Monday, September 22, 2014

The Love Affair Conservatives Should Be Having

Paul Krugman and Josh Barro are going after conservatives for their "new love affair with Canada". They claim conservatives are incorrect to view Canada's successful fiscal consolidation in the 1990s as evidence of  "expansionary austerity." Here is Krugman:
Canadian austerity in the 1990s was offset by a huge positive movement in the trade balance, due to a falling Canadian dollar and raw material exports...Since we can’t all devalue and move into trade surplus, this meant that the Canadian story in the 1990s had no relevance at all to the austerity debate of 2010.
Actually, the Canadian story is very relevant to the austerity debate of 2010, but not in the way portrayed by most conservatives. For the Canadian story is largely about expansionary monetary policy offsetting contractionary fiscal policy. The Canadian dollar's fall was not some random event, but the result of concerted efforts by the Bank of Canada to counter the drag of fiscal austerity. This is an important story and it is not the first time it has transpired. About fifteen years earlier the Bank of England also used monetary policy to offset fiscal policy. Ramesh Ponnuru and I wrote about it these experiences back in 2012 in The Atlantic:
The Bank of England vividly demonstrated the power of central banks to offset fiscal policy at the dawn of the Thatcher era. In 1981 her government introduced a budget that would sharply reduce the deficit in the midst of a recession. Most economists opposed it on Keynesian grounds, with 364 of them signing a now-famous letter arguing there was "no basis in economic theory or supporting evidence" for it. Yet the Thatcher government implemented its plan and by late 1981 the economy was recovering. The Bank of England at the same time had begun a cycle of monetary policy easing, and the economists had underestimated its effects.
Something similar happened in Canada in the mid-1990s. After running several decades of budget deficits that had led to a debt-to-GDP ratio of 70 percent in 1995, then-Finance Minister Paul Martin introduced a budget plan that began a half decade of reducing the federal budget, largely through cuts in spending. This fiscal tightening led to budget surpluses by the early 2000s. As in the British case, the Bank of Canada eased monetary policy over the same time, offsetting any fiscal drag. The economy performed nicely.
The U.S. economy over the past two years has exhibited the same pattern. Since mid-2010, total federal expenditures, measured in dollars, have trended down. The budget deficit as a share of the economy has fallen more than 2 percent over this time. This fiscal tightening has taken place in the midst of a barrage of economic shocks including the Eurozone crisis, the 2011 debt ceiling talks, and concerns about an Asian economic slowdown that have kept economic uncertainty elevated. Yet nominal spending has been incredibly stable, growing at about 4.5 percent a year. The recovery has been sluggish, but the Fed appears to have kept fiscal contraction and other economic shocks from ending it.
So yes, the Canadian experience was very relevant in 2010. And it became even more relevant in 2013 when budget sequestering further tightened fiscal policy. In fact, the context of the above article was the "fiscal cliff" crisis of 2012 that led up to the sequester. We were arguing back then the Fed, like the Bank of England and the Bank of Canada, had the ability to offset the looming fiscal austerity of 2013. Paul Krugman, on the other hand, was worried the spending cuts would further depress the economy. Here, for example, was an October, 2012 comment by Krugman:
[T]he only reason to worry about the fiscal cliff is if you’re a Keynesian, who thinks that bringing down the budget deficit when the economy is already depressed makes the depression deeper.
Fortunately, the Fed started QE3 and the Evans Rule about that time. We believed that though these programs were far from perfect--they were not properly designed to restore full employment--they had the potential to at least offset the fiscal austerity of 2013 even with a binding zero lower bound (ZLB). As Mike Konczal noted our views would be put to the test in 2013. The year 2013, therefore, would provide a natural experiment of sorts that would test whether monetary policy could offset contractionary fiscal policy at the ZLB. Even Paul Krugman recognized this point: 
On the right are the market monetarists like Scott Sumner and David Beckworth, who insist that the Fed could solve the slump if it wanted to, and that fiscal policy is irrelevant... [A]s Mike Konczal points out, we are in effect getting a test of the market monetarist view right now, with the Fed having adopted more expansionary policies even as fiscal policy tightens.
And let's be clear: fiscal policy was tightening. The IMF's cyclically-adjusted government budget balance as a percent of potential GDP showed fiscal policy had been tightening since 2010. It just tightened more so in 2013. This natural experiment would put all the Keynesians, Post-Keynesians, and sectoral-balance theories to the test. Many of these folks made dire predictions about the sequester. There are many I could list, but one predicted it would cost 700,000 jobs over 2013-2014.

So how did this natural experiment at the ZLB turn out? The economy did not collapse and 700,000 jobs were not lost. Real GDP maintained stable growth and over 4 million new jobs have been created so far in 2013-2014 period. More importantly, the one variable both fiscal policy and monetary policy directly affect, aggregate nominal spending, did not collapse in 2013-2014.This experiment indicates, then, that monetary policy can offset fiscal policy at the ZLB.

Conservatives should be having a love affair with this outcome. It shows that government spending can be curtailed without adverse consequences for the economy if monetary policy provides an offset. It is the same story that unfolded in Canada in the mid-1990s and the United Kingdom in the early 1980s. Conservatives need to embrace this view and run with it. It implies a reduced role for fiscal policy in stabilizing the economy.1 Some conservatives have embraced it, but most have not and continue to draw the wrong lessons from these experiences. If they want to make a convincing argument against an activist fiscal policy this is it.

