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Tuesday, June 9, 2009

David Takes On Goliath and Loses: The Ferguson - Krugman Exchange

By Edward Hugh: Barcelona

"As long as excessive debt is not digested, both monetary and fiscal policies are inefficient. There is not much of an alternative. Either to let the economy collapse, in order to reduce debts, and then use fiscal policy to revive it, or inundate the insolvent economy with public credit, to avoid the collapse, and loose the ability of fiscal policy to pull it out of a prolonged lethargy. Either a horrible end or an endless horror."
After the Crisis: Macro Imbalance, Credibility and Reserve-Currency: André Lara Resende

Well, I think the title to this post makes my view on the high-profile shenanigans we are currently witnessing on the part of two widely respected contemporary intellectuals clear enough, even if Paul would probably respond that he is perfectly well able to take care of himself, thank you very much. Nonetheless, looking at the way the tone of his most recent and most public debate with Niall Ferguson has deteriorated (yes, it is Niall I'm talking about here, and not Sir Bobby, although sometimes even I have my doubts), let me confess, I am not entirely convinced on this point (Niall Ferguson's argument can be found summarised in his Financial Times Op-Ed here, and in his rejoinder letter to Martin Wolf reproduced by the FT Alphaville's ever interesting Izabella Kaminska here, while Paul Krugman's "input" to the debate can be found here, here, and here).

So, since the thunder and lightening that such high profile exchanges generate tends to obscure more than it reveals, let me be so bold as to add my own 2 centimes worth - even if, apologies in advance, the whole affair ends up being most terribly "wonkish". If you want to save yourself a good deal of trouble, and heart searching, the central point is a simple one: are long term US interest rates rising because investors are worrying about having to buy so much public debt (as K would point out, what else were they thinking of doing with the money - which isn't really "money" at all, but, oh, never mind), or are they rising because investors expect the time path of US short term interest rates to move steadily upwards? It's as easy, or as hard, as that. So now, you decide!

Someone To Watch Over You

Amidst so much disagreement one point is, at least, agreed common ground: Paul Krugman is a macro economist, while Niall Ferguson is a historian, one who believes, if we are to take him at his word, that cats may sometimes look at kings, and live to tell the tale. Let's see if he's right.

The other point we are all agreed on, I think, is that yields on 10 year US treasuries have been rising of late, and this phenomenon lies at the heart of the debate. Indeed, if I read him aright, this is Niall's main point of current concern.
On Wednesday last week, yields on 10-year US Treasuries – generally seen as the benchmark for long-term interest rates – rose above 3.73 per cent. Once upon a time that would have been considered rather low. But the financial crisis has changed all that: at the end of last year, the yield on the 10-year fell to 2.06 per cent. In other words, long-term rates have risen by 167 basis points in the space of five months. In relative terms, that represents an 81 per cent jump.
Where we are not agreed - the economists and the historians among us that is - is over the significance to be placed on this evident fact. Although, having said this, Niall does rather seem to suggest that the development is some sort of litmus test for his view, since he argues it "settled a rather public argument between me and the Princeton economist Paul Krugman". Now what was it they used to say about rushing in where angels fear to tread!

Of course, Niall is no fool, he is an excellent historian, and I greatly enjoy reading his books, but he really, really should know better than to get himself involved in the kind of technical argument which his experience and background ill equips him for. Citing the Chinese central bank as authority for your monetary views (see below) may go down well with the after dinner port-and-stilton set, but it is hardly rigorous argument, and Niall must surely well know that.

It's The Expectation On Long Term Yield, Silly!

The Fed probably won’t make any adjustments to the size of the Treasury purchase program before its next policy meeting on June 23-24, in part to avoid reinforcing perceptions policy is reacting to swings in yields, according to Jim Bianco, president of Chicago-based Bianco Research LLC.

“The Fed wants to operate in predictable ways,” Bianco said. “They are also trying to not just look arbitrary, which makes people think ‘I can’t ever go to the bathroom because there could be a press release that the Fed changed the buybacks.’ That’s been a real concern: ‘Wow, I just went to the bathroom and lost $2 million dollars.’”

The thing you should always bear in mind when you enter the fray in areas where others have the benefit of the expertise is that there may be more than one available interpretation for the phenomena, and, as is so often the case in science, the counter intuitive explanation may have more going for it than the layman may grant at first sight (wasn't that the sun I just saw hurtling past across the sky). In this sense, the recent rise in long term US treasury interest rates has just provided some of us with a fascinating example of a phenomenon that those economists who have busied themselves studying the use of quantitative easing in Japan have been flagging for some time, and that is, that long term interest rates may indeed be unduly influenced by longer term inflation expectations, but not necessarily in the way laymen Niall and others may imagine they are.

