretation, but I am not convinced it is the entire story. For starters, if a belief in price stability led to a decline in the term premium, why did it suddenly kick in a few years ago? The Fed has had inflation-fighting credibility for several decades now so what makes the mid-2000s so special? Another problem with this interpretation is that the inverting of the yield curve was a global phenomenon. The above interpretation cannot explain why it was global. The saving glut was a regional one and its destination was regional too. At best, then, it could only have affected regional interest rates.

A more straightforward interpretation is that bond markets across the globe were sizing up the economic imbalances and foresaw the current global recession. As a result, they expected monetary authorities to cut future short-term rates across the globe and priced it into long-term interest rates. Now this is purely conjecture on my part, but I know of at least one study that provides evidence consistent with this view for the United States. Joshua Rosenberg and Samuel Maurer in a New York Fed study decompose the yield curve spread into its (1) interest rate expectations and (2) term premium components. What they find can be seen in the following figure where the gray columns denote recessions: (click on figure to enlarge.)


This figure reveals that for the United States the inverted yield curve prior to this recession was mostly the result of changes in the interest rate expectations component rather than the term premium component.

Is Another Global Liqudity Glut Forming?

Yes is the answer from Joachim Fels & Manoj Pradhan of Morgan Stanley. From a global perspective they note the amount of money creation is staggering but accomplishing what central bankers hoped it would: (1) support global asset prices, (2) help end the global recession, and (3) remove the global deflation threat. However, they note the creation of this new global liquidity glut may set the stage for some uncomfortable global inflation once the recovery starts. This is an interesting article, but I wish the authors would have provided some numbers on the size of the global liquidity glut. Here it is:

Excess liquidity surges to a new record-high... Back in January, the available data indicated that the new liquidity cycle was only in its infancy. Our favourite metric for excess liquidity - the ratio of money supply M1 to nominal GDP (a.k.a. the ‘Marshallian K') - had only started to tick up slightly for the G5 advanced economies (the US, euro area, Japan, Canada and UK) and was still declining for the BRICs aggregate. Now, our updated metrics, which include data up to March 2009, confirm that a powerful liquidity cycle is underway, with excess liquidity surging to a new record-high both in the advanced and the emerging economies. Thus, the jump in excess liquidity over the past two quarters has more than fully reversed the preceding decline in excess liquidity, which had foreshadowed the credit crisis.

...and further increases are likely in the coming quarters: The surge in excess liquidity reflects both rapid M1 growth in response to monetary easing, and the outsized declines in GDP in most economies over the past couple of quarters (recall that the growth rate of excess liquidity equals the growth rate of M1 minus the growth rate of nominal GDP). Looking ahead, further growth in excess liquidity appears likely, though probably at a slower pace. We expect M1 growth to remain strong or even accelerate further, reflecting the active quantitative easing in the US, UK, Japan and euro area that is underway and still has further to go. At the same time, we expect global GDP to bottom out soon, so that the real economy will start to ‘absorb' some of the additional money that central banks are printing. Yet, further growth in excess liquidity appears likely in the foreseeable future as central banks are far from done with quantitative easing, and we deem a V-shaped economic recovery to be unlikely.

Asset markets supported: We have argued repeatedly over the years that the ups and downs in excess liquidity have been key drivers of past asset booms and busts... The mother of all credit and housing bubbles was also fuelled by the surge in excess liquidity that started in 2002, just as the downturn in excess liquidity in the G5 from 2006 onwards and in the BRICs from mid-2007 foreshadowed the crisis of 2007/08.

This time around, it doesn't seem to be any different. Risky assets such as equities, credit and commodities have rallied over the past few months as excess liquidity has surged. The ‘wall of money' has dominated the (justified) concerns about the outlook for corporate earnings and the implications of deleveraging in the financial sector and the private household sector. Whether the rally in risky assets can continue remains to be seen... our analysis suggests that there is plenty of liquidity around - and more coming - to support asset prices.

Global bottoming is near: Also, our view expressed in January that the massive liquidity injections by central banks would find traction and help to end the recession in the course of this year appears to be on track... While the bank lending channel remains impaired, easy monetary policy has been affecting the global economy through several other channels, including asset markets, inflation expectations and cross-border money flows into countries pegging to the dollar, such as China...

