Inverted Yield Curve Doesn’t Cause Recessions, But It Predicts Them

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Source: AP Photo/Seth Wenig

One of the big financial news stories of the past month has been the inverted yield curve, which means that the interest rate on long-term government debt is lower than that on short-term debt. During expansions, interest on short-term government debt is lower than long-term. In other words, things are upside down. Inverted yield curves are rare events and often predict a recession within two years, although a couple of recessions have happened without the curve inverting.

John Tamny recently chastised market pundits for claiming that the Fed’s monetary policy is too tight and caused the inverted yield curve. The writers and talking heads who make that claim are followers of a school of macroeconomics known as monetarism. Milton Friedman was a famous monetarist. Monetarists believe that monetary policy drives everything. They have no objective measure of “tight” or “loose” monetary policy. Policy is too tight if the economy is slowing and too loose if inflation gets out of control.

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Washington Irving predicted our next recession

The US stock market was stuck “in irons,” as sailors describe a ship sitting still in a windless ocean, for most of this year. But recently it tested new highs as earnings reports from banks and the tech sector inflated its sails. Mainstream economists can see no icebergs ahead in their crystal balls. One might describe the current investing climate this way:

Every now and then the world is visited by one of these delusive seasons, when “the credit system” as it is called, expands to full luxuriance; everybody trusts everybody; a bad debt is a thing unheard of; the broad way to certain and sudden wealth lies plain and open; and men are tempted to dash forward boldly, from the facility of borrowing.

Macroenomics fails again

The economist Axel Leijonhufvud quipped in his essay “Life among the Econ” that,

The Math-Econ [tribe] make exquisite models finely carved from bones of Walras. Specimens made by their best masters are judged unequalled in both workmanship and raw material by a unanimous Econographic opinion. If some of these are “useful” – and even Econ testimony is divided on this point – it is clear that this is purely coincidental in the motivation for their manufacture.

Read the whole essay because it's very funny. It’s an inside joke; the father of math models in economics was Leon Walras. I thought of the essay when reading Martin Wolf’s recent article in the Financial Times, “Economics failed us before the global crisis.”Wolf’s is only the latest in a long line of laments over the “usefulness” of macroeconomics after the Great Recession. He wrote,

The tests of this discipline are whether its adepts understand what might go wrong in the economy and how to put it right. When the financial crisis that hit in 2007 caught the profession almost completely unawares, it failed the first of these tests. It did better on the second. Nevertheless, it needs rebuilding.”

How does Wolf know that macroeconomists did better at the second, putting the economy right? Because we didn’t have another Great Depression:

A comparison between what happened in the 1930s and this post-crash period shows we have indeed learnt some important things. Compared with the Great Depression, the immediate declines in output and rises in unemployment were far smaller. Moreover, prices have also been far more stable this time. These are true successes.”

In other words, because we didn’t have a depression like the Great D that proves the money printing and deficit spending worked to save us. Wolf reminds me of another joke: a police officer approached a man furiously blowing a trumpet in the park and asked him why he was doing that. The man said he was keeping elephants away. The policeman said there never have been elephants in the park, to which the trumpeter responded, “It’s working!”

Wolf’s problem is he doesn’t know economic history, but then few economists do. The US has suffered through about 70 recessions/depressions since 1790. Before 1929, the US economy recovered from depressions with no help whatsoever from a central bank or the federal government. All of them were milder than the Great one. The Great D became the worst ever because the government decided to rescue us. The Smoot-Hawley tariff destroyed international trade so much that it took another 70 years to recover. Other efforts by FDR to “save” us caused equally bad outcomes and made the depression in the US last longer than in any other country.

Some think the Great Recession was almost as bad in terms of GDP decline, but combining the recessions of 1981 and 1982 (six months apart) produces one equally as bad. In response, the Fed kept interest rates high and Reagan did nothing to bail us out, yet the economy recovered very fast.