Longer term inflation expectations - or so it is argued by a broad spectrum of monetary economists - may work against the fluid operating of a quantitative easing regime in or on the boundary of a liquidity trap, not because investors fear that a country like the United States is about to become the new Zimbabwe, but precisely because they know it won't. Indeed, as I frequently find myself saying of late, the United States is not Argentina, gee, it isn't even Italy, by which I mean that investors know perfectly well how Ben Bernanke and his colleagues over at the Federal Reserve will react to a situation where inflation is perceived as rising above their target range - they will start to raise short term interest rates, and it is this expectation of future increases in short term rates which ironically cause longer term interest rates to rise, in just the way they are doing right now, in what is almost a text book case study in the United States. As Krugman's former PhD student Gauti Eggertsson put it in one highly relevant paper (Eggertsson and Ostry: 2005, see references below).

A central bank following a Taylor rule raises interest rates in response to inflation above target and output above trend. Conversely, unless the zero bound is binding, the central bank reduces the interest rate if inflation is below target or output is below trend (an output gap). If the public expects the central bank to follow the Taylor rule, it anticipates an interest rate hike as soon as there are inflationary pressures in excess of the implicit inflation target. If the target is perceived to be price stability, this would imply that quantitative easing has no effect, because commitment to the Taylor rule would imply that any increase in the monetary base would be reversed as soon as deflationary pressures had subsided.
Indeed talking of the Taylor rule, none other than John Taylor himself recently came out and argued that -applying his rule - the Federal Reserve would need to start once more to raise interest rates in the near future, “My calculation implies we may not have much time before the Fed has to remove excess reserves and raise the rate,” he said recently at an Atlanta Fed conference. And if John can do the calculations so too can other investors.

Of course the United States Federal Reserve is not at this point following a Taylor-type rule (although Bernanke is a known supporter of some sort of inflation targeting) but let us not get bogged down in that minor, rather technical detail, the key issue is that long term interest rates are influenced more by the expected time path of short term rates than by any other single factor, and if, instead of beating about the bush, we go right to the heart of the matter, what do we find, well Lo & Behold, only last Friday:

The dollar advanced the most against the yen in more than three months and rose versus the euro as economic data showed evidence the U.S. recession is easing, boosting demand for the nation’s assets. The greenback climbed this week as a government report indicated slower deterioration of the labor market, supporting bets dollar-denominated assets will gain as the U.S. leads the global economy out of its slump.....

The dollar also gained against the yen on speculation the Federal Reserve will raise interest rates later this year, reducing the advantage of borrowing in the U.S. to fund purchases elsewhere. Traders added to bets the central bank will increase its target rate for overnight loans between banks by its November policy meeting, according to futures traded on the Chicago Board of Trade. The contracts show a 66 percent chance of a rate increase by then,compared with 24 percent odds a week ago.
Well, there you are, investors (I have no idea whether they are being rational or not) simply act as theory predicts, and chaffe at the bit (sometimes called "getting ahead of themselves") to take positions in anticipation of expected future hikes in US interest rates, something which sends rates rippling upwards all along the yield horizon. Incidentally, can someone kindly tell me where I have to write to become a formal member of the "Thank God For Bloomberg" brigade, since where would we really be without those dedicated scribes, who will, incidentally, obviously provide so much material for future generations of historians? (Incidentally, you can find a very good summary of just what a headache the volatility in US government bonds is proving to be for Bernanke in this Bloomberg article, from which the Bianco quote above was taken).

So, far from the position being as Niall imagines it is, with investors demanding enhanced premiums for holding US assets due to their fear of impending inflation, what we have here is a kind of see-saw process, whereby bad economic data, which leads investors to anticipate interest rates being held low in the US for some considerable time, raises risk sentiment (see this post: Don't Get Carried Away Now) and sends them off into riskier emerging market assets (with Big Ben playing sheet anchor) in the process sending the grenback to ever lower levels, while positive economic news makes playing carry with the USD as one of your currency pairs increasingly riskier, and thus leads the punters themselves to retreat, sending the dollar cruising back up again. All of which is very counterproductive, since given the knife edge character of the current US "recovery" all it does is slow things down (since the cheaper USD is good for exports) and ramp up the deflationary pressure.

But this story about investors being nervous about holding US Treasuries due to the high inflation risk, well, as far as I am concerned, go tell it to the marines, or at least to the those people over at the Chinese central bank (you know, the ones who have been running up all those dollar reserves) who Niall seems to regard as his economic authority in these matters.

