Always, always the interest rate fallacy. Like last week my examination of Economics tardily discovering interesting and key facts on collateral in the world’s primary monetary arrangements, there’s some (very slight) movement in the direction of solving the related “puzzle” over persistently low rates. These are textbook stimulus yet the world hasn’t reacted to them at all in the way predicted.
This has been a long-sought problem, an unforced error in the forced transition from money-based understanding to expectations-based manipulation central banks had begun by default half a century ago.
To take some of the heat off, and to try to answer the chief financial “anomaly” of its day, before he was Chairman of the Federal Reserve in March 2005 Ben Bernanke traveled the short distance from DC to Richmond. Appearing before the Virginia Association of Economists, the then-Governor took on the roaring housing bubble and the inconsistency of risk-free rates by blaming both on foreigners.
It had been his putative boss, Alan Greenspan, who had questioned each at practically the same time. For the former, the bubble, the Federal Reserve’s official position was always the same – housing like any financial asset can get “frothy”, so it wasn’t something they worried much about. As to Treasury yields, well, that really perplexed the throngs of official Economists (Bernanke being one).
According to them, as Greenspan explained to Congress in February ’05, while his Fed had been raising rates dating back to June ’04 those outside of the short run money markets hadn’t been moving as predicted and expected. Notoriously calling this a “conundrum”, the “maestro” was puzzled, perplexed and generally unsettled; so much so that he briefly departed from his usual public fedspeak regimen, for once revealing his complete inner thoughts.
Testifying, he laid bare the textbook theory: “Ten-year [UST] yields, for example, can be thought of as an average of ten consecutive one-year forward rates.” This is the model we are all given starting at the most elementary stages of Economic schooling; the Fed, or any central bank, sits in the middle of the system, indeed the whole economy, and uses levers of arcana to set prices and rates throughout it in a seamless, predictable manner.
The series of one-year forwards implied only obedience; the Fed sets the first forward in the series, the short-term, and then each corresponding down the curve follows in direct compliance with the authored command.
But in 2005 – and continuing through the entirety of the cycle thereafter – Greenspan’s committee was voting straight rate hikes into the federal funds target bullying the short end, while the early middle out to longer parts of the yield curve remained wholly unmoved by contrast; at some points, yields there actually fell.
Conundrum, indeed.
This all occurred, as I mentioned, during the height of the housing bubble, a credit-fueled mania that no one living through it will ever forget – just as while it was unfolding it had been unmistakable except by way of the Economics textbook. Among its non-housing related symptoms was a rapidly falling dollar and the seemingly corresponding deterioration (deficit) in the American current account.
Attempting to reconcile these things, Bernanke at Richmond in March ’05 came up with his infamous “global savings glut.” The issues with the current account shortfall as well as those related to Treasury yields and housing excesses could be laid, he argued, at the feet of overseas savers. He said:
“This increased supply of saving boosted U.S. equity values during the period of the stock market boom and helped to increase U.S. home values during the more recent period, as a consequence lowering U.S. national saving and contributing to the nation's rising current account deficit.”
Governor Bernanke further proposed that a key source of this “savings glut” had been the apparent excess of worldwide Baby Boomers reaching sufficient age, wealth, and status to have begun accumulating financial assets (savings) in anticipation of retirement. They must not have liked local investments, he reasoned, preferring instead safe, liquid US assets.
Was he right?
When first unveiled, his theory was, of course, heralded far and wide as the product of pure genius. But even as it was, to embrace it had meant also recognizing if not fully appreciating the unsettling notion how Greenspan’s series of forwards, therefore, must be wrong. If foreign savers could achieve such an unshakable grip over the very basics of risk-free rates outside the very short run, then surely the allegedly omnipresent central bank could not have been living up to its own lore.
Rates acted independently from both policy and supposedly settled philosophy.
A mere few weeks ago, a pair of enterprising researchers at the Chicago Fed decided to take on the glut and check it against the decade and a half of history since its Virginia introduction. First, they note that original hypothesis had been substantially rewritten over the years mostly by Bernanke himself which tells you already a good deal about where this is going.
These branch staffers state the premise thusly:
“First, falling long-term real interest rates were considered a major source of the housing boom that eventually gave way to the global financial crisis of 2007–08. Second, long-term rates stubbornly continued to fall during the expansion following the 2001 recession despite a sequence of increases in the federal funds rate and associated short-term market rates—a phenomenon that became known as the ‘Greenspan conundrum.’”
The mainstream, orthodox textbook would and does consider low rates as the probable cause for asset bubbles – but not why they would remain low in the face of contrary monetary policy as well as account for the dollar’s behavior alongside current accounts on each side of the US border. In short, the global savings glut explanation was one way for officials like Bernanke to try to account for the real world misbehaving, implicitly recognizing this as fact within it.
But, the theory in any of its forms can’t outlast the mere beginnings of GFC1. As much deference (really blatant ass-kissing, pardon my expression) as the authors pour into their statistical work and interpretations of it, in the end they don’t find much which survives the badly needed scrutiny:
“We observed that the decline in the absolute value of current accounts paralleled the reduction in gross trade flows occasioned by the Great Recession. Consequently, we concluded that the ability of the GSG hypothesis to explain the fall in long-term real rates between 2002 and 2006 is probably significantly greater than its ability to account for the further fall in rates from the Great Recession onward.”
That’s putting it charitably; “probably significantly greater” in less fedspeak terminology really means it was somewhat dubious in attempting to square what actually happened between 2002 to 2006 with orthodox theory to begin with, but 2007 and after it falls apart completely.
Why?
