Liveblogging World War II: June 27, 1942
John Quiggin Confronts Once Again the Puzzle of John Cochrane

The Bond Market Is Terrified, or the Bond Market Is Broken: Take Your Pick

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Project Syndicate: We economists steeped in economic and financial history--and aware of the history of economic thought about financial crises and their effects as well--have reason to be very proud of our analyses over the past five years: that the rapid run-up of house prices coupled with the extension of leverage posed macroeconomic dangers, that the recognition of large bubble-driven losses in assets held by leveraged financial institutions would cause a panicked flight to safety, that to prevent a deep depression required active intervention of the government as a lender of last resort, that monetarist cures were likely to prove insufficient, that sovereigns needed to guarantee each others' solvency, that there were enormous dangers in withdrawing support too soon, that premature attempts to deal with long-run budget balance would worsen the short-run catastrophe and be counterproductive even in the long-run, that we faced the threat of a jobless recovery not from any structural changes but from cyclical factors--on all of these we were right.

Our intellectual adversaries, who said, variously, that there would be no downturn, or that bounceback would be rapid, or that the economy's real problems were structural, or that supporting the economy would produce inflation, or produce high short-term interest rates, that the Confidence Fairy was on the way, or that immediate fiscal austerity would be expansionary--they were wrong, and completely wrong. We were not surprised that they were wrong. (We are, however, surprised at how very few of them have marked their beliefs to market in any sense--how many of them have octupled-down with their reputations underwater, and thrown the dice one last time in the hope that events will, for once, break their way and they can induce people to forget their track record.)

The big lesson is, therefore: trust those who work in the tradition of Bagehot, Minsky, and Kindleberger--Krugman, Romer, Gorton, Reinhart, Rogoff, Rajan, Wolf, Summers, Eichengreen, Blanchard, and their peers. As they got the recent past right, so they are most likely to get the distribution of possible futures right.

But we--or at least I--have gotten three significant pieces of the past four years wrong. Three things surprised and still surprise me:

  1. The failure of central banks to adopt a rule like nominal GDP targeting, or it's equivalent.
  2. The failure of wage inflation in the North Atlantic to fall even farther than it has--toward, even if not to, zero.
  3. The failure of the yield curve to sharply steepen: federal funds rates at zero I expected, but 30-Year U.S. Treasury bond nominal rates at 2.7% I did not.

The first remains incomprehensible to me, and I will not write a column about it until I think I understand it.

The second remains a surprise: even with 1/3 of the American labor force changing jobs every year, sociological factors and human network ties appear to exercise an even stronger influence on the level and rate of change of wages at the expense os balancing supply and demand than I would have credited.

The third, however, may be most interesting.

Back in March 2009, the University of Chicago's Robert Lucas confidently predicted that within three years the U.S. economy would be back to normal. A normal U.S. economy has a short-term nominal interest rate of 4%. Since the 10-Year U.S. Treasury bond rate tends to be one percentage point more than the average of expected future short-term interest rates over the next decade, even five expected years of a deeply depressed economy with essentially zero short-term interest rates should not push the 10-Year Treasury rate below 3%. (And, indeed, the Treasury rate fluctuated around 3 to 3.5% for the most part from late 2008 through mid 2011.) But in July of 2011 the 10-Year U.S. Treasury bond rate crashed to 2%, and at the start of June it was below 1.5%. The normal rules of thumb would say that the market is now expecting 8 3/4 years of near-zero short-term interest rates before things return to normal. And similar calculations for the 30-Year Treasury bond show even longer and more anomalous expectations of continued depression.

The possible conclusions are stark: either those investing in financial markets expect economic policy to be so dysfunctional that current global depressed economy to endure in more-or-less its current state for perhaps a decade, perhaps more; or--even now, more than three years after the end of the financial crisis--the ability of financial markets to do their job and sensibly price relative risks and returns at a rational level has been broken at a deep and severe level, a level that makes them incapable of doing their proper job of bearing and managing risk and channeling savings to risky and entrepreneurial ventures.

Neither alternative is something I would have or did predict, or even imagine.

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