During the Great Recession, Congress passed no Smoot-Hawley tariff so there was no reason to think the latest recession would turn into a Great Depression. Wolf and most mainstream economists predicted that the Great Recession would turn into an “elephant in the park” so when no elephants appeared they declared victory. It’s an old political ploy to predict the worst and when it doesn’t happen take the credit. Politics is all about taking credit for the work of others and most macroeconomists act like politicians.

Wolf blames macroeconomist’s assumptions of the efficient markets hypothesis and rational expectations for their failures, but those were never problems. The roadblock has always been the desire for precise math model, like those “carved from the bones of Walras.” Making their models work required the assumption of equilibrium, which assumes away the very things we want explained, such as recessions. Wolf is correct that “It is better to be roughly right than precisely wrong.” But he doesn’t seem to know that the quote comes from FA Hayek’s Nobel speech, not from Minsky. Hayek was trying to convince economists to get some therapy for their obsession with their equilibrium models.

Wolf stepped dangerously close to the truth about the causes of crises with this: “Moreover, crises are endogenous: that is to say, they come from within the economy. They are a result of the interaction between tendencies towards excessive optimism and the fragility of any system of highly leveraged financial intermediaries.” But then he flinches and runs away. Had he been made of sterner stuff, he would have asked, where does the excessive optimism and high leverage come from if not from central bank monetary policies flooding the world with cheap money? And if high leverage is the problem, how is it also part of the cure? Is bourbon the solution to alcoholism?

And his remedy shows some promise: “Obvious solutions include eliminating the incentives towards leverage in our tax systems, encouraging greater use by the economy of equity finance and debt that can be readily converted into equity, raising the reserve and capital requirements of banks and moving swiftly towards the issuance of digital central bank cash.” But what about the chief dealer of the drug he calls leverage, the Federal Reserve? Even without the policies he mentions, excessive leverage could never happen if the Fed allowed the market to determine interest rates and didn’t keep them near zero for over a decade. And those same policies can never prevent the Fed from flooding the country with cheap money and increasing leverage.

Wolf and mainstream economists see the impact of money printing as asymmetric: it produces only good outcomes in the short run and nothing worse than inflation in the long. He thinks that because he has an emaciated theory of money. If he learned a robust theory of money as the Austrian school teaches he would see the devastating effects of money printing in the near term. Keynes was addressing economists like Wolf when he said, “In the long run we’re all dead.” Most fail to quote the next sentence: “Economists set themselves too easy, too useless a task, if in tempestuous seasons they can only tell us, that when the storm is long past, the ocean is flat again.” In other words, mainstream economists fixate on the long run effect of inflation to the exclusion of the near term storms.

Wolf sets before economists two tasks: “The first is how to make the body economic more resistant to the consequences of manias and panics. The second is how to restore it to health as quickly as possible. On both counts, we need to think more and do more.”

By identifying the problem with leverage, Wolf is very close to the Austrian business-cycle theory (ABCT), which blames central bank policies for creating high leverage through 1) below market interest rates and 2) expanding the money supply by buying US treasuries from banks. Loose monetary policy encourages people to go into debt and causes unsustainable expansions that end in manias. The inevitable crash causes panics. Why can’t he connect the dots?

He can’t because of his socialist tendencies. Wolf, like all mainstream economists, wants to blame capitalism for crises. He can’t indict the real culprit, the quasi-governmental central bank, because that would let capitalism off the hook and put the burden on his idol, the state.

We are probably now in another recession, which typically last 18 months. What will mainstream econ say about it in two years?

Why the Fed can't drive

One of Milton Friedman’s favorite analogies about monetary policy was driving a car. He compared money creation by the Fed to pushing on the gas pedal. On flat ground giving the engine more gas makes the car speed up, so giving the economy more gas should cause it to accelerate as well. But giving the engine more gas by pushing on the pedal may allow the car to slow down when climbing a hill if the engine doesn’t get enough gas to overcome the gravity involved in climbing the hill.

Friedman’s point: interest rates tell us nothing about whether Fed policy is too tight or too loose. Only the speed of economic growth can tell us that. Low interest rates may be too high if the economy is climbing a steep hill, like a recession. On the other hand, high rates may be too low if the economy is speeding up, as it does near the end of an expansion. The grandchildren of Friedman use that analogy to argue for nominal GDP targeting by the Fed instead of price targets. The problem with the Fed’s driving strategy is that it never knows if it is climbing or descending a hill or how fast the economy is growing at the time it makes its policy decisions because of long lag times from policy decision to its impact.