Because the facts are unmistakable: current accounts worldwide shifted…while US Treasury rates did not. Whereas the former dropped off – the collapse of global trade and the unanticipated inability of the world economy to recover following the 2007-09 crisis – interest rates worldwide kept moving lower. In fact, they moved further downward during and after GFC1 than they had before at the presumed peak of Bernanke’s glut:
“Very roughly, it seems fair to say that the ten-year real interest rate in the United States declined about 150 basis points between the latter half of the 1990s (when it averaged around 3.5 percent) and the prelude to the global financial crisis (when it averaged around 2 percent), and then it fell another 200 basis points commencing with the collapse of Lehman Brothers in September 2008 and continuing to the present. While the first drop of 150 basis points is very plausibly a consequence of capital inflows, the post-crisis drop of 200 basis points is unlikely to be attributable primarily to the GSG; instead, that second drop suggests a somewhat parallel story of weak domestic investment in the United States.” [emphasis added]
As we know from all the QE literature throughout that program’s 20-year history not even central bankers will claim, if they’re being honest, that it was LSAP’s and “bond buying” which had actually reduced post-2008 rates; these only accounted for, in the academic statistical sense, a very small part of interest rates and yields (and that’s arguable) which declined far more from market action.
In fact, at least in this one academic piece, the authors nakedly explain where this is all leading:
“The role of weak investment worldwide appears to tie in well with the secular stagnation hypothesis—a close, but brasher, cousin of the GSG hypothesis.”
In other words, low rates must therefore tie in closer to bad economic outcomes, not fundamentally positive central bank policies (stimulus) that we’re constantly told easily solve them.
And that’s not all; in the same study the researchers also state:
“We found the second channel helpful for explaining why the rates on safe and liquid assets fell while national-income-based measures of the return on capital showed no drop. Borrowing from Krishnamurthy and Vissing-Jorgensen (2012), we estimated that the safety and liquid assets channel accounted for about 50 basis points of the drop in U.S. Treasury yields.”
While weirdly attributing demand for safe and liquid assets to what amounts in their view to some unspecified cultural preferences in Asia, the numbers don’t quite lend themselves to this ridiculous bending over backward to limit the damage from having exposed what really was an enormous – and enormously consequential – error.
Why else might, especially those in Asia, prefer safe and liquid assets particularly during specific episodes only beginning with the 2008 crisis? As I wrote in April 2016 amidst one especially severe, Asian-focused of these recurring flare-ups:
“Bernanke was absolutely correct about one thing, as he said in his 2005 speech it was absolutely essential to ‘understand the influence of global factors.’ He never did which explains a lot about the last decade or so. It's an unforgivable omission because ‘global factors’ weren't really that at all, but instead dollars. There was never a global savings glut…The very central bank charged with managing the dollar never realized, and still doesn't to this day, that it was the transformation of its own currency that caused(s) so much constant mystery, heartache, and now, for as long as conditions remain as they are, continued economic misery. At least they got the ‘global’ part right.”
Ben Bernanke, as well as Alan Greenspan, in the middle 2000’s was very clearly eyeing the effects of the eurodollar’s rapid offshore rise and its most obvious onshore distortions while attempting to resolve them with his own unmovable worldview wherein there never could be something like a global dollar system operating far beyond his functional as well as intellectual agenda.
It had never been savings; these weren’t Middle Eastern or Chinese Baby Boomers getting ahead of their old age needs, it had been just the domestic spillover from the vast external banking architecture going nuclear from the mid-90s to the mid-00s. To Bernanke and Economists, it looked like foreign money because in a very real sense that’s what the modern dollar had long ago become!
Thus, the global savings glut was kind of, sort of plausible before 2007 when proliferating eurodollars could be mistaken as increased foreign savings to the point of trillions finding their way onshore into the US, but then those dollars – and therefore global trade and marginal economic growth – disappeared afterward meaning no more “glut.” It was there; and then it was gone.
This, too, explains even Greenspan’s conundrum during the height of the eurodollar expansion. The market – unlike the Fed – understood at least the potential of the whole thing unraveling in the most violent and unpredictable way, as it would, therefore it had been prudent even while taking huge risks to stockpile safe and liquid assets if because of taking huge risks; all the while ignoring the Federal Reserve raising short-term rates which had been meant as an all-clear signal with regard to those very perceptions.
No conundrum at all; rates really do act independently.
Over the past few months, the US central bank staff has finally discovered and written about the importance of collateral. Others have now said the global savings glut doesn’t and really didn’t stand up to serious investigation. In Europe, officials have been moving in on SFTs (secured financing transactions). A whole lot more have been forced to recognize that the market, private financial and monetary demand for safe and liquid assets, has reduced global interest rates far, far more than every combined QE.
We’re getting somewhere. Officially, the last several decades are being slowly, painfully, belatedly rewritten ever so incrementally closer toward the truth. And that continues to be the interest rate fallacy, which not only describes what’s happening but more importantly why.
Don’t say you weren’t warned; once more, Milton Friedman in 1967:
“As an empirical matter, low interest rates are a sign that monetary policy has been tight - in the sense that the quantity of money has grown slowly; high interest rates are a sign that monetary policy has been easy - in the sense that the quantity of money has grown rapidly. The broadest facts of experience run in precisely the opposite direction from that which the financial community and academic economists have all generally taken for granted.”
More than a decade and a half too late, at least now, today, the fallacy is being taken just a tiny smidge less for granted within the financial community and among some small number of academic Economists. Hardly impressive, and it certainly won’t end the unbroken glut of global QE’s anytime soon, nor will it forestall the current reign of gross confusion at continuing low yields even after the trillions in “stimulus” (fiscal and monetary) thrown at them, it is at the very least something.