Deflation fears dispelled: Finally, decisive monetary action has in fact helped to dispel the fears of lasting deflation that were so widespread around the turn of the year. Market-based measures of inflation expectations have increased significantly from very low levels back to more normal levels over the past several months. In our view, however, inflation expectations still look too low and could move substantially higher once markets start to focus more on the potential implications of the monetisation of government debt that is currently underway...

Sovereign risk = inflation risk: Indeed, there are some signs that, over the past week or so, investors have started to worry about inflation risks. While the headlines have been dominated by concerns about sovereign risk and potential sovereign downgrades, we find it interesting that the accompanying rise in nominal bond yields has been almost entirely due to a rise in breakeven inflation rates, rather than real yields. This makes sense as the risk of a sovereign default for countries such as the US, where government debt is denominated in the domestic currency, is virtually zero. If needed, the central bank will simply be instructed to print more money to service the debt. Thus, sovereign risk in these cases is really inflation risk, and should be reflected in rising breakeven inflation rates.

Bottom line: Reviewing the evidence to date, we conclude that the new global liquidity cycle, which started late last year, is alive and kicking. Excess liquidity has surged, asset markets have rallied, the global economy looks set to bottom out, fears of lasting deflation have been dispelled, and inflation risks are on the rise. With quantitative easing still in full swing and the economic recovery in 2H09 expected to be rather anaemic, we believe that there is no early end in sight for this liquidity cycle.

Understanding Recent Economic History

The Economist magazine has an article on what it sees as the beginning of a new global economic order. In the article, the history of international monetary systems up through the present economic crisis is reviewed. Here is an excerpt from this history that I particularly liked:

The post-Bretton Woods system worked well, engendering the long period of low inflation and steady growth known as the Great Moderation. But one of the reasons for its apparent success—the growth of India and China—may have sparked its demise. The addition of these two great nations to the international financial system was a supply shock that put downward pressure on inflation rates.

As Stephen King, an economist at HSBC, has pointed out, the result might have been a benign deflation that boosted Western living standards. But central banks struggled to avoid a deflationary outcome; the result was a loose monetary policy that encouraged asset bubbles. Those bubbles lasted longer than expected because the flood of savings from developing markets held down the risk-free rate.

This is spot-on analysis by The Economist. I make a similar argument in this recent article in the Cato Journal.

The First Crack in the Fed's Armor

The WSJ is reporting that former NY Fed President and now U.S. Treasury Secretary Timothy Geithner admitted that the loose monetary policy of the Fed and other central bankers in the early-to-mid 2000s contributed to the economic imbalances that led to this current economic crisis:

I would say there were three types of broad errors of policy and policy both here and around the world. One was that monetary policy around the world was too loose too long. And that created this just huge boom in asset prices, money chasing risk. People trying to get a higher return. That was just overwhelmingly powerful...It was too easy, yes. In some ways less so here in the United States, but it was true globally. Real interest rates were very low for a long period of time.

For all the grief the Treasury Secretary is receiving, he should be given credit for this admission of policy failure. I would note, though, that monetary policy was highly expansionary across the globe primarily because it was expansionary in the United States. As I have noted earlier:

The Fed is a is a monetary hegemon. It holds the world's main reserve currency and many emerging markets are formally or informally pegged to dollar. Thus, its monetary policy is exported across the globe. This means that the other two monetary powers, the ECB and Japan, are mindful of U.S. monetary policy lest their currencies becomes too expensive relative to the dollar and all the other currencies pegged to the dollar. As as result, the Fed's monetary policy gets exported to some degree to Japan and the Euro area as well. (See this post on evidence for U.S. monetary policy being exported to ECB.) The global liquidity glut story seems most compelling for the 2002-2004 period when the Fed's policy rate was negative in real terms and below the growth rate of productivity (i.e. the fed funds rate was below the natural rate). Thus, its highly accommodative monetary policy during this time was exported to the world.