The Fed is flummoxed – ABCT has the cure

Last week the Wall Street Journal printed a report card of Fed activity for the new millennium. The writers think the Fed failed most of its curriculum.

"In the past decade Federal Reserve officials have been flummoxed by a housing bubble that cratered the financial system, a long stretch of slow growth they failed to foresee and inflation persistently undershooting their goal."

Part of the Fed’s problem is that it believed the media’s hyperbole about former Fed chairman Greenspan, referring to him as the maestro during the “Great Moderation” of the decade of the 1990s. Fed officials didn’t comprehend that the mainstream media is very socialist and will grossly exaggerate every apparent success by a government agency. The Fed and most mainstream economists took the praise from the media to heart and began to believe they were invincible. They even announced that they had slain the dragon of business cycles. Meanwhile, Austrian economists warned that the corpse resembled a wind mill more than a dragon.

Where's the growth?!!!

Decades ago an old lady yelled, “Where’s the beef?” when handed a burger in a fast food commercial. It became a catch phrase for occasions when people wanted to advertise that an idea lacked substance. So while the media proclaims the virtues of the current economy, many economists are asking, “Where’s the growth?”

The Bureau for International Settlements (BIS), the central bankers’ bank, recently issued a report card on the efforts of their client central banks to boost growth since the last recession and given them a failing grade. In the report “Unconventional monetary policies: a re-appraisal,” the BIS economists wrote:

We reach three main conclusions: there is ample evidence that, to varying degrees, these measures have succeeded in influencing financial conditions even though their ultimate impact on output and inflation is harder to pin down;

How GDP fools economists

Economists look to GDP to determine if the US economy is in a recession. Generally, it takes two quarters of the economy shrinking (economists call it negative growth, but they’re linguistically challenged) for the National Bureau of Economic Research to declare a recession. Of course, those two quarters indicate the bottom of the recession, by definition.

ABCT Extends to Emerging Markets

Trouble in emerging markets has provided the rationale for at least part of the recent correction in the stock market. Emerging markets, such as, Brazil, Russia, India, Turkey, Thailand and China, are suffering largely because of the withdrawal of US dollar investments from them and this confirms the effects of monetary policy as described by the ABCT, the Austrian business cycle theory. Here is a chart showing the performance of emerging market stocks relative to the rest of the world:

To refresh your memory, the ABCT states that inflationary monetary policies such as those of the Fed for the past five years will cause an unsustainable boom as new money pours into the economy and stimulates demand for consumer goods and for investment. Usually we think of the ABCT in terms of a single nation, but the EM problems demonstrate that it has international implications, especially in a world of increasing trade integration and a currency that other countries use for trade and their banks for reserves.

Krugman advertises ignorance

ABCT Investing is based on the Austrian business cycle theory, so I become mildly concerned when others criticize the theory. I never become seriously concerned because I have learned over the years that most critics are unbelievably lazy. If they bother to read Mises or Hayek they do so through the lenses of mainstream econ and fail to understand what the authors are actually saying. 

The Social Democracy blog has posted a long diatribe against Ludwig von Mises, which I would normally ignore had Paul Krugman not advertised it. Krugman even gets wrong much of what the blog says, but the blog gets a few things wrong so here are my responses:

Natural rate of interest

The blog is right that the “natural rate” of interest doesn’t exist. Of course, neither does “equilibrium.” Both are theoretical constructs to help us think about economics. Wicksell defined the natural rate as the rate of interest in a barter economy. Interest would exist if we were forced to barter goods because interest is nothing but the opportunity cost of giving up the use of something for a period of time. Austrian economists picked up on the idea as a useful way to explain how interest under barter differs from interest using money. It’s a teaching devise. But if you don’t like it you can ignore it. It helps teach the ABCT, but has little importance to the working of the theory.

Mises and fascism