P.S. Unfortunately, the many voices who were predicting doom and gloom because of the sequester have gone silent. No mea culpas from them. Their silence speaks volumes. Others, instead, point to the continued absence of full employment, but this is simply a moving of the goal posts. The original argument made by Market Monetarist was only that an offset was possible. We did not claim QE3 and the Evans Rule would restore full employment. We argued that would require something bolder like a NGDP level target.

Update: I was asked for evidence showing the Bank of Canada (BoC) explicitly eased policy in the mid-to-late 1990s. Below is a figure of their target policy interest rate corridor from a BoC report in 1998. It shows a sustained path of lowered policy interest rates--roughly 500 basis points!-- through early 1998. Here is a link to how the BoC manages its target.

1Okay, I have endorsed a NGDP-level target-based helicopter drop which is technically fiscal policy. The proposal is outlined here. The main reasons for my endorsement is to incentivize the Fed to act properly and provide insurance against central bank incompetence. This is a pragmatic proposal.

Monday, September 1, 2014

Another Bond Market Conundrum?

Is the U.S. economy in the midst of another bond  market "conundrum"? The last time we had one was in 2005 when former Fed chairman Alan Greenspan became perplexed over long-term interest rates failing to rise with the tightening of monetary policy. Some observers see something similar happening today. They note that the Fed has been tightening monetary policy with its tapering of QE3 and yet the benchmark 10-year treasury interest rate has been falling since the beginning of 2014. This conundrum gets even more interesting when one looks at the five-year treasury interest rate. It has hardly budged since the beginning of the year even as the 10-year interest rate has steadily declined. Jim Hamilton calls these developments the 'bond market condrum redux.

So what could be driving these developments? Robin Harding and Michael Mackenzie suggest it is the worsening economic conditions in the Eurozone and its implications for ECB monetary policy. Here is Harding-Mackenzie:
The link between US monetary policy and US bond yields has fallen apart this year, showing how fears of deflation in Europe are driving global financial markets. According to analysis by the Financial Times, the correlation between five- and ten-year Treasury yields has fallen to its lowest level on record, with US bonds appearing to track European monetary policy instead.


Five-year bond yields closely reflect the path of interest rates that markets expect from central banks. Ten-year yields normally move in tandem. But so far in 2014, the US ten-year has fallen from 3 per cent to 2.4 per cent – even as news on the economy has got stronger – while the US five-year yield has barely changed.

That is unprecedented: no other global shock going back to the 1960s has ever caused US five and 10-year yields to diverge like this. In recent months, the US 10-year yield has been more correlated with falling five-year yields in Europe.
I think Harding-Mackenzie may be on to something with the Euro zone-U.S. treasury yield connection. It is worth taking a closer look. To do so, we first need to recall that long-term interest rates can be broken down into the following components:

(1) long-term interest rate = average short-term interest rate expected over same horizon + term  

The term premium is the added compensation investors require for holding long-term treasuries over short-term ones. For example, if a financial panic causes a "rush to safety" by investors and they are more willing to hold long-term treasuries, then they will demand less compensation and the term premium will decline. The other component, the average short-term interest rate, is a nominal interest rate and via the Fisher relationship can be further decomposed into real interest rate and expected inflation terms:

(2) long-term interest rate = (average expected real short-term interest rate + average expected 
     inflation) +  term premium 

The average expected real short-term interest rate is typically tied to the expected growth of the economy.1 If the U.S. economic outlook is improving, it should increase and vice versa. Over the short-run it should track the business cycle while over the longer run it should track trend economic growth. It is also called the real risk-free interest rate and approximates what many macroeconomists call the natural interest rate.

Okay, with all that said we can now take a look at these components and assess the Harding-Mackenzie explanation for recent interest rate movements. The figure below shows these series since 2013 (It is constructed using the Adrian, Crump, and Moench (2013) term premium estimates and implied inflation forecasts from TIPs.)

This figure shows two interesting developments since the beginning of 2014. First, the term premium has been steadily falling. This decline could be explained by increasing worries over the Eurozone driving investors on the margin to treasury securities. This is not exactly the Harding-Mackenzie story, but it does provide a potential link between what is happening in Europe and long-term U.S. yields. 

Second, the real risk-free rate has been steadily climbing since the beginning of the year. This is consistent with the gradually improving U.S. economic outlook. As I have shown before, short-term swings in this real risk-free interest rate track the business cycle fairly closely. Consequently, this second development should not be surprising.

So on one hand the term premium is arguably falling because of Eurozone woes, while on the other hand the real risk-free rate is rising because of the improved U.S. economic outlook. The term premium decline, however, is larger and on net is dragging down the 10-year treasury yield (given stable inflation expectations).

But what about the 5-year treasury yield? The figure below provides the same decomposition as above and shows similar developments:

The big difference here is that changes in the term premium and real risk-free rate are much closer in size and therefore closer to offsetting each other. The graph below summarizes these differences. It shows similar increases in the real risk-free yield for both treasury securities, but much larger declines in risk premiums for the 10 year security.

In my view, then, the real bond market conundrum is why has the term premium falling more for the 10-year treasury? Has the flight to safety associated with the Euro crisis been weighted more toward long-term treasury securities? Or is it something else?

Update: See this Bruegel review of blogs for more the bond market conundrum.

 1It is technically tied to the expected growth of productivity, the expected growth of the labor force, and household's discount rates. See here for more on these points.