I am hoping the Secretary's admission will open the door for a mea culpa from those Fed officials who actually oversaw U.S. monetary policy at this time. If we are to learn from this experience we need to come clean on all the contributors to this economic crisis.

The Shadow Open Market Committee

The Shadow Open Market Committee recently put on a panel discussion at the Cato Institute. Here are the participants and their talks:

1. Michael Bordo, Rutgers University, "The Great Contraction 1929–1933: Are There Parallels to the Current Crisis?"
2. Charles Calomiris, Columbia University, "The Dos and Don'ts of Financial Regulatory Reform" and "TALF and PPIP: Will they Work to Unclog the Financial Plumbing?"
3. Marvin Goodfriend, Carnegie Mellon University, "We Need an Accord for Fed Credit Policy"
4. Mickey Levy, Bank of America, "What's in Worse Shape, the Economy or Fiscal Policy?"
5. Bennett McCallum, Carnegie Mellon University, "China, the U.S. Dollar, and SDRs";
6. Anna Schwartz, NBER, "Boundaries Between the Fed and the Treasury"

The panel was moderated by Gregory Hess and can be viewed here.

How to Make a New Reserve Currency

As a follow up my earlier posts on the SDRs as reserve currency, here are two related article worth reading. The first one is by Owen Humpage of the Cleveland Federal Reserve who does a nice job quantifying why the dollar is the reserve currency. Humpage concludes the SDRs are unlikely to supplant the dollar anytime soon. The second article is from Barry Eichengreen who agrees there are many hurdles to clear before the SDRs could become a reserve currency. Eichengreen, however, does spell out some ways to clear these hurdles:

If China is serious about elevating the SDR to reserve-currency status, it should take steps to create a liquid market in SDR claims. It could issue its own SDR-denominated bonds. Better still, it could encourage other G-20 countries to do likewise. They would pay a price, since investors in these bonds would initially demand a novelty premium. But nothing is free. That price would be an investment in a more stable international system.

Of course, an earlier attempt was made to create a commercial market in SDR-denominated claims. Back in the 1970’s, there was some limited issuance of SDR-denominated liabilities by commercial banks and SDR-denominated bonds by corporations. But these efforts ultimately went nowhere. The dollar being more liquid, its first-mover advantage proved impossible to surmount.

Overcoming that advantage now would require someone to act as market-maker for private as well as official transactions and subsidize the market in its start-up phase. The obvious someone is the IMF. The Fund could stand ready to buy and sell SDR claims to all comers, private as well as official, at narrow bid/ask spreads competitive with those for dollars.

The dollar originally acquired international currency status in the 1920’s, when the newly established Federal Reserve started buying and selling dollar acceptances, backstopping the market and enhancing its liquidity. If the international community is serious about the SDR as an international currency, it will have to empower the IMF to do likewise.

Again, there would be a cost. The IMF would be using real resources to subsidize the market until private market-makers saw it as attractive to provide those services at comparable cost. The Fund’s shareholders would have to agree to incur those costs. But, again, what is this if not an investment in a more stable global monetary system?

Transforming the SDR into a true international currency would require surmounting other obstacles. The IMF would have to be able to issue additional SDRs in periods of shortage, as when the Fed provided dollar swaps to ensure adequate dollar liquidity in the second half of 2008. At the moment, countries holding 85% of IMF voting power must agree before SDRs can be issued, which is no recipe for liquidity.

The IMF’s management would also have to be empowered to decide on SDR issuance, just as the Fed can decide to offer currency swaps. For the SDR to become a true international currency, in other words, the IMF would have to become more like a global central bank and international lender of last resort.

Working through the IMF and its member countries makes some of the above suggestions difficult. I wonder if there might be a role for an Asian Monetary Fund in China's efforts to promote an alternative reserve currency.

Assorted Musings

Here are some assorted musings piled into one post.

1. Just when the IMF thought it was becoming relevant again, the Asian Development Bank Fund moves closer to establishing an Asian Monetary Fund.
   
