Excellent Returns
The period from 1983 until a year ago featured some of the most spectacular returns on investment ever seen. With some hiccups in each, almost every asset class, from Treasuries to stocks to real estate to commodities to corporate debt did very well.
It's pretty clear that this remarkable performance of assets was not due to a similarly awesome period of growth in the economy. While growth did become remarkably stable, it did not become any faster.
So to what can we ascribe these tremendous gains to which we all became accustomed? Most likely, to a nearly monotonic decline in real interest rates seen during the period. The "Neutral" rate in the below graphic from the FRBSF is really a smoothed average of the actual real fed funds rate. Interpret it as such.
source: FRBSF
Real Interest Rates
The real interest rate is one of the most powerful factors in asset pricing, because it's used to discount the cash flow from investments. A decline in real interest rates will cause Tobin's q to rise dramatically. Commodity prices will soar. As long as inflation doesn't pick up, the price of Treasury bonds will climb.
But indeed, shouldn't we expect a low real interest rate to lead to higher inflation as asset prices rise and economic growth accelerates? Not necessarily. This depends critically on the equilibrium real rate of interest, hereafter the "equilibrium rate."
The equilibrium rate has had a lot of definitions over the years, but it's most simply thought of as the right real interest rate to keep inflation stable. Monetary policy keeping the real interest rate from swinging too far away from equilibrium in the wrong direction -- or even nudges it away from equilibrium in the right direction -- is a likely cause of the Great Moderation.
A critical aspect of the equilibrium rate ignored by early economic research is that it's time-variable. Its present value is very difficult to determine in real-time. Even worse, the equilibrium rate is very hard to predict, as we have limited knowledge of what should affect it.
Higher population growth and higher productivity growth should mean a higher equilibrium rate. Capital accumulation and decreasing risk premia should mean a lower equilibrium rate. I believe(and now I find, so did PIMCO) monetary policy can indirectly alter it over time. But in truth, while we have a few models, nobody really knows.
Here are some examples of these rates in action.
| Inflation Rate | Interest Rate | Real Interest Rate | Equilibrium Rate | Policy Stance |
| 12% | 16% | 4% | 5% | Accommodative |
| 5% | 7% | 2% | 1% | Restrictive |
| 2% | 4% | 2% | 2% | Neutral |
| 4% | 2% | -2% | -1% | Accommodative |
| -3% | 0% | 3% | 2% | Restrictive |
While real interest rates, inflation rates, and equilibrium rates can all be negative, the nominal interest rate cannot be.
Back to reality. Refer back to the FRBSF graph above, which depicts a smoothed average of the real fed funds rate over a long period. It could be considered an approximation of the actual equilibrium if the long-term average real fed funds rate converges on the neutral rate during periods of stable inflation. During this monotonic downtrend in real rates since 1982, inflation, as measured by the GDP deflator, wages, and other metrics, declined as well, suggesting in particular that the neutral rate estimated in the 1980's is a little high. But it's close, and the trend is fairly consistent with model predictions.
Deflation Returns
As the equilibrium rate drifted inexorably lower, the threat of excessive disinflation -- a deflationary recession -- grew more real.
To encourage economic growth, the Fed needs to push the real fed funds rate below the equilibrium rate. To curb economic growth, the real fed funds rate must rise above the equilibrium rate.
But the Fed can't directly control the real fed funds rate; it can only control the nominal rate. Because inflation responds only with a lag, that's generally sufficient to control the real rate. A lower equilibrium rate reduces the Fed's ability to be accommodative until it crunches against the zero bound.
There, monetary policy fails, and a so-called liquidity trap arises, as the Fed becomes unable to be accommodative. The fifth example above illustrates a Fed that is stuck in restrictive stance against its wishes.
So why the panic to get out of it immediately? Two reasons.
1. A higher real interest rate than the equilibrium rate -- restrictive policy -- will tend to reduce the inflation rate. As the inflation rate goes down further, policy becomes more restrictive. The fed funds rate is still 0%, but with inflation of -5%, the policy rate is now extremely restrictive.
2. If this persists long enough in a heavily indebted economy, the risk of falling into the debt-deflationary spiral discussed by Irving Fisher increases.
For that reason, an abnormally large real fed funds gap was created to prevent a collapse into deflation after the dot.com crash. That experiment has clearly failed. It led