"Monetary expansion in the US, where M2 is growing at an annual rate of 9 per cent, well above its post-1960 average, seems likely to lead to inflation if not this year, then next. In the words of the Chinese central bank’s latest quarterly report: “A policy mistake ... may bring inflation risks to the whole world.”"
What we have here, is what the late Niklas Luhman would have termed a "narrative discourse". Repeating the same arguments ad infinitum may produce a pleasing to sensation among those who have convinced themselves they are right, but that does not make them "true", nor is it a substitute for rigourous economic analysis, or a basic understanding of what is actually going on. As I say, it does go down well with the port and stilton set though, and would undoubtedly make one VI Ulyanov (aka Lenin) turn merrily over in his mausoleum, since evidently he was right: "every cook can and does govern".

But back to the basic thread, putting all this pressure on public officials at this point is a completely counterproductive exercise, since the surge in long term interest rates - produced by the rise in expectations that the central bank will move to reign-in inflationary pressures sooner rather than later, simply leads to further signs of weakness in the US economy, which means the expectation once more grows that rates will stay lower longer, and on and on we go. But of course, as Niall Ferguson points out, it is none other than Bernanke himself who has most recently and most evidently been expressing concern about the future size of the Federal deficit, and again this would seem to me to be a reflection of the political pressure that this mistaken narrative is exerting. Accodring to the Wall Street Journal:

The Fed must decide, perhaps as soon as its June 23-24 policy meeting, whether to increase its purchases of Treasury bonds. It is on course to buy $300 billion worth of bonds by September. If investors perceive the Fed's actions as an effort by the central bank to facilitate bigger deficits, they could conclude inflation is coming and flee Treasurys, pushing interest rates up. Mr. Bernanke's comments were aimed at thwarting that perception.
Counter intuitively, the only real way to break this spiral is for Bernanke to commit to holding rates near the zero bound for an extended period of time - or to "commit to being irresponsible" in the immortal words of Eggerston and Woodford. At this point I find myself asking if it isn't the whole suite of Princeton monetary economists - including Lars Svennson - that Niall doesn't like (but remember, Bernanke also came from Princeton, and is certainly no Keynesian, so the simple version of the discourse doesn't work) rather than his simply holding Krugman in bad rather odour, which I could have understood more as a dislike of his fairly well known political views than as a rejection of a far more technical corpus of economic analyses, which I am sure Niall would have to admit he has not enetered into sufficiently to be able to pass judgement on. Arguing against what has to be the strongest group of academic monetary economists on the planet (and leaning on the "savants" of the Bank of China for support) may appeal to basic anti-intellectual gut instincts, but there's the rub: Niall is himself an intellectual.

Personally, I have no idea whatsover as to the properties semi-conductors may exhibit at temperatures below absolute zero, but then I would not join issue with a theoretical physicist who mentioned preposterous sounding processes by starting off saying "well when I heat milk in a saucepan, eventually it boils" Still, if you are foolish enough to stick your neck in the noose, in the noose it will go!.

As Eggertsson points out in the Japan context long-term interest rates depend on expectations about future short-term interest rates and the risk premium, and neither of these depends on the quantity of long-term bonds in circulation or on the monetary base at zero interest rates (my emphasis thoughout), and this is a technical finding - which may ultimately be right or wrong, but I doubt that the opinion over at the Chinese central bank counts as evidence one way or another, nor does it seem reasonable to strongly assert as evidence of inflation risk that a growth in M2 of 9 per cent a year "seems likely to lead to inflation if not this year, then next", since this is just the theoretical issue economists are struggling with at the moment (to what extent an increase in base money feeds through to an increase in economic activity such that the "output gap" would start to shrink). Without a much more rigourous technical analysis, and some examination of recent history, you just can't make this sort of claim, but in any event if Niall has good reason for being so sure about this, then the people over at the Bank of Japan would almost certainly like to hear from him.

And then, getting horribly wonkish, we have the whole debate about the so called "portfolio channel", and how expectations for increases in short term interest rates can even undermine the efficacy of one of Bernanke's most beloved tools -government purchases of long term bonds to lower rates at the longer end of the yield curve in the short term (see Bernanke and Reinhart: 2002), since according to the findings of Eggertsson and Woodford (2003), and basing themselves on assumptions implicit to any general equilibrium model, purchases of long-term government bonds have no effect on long-term yields if expectations about future interest rates remain constant. While discussing the experience of quantiative easing as used by the Bank of Japan (BoJ), Eggertsson already foresaw the liklihood of the kind of evolution in long term bond rates which Niall feels provides such strong evidence in support of his case.

It has been suggested that the irrelevance results outlined above can fail due
to a portfolio channel (see, e.g., Meltzer, 1999; McCallum, 2000; and Coenen and
Wieland, 2003). If the monetary base is expanded by purchasing assets other than
short-term governments bonds, the BoJ may be able to change the prices of those
assets. One example is purchases of long-term government bonds, a policy the BoJ
has in fact adopted. Eggertsson and Woodford (2003), however, cast doubt on the
effectiveness of such a portfolio channel, arguing that in a general equilibrium
model, purchases of long-term government bonds have no effect on long-term
yields if expectations about future interest rates remain constant.