2. Ben Bernanke is feeling the heat. Congress is planning televised hearings on whether Bernanke and Paulson pressured Ken Lewis and Bank of America (BoA) to be quiet and complete its acquisition of Merrill Lynch after BoA found out there were more problems with the bank. The WSJ reports that the congressional "review of documents, notes from phone conversations involving Federal Reserve officials and other information suggest 'there's fire there.' "
3. Wow. Ben Bernanke was interested in pushing the federal funds rate to 0% in 2003. One can only imagine how much more pronounced the housing bubble and subsequent financial collapse would have been had the policy rate hit 0%.
4. I listened to Russ Robert interview Ed Leamer on EconTalk (while doing grades!). One interesting point that Leamer makes is that no matter what has hit the the U.S. economy it has always returned to its trend growth rate of just over 3% per annum. While this consistency is a remarkable, what I find even more amazing is that the level of the U.S. economy seems to follow a deterministic trend. One striking example of this can be seen by looking at the log level of the U.S. economy after the Great Depression. The U.S. economy is where it would have been--based on a linear trend--had there been no Great Depression! This can be seen in the figure below (click on it to enlarge):
   

In short, the eyeball test seems to indicate that over the long run the U.S. economy is trend stationary not difference stationary. (Menzie Chinn provides some formal evidence that my eyeball test is correct.) It is almost as if this trend is a constant of nature.

Martin Wolf on Monetary Policy Mishaps

Martin Wolf has a great column on how monetary policy in the early-to-mid 2000s contributed to the buildup of economic imbalances that in turn led to the current economic crisis. Here are some key excerpts with my comments interspersed:

Just over five years ago, Ben Bernanke, now chairman of the Federal Reserve, gave a speech on the “Great Moderation” – the declining volatility of inflation and output over the previous two decades. In this he emphasised the beneficial role of improved monetary policy. Central bankers felt proud of themselves. Pride went before a fall. Today, they are struggling with the deepest recession since the 1930s, a banking system on government life-support and the danger of deflation. How can it have gone so wrong?

[...]

First, John Taylor of Stanford University, a former official in the Bush administration, argues that the Fed lost its way by keeping interest rates too low in the early 2000s and so ignoring his eponymous Taylor rule, which relates interest rates to inflation and output. This caused the housing boom and the subsequent destructive bust.

Prof Taylor has an additional point: by lowering rates too far, the Fed, he argues, also caused the rates offered by other central banks to be too low, thereby generating bubbles across a large part of the world. In retrospect, for example, the autonomy of the Bank of England was much smaller than most imagined: the wider the interest rate gap vis-a-vis the US, the more “hot money” flowed in. This induced a lowering of standards for granting credit and so a credit bubble.

David here. Martin Wolf and John Taylor are correct, but there is an even stronger argument to made here about the Fed: it is a monetary superpower because it manages the world's reserve currency. As a result, many countries either formally or informally peg to the dollar and import their monetary policy from the Fed. This means the Fed's easy monetary policy in the early-to-mid 2000s created a global liquidity glut. The ECB and the Bank of England, therefore, not only had to keep an eye on low U.S. interest rates, but also on low interest rates in the dollar block countries lest their European currencies appreciated too much. In short, the Fed's easy monetary policy at this time was exported across the globe. Back to Martin Wolf:

Second, a number of critics argue that central banks ought to target asset prices because of the huge damage subsequent collapses cause. As Andrew Smithers of London-based Smithers & Co notes in a recent report (Inflation: Neither Inevitable Nor Helpful, 30 April 2009), “by allowing asset bubbles, central banks have lost control of their economies, so that the risks of both inflation and deflation have increased”.

[...]

Finally, economists in the “Austrian” tradition argue that the mistake was to set interest rates below the “natural rate”. This, argued Friedrich Hayek, also happened in the 1920s. The result is misallocation of resources. It also generates explosive growth of unsound credit. Then, in the downturn – as the American economist, Irving Fisher, argued in his Debt-Deflation Theory of Great Depressions, published in 1933 – balance-sheet deflation will set in, greatly aggravated by falling prices and shrinking incomes.

Whichever critique one accepts, it seems clear, in retrospect, that monetary policy was too loose.

David here. One can reasonably incorporate all three views, a kind of hybrid Keynesian-Austrian perspective where the Fed tries to stabilize nominal spending while monitoring systemic risk in the financial system. George Selgin has some good ideas on how to stabilize nominal spending while the folks at the BIS, particularly Claudio Borio, have some interesting ideas on a macroprudential approach to economic policy. I really hope that as observers cotinue to reflect over what caused this crisis the role of monetary policy will not be ignored.

Making the Right Call

Andy Xie had a recent article in the FT that has caught the attention of Mark Thoma, Brad DeLong, Yves Smith and others. The crux of the article is that the reserve status of the dollar is dependent on China's faith in the U.S. economy and its economic policies. Lately, that faith is waning and if unchecked could cause China to accelerate its move away from the dollar. Since China holds about $1.5 trillion in dollar reserves and is a leader in the Asian world, any move by it to unload its dollar holdings would most likely be followed by other nations and investors and lead to the end of the dollar's reserve status.

There have been variations of this story told for sometime now, but coming from Andy Xie it is worth hearing again. This is because he was incredibly prescient in calling this economic crisis long before it started. Here is what he said way back in 2004:

The global economy has experienced a positive capacity shock through globalization. The need to find an equilibrium should have caused a downward price level adjustment in the developed economies. Instead, monetary authorities, mainly the Fed, are using cheap money to fight this adjustment, causing a massive property bubble that creates superficial demand and stops prices from declining. However, as soon as the bubble bursts, the world will need a bigger downward adjustment because of the extra capacity formed during the bubble.

Most importantly, so much debt has been created that it may lead to debt deflation. Globalization would have caused benign deflation that benefits consumers and causes some industries to relocate to lower-cost locations. But fighting against this sort of deflation with bubbles and debts must lead to deflation...

When the global property bubble bursts, debt deflation could ensue. It is always possible that the Fed could create another bubble to postpone the inevitable. For example, direct purchase of US Treasuries to push the 10-year yield down to 2% could create another property bubble. However, the Fed may repent and Mr. Greenspan could retire. It may not be profitable to bet on the next bubble.

In short, he believed the well-intended but misguided response to offset the benign deflationary pressures in 2003 would ultimately lead to malign deflationary pressures in the future. He made this call in 2004 and that is why it is worth listening to him now.

Update: Rebecca Wilder in the comments section and Chevelle over at Models and Agents question Xie's claims.

Merle Hazard: "Will we Become Zimbabwe or will we be Japan?"

Is the United States is about to fall into a deflationary spiral or is it on the brink of run-away inflation? Allan Meltzer has looked at the near-zero interest rates, the blow up of excess bank reserves, and the more than doubling of the Fed's balance sheet and is certain that the United States is set to repeat its 1970's experience with inflation. Paul Krugman, on the other hand, takes a look at the large negative output gap and declining wages and sees deflation as a more likely threat. What are we to make of this debate? As noted by Mark Thoma and Martin Feldstein, the answer is that both outcomes are possible; it is just a question of timing. In the near term there is no doubt that the clear and present danger is deflation as domestic demand continues to collapse. At the same time, the Fed's vigorous (if somewhat haphazard) monetary expansion intended to stabilize nominal spending and prevent deflation will be very difficult to reverse once the recovery begins. If so, inflation will become a major problem. So brace yourself for the possibility of deflation in the near term, but plan in the mid term for the specter of inflation.

For further clarity on these issues I present Mr. Merle Hazard and his sidekick Mr. Bretton Wood:

Encouraging News

Throw in some sustained productivity growth to this good news on demographic trends and we may just dodge some of the looming funding problems for entitlement programs in the United States:

Something dramatic has happened to the world’s birthrates. Defying predictions of demographic decline, northern Europeans have started having more babies. Britain and France are now projecting steady population growth through the middle of the century. In North America, the trends are similar. In 2050, according to United Nations projections, it is possible that nearly as many babies will be born in the United States as in China. Indeed, the population of the world’s current demographic colossus will be shrinking. And China is but one particularly sharp example of a widespread fall in birthrates that is occurring across most of the developing world, including much of Asia, Latin America, and the Middle East.

This is from Martin Walker in the Wilson Quarterly (HT Freakonomics).