The reason is that the long-term interest rate depends on expectations of future
short-term interest rates and a risk premium. Neither of these, however, depends on the quantity of long-term bonds in circulation or on the monetary base at zero interest rates. Open market operations involving purchases of long-term bonds, but which provide no credible indication about the duration of the quantitative easing policy, are thus unlikely to be effective.

Of course, all of this is highly obscure and technical. Fortunately the debate does have its lighter moments, as for example when Niall cites Krugman as the point of reference for the savings glut idea:

"Did I not grasp that the key to the crisis was “a vast excess of desired savings over willing investment”? “We have a global savings glut,” explained Mr Krugman, “which is why there is, in fact, no upward pressure on interest rates."
In fact, as those of us who have been following the liquidity debate over the last years well know, the global savings glut thesis is famously an idea which was first initially advanced not by Krugman but by none other than Ben Bernanke, and even more to the point the whole issue goes back well before the onset of the present crisis. Indeed the "savings glut" issue lies at the heart of the whole "imbalances" debate, that is, it is one of the possible explanations for how we got here in the first place, and not some rabbit conveniently drawn out of a hat Paul Krugman to gain the advantage in the current debate about bonds. But if you do understand the role the savings glut thesis plays in explaining how we generated the imbalances which are now correcting, then you may see why there may not be any special problem in "placing" the large quantity of government bonds which will hit the marekt next year. But then, maybe I just hit on the core of the problem: perhaps Niall doesn't see that the US economy is correcting, and that the large current account deficit we have gotten so used to is about to become, what else, history!

The we have this:

"It is hardly surprising, then, that the bond market is quailing. For only on Planet Econ-101 (the standard macroeconomics course drummed into every US undergraduate) could such a tidal wave of debt issuance exert “no upward pressure on interest rates”."

Well I'm sorry Niall, but there is another place where a tidal wave of debt issuance has exerted “no upward pressure on interest rates”, and that place is planet Japan.

Even A Stopped Clock Is Right Twice a Day

Which takes me over to the rather historical issue of stopped clocks, and what has now been happening to Japan over the last decade and a half. At times even Daily Telegraph economics correspondent Ambrose Evans Pritchard has something interesting to say, since, of course, even stopped clocks are not wrong all the time. The point he makes here is very, very relevant:

"It is striking how many of those most alert to the deflation danger are either veterans of Japan's Lost Decade or close students of it: Albert Edwards at Société Générale, Russell Jones at RBC Capital, Nobel laureate Paul Krugman, the Fed's Ben Bernanke, and Athanasios Orphanides, who helped draft the Fed's study on the Japan trap. "People always thought Japan's bond yields had to rise, but they kept falling and Japan is still not really out of deflation," said Mr Edwards. Indeed, 20 years after the Nikkei peaked at over 39,000 it stands today at 9,280. Interest rates are 0.01pc. The yield on two-year state bonds is 0.34pc. Still there is not a whiff of inflation."

And guess what, Japan gross debt to GDP is about to push its way skywards through the 200% mark in the next year or two, which makes this retort to the FT's Martin Wolf (who had the temerity to question Niall's arguments):

Mr Wolf blithely writes: “Historically well-run economies are certainly able to support higher levels of public debt very comfortably.”His favourite macroeconomics textbook may make this claim. But the annals of history provide very few cases of economies with public debts in excess of 100 per cent of gross domestic product that were either well-run or very comfortable.
look frankly quite ridiculous, since while it may well be the case that Japan is neither well run nor a comfortable place to be (no comment, I have no opinion), it is still the world's second largest economy, so hardly an irrelevant comparison, and the Japanese government has been shoveling JGBs onto the market for years without the much predicted surge in interest rates (which doesn't mean that the US has to be the same as Japan, but it does mean that there is more to discuss here, and you can't have it so easy as Niall would like).

Well, the bottom line in all this surely is, what exactly are we being offered here, an empirically testable prediction, or just another load of old waffle?

At the end of the day what I think is, if I were a historian and not an economist, then I might like to be just a bit more modest in what I had to say (and even more modest in how I said it), be a bit more prepared to listen to those who have spent a lifetime studying these sort of problems, and then if, having done this, at the end of the day if I still found I wanted to differ from the experts I would at least try to make sure I understood what exactly it was they were trying to say first. Otherwise, I might find myself worrying that I was being more of a Xenophon than a Thucidydes, since while both were reputedly excellent generals, the latter stuck to what he was good at (namely writing history) while the former offered us (in his life of Socrates) the kind of philosophy which frankly reduced the both the author and his subject to the realm of port and stilton bufoonery. And, frankly, it would personally worry me to think that over two thousand years after the event people might still be remembering me more for what I was bad at than for any more positive contribution I might have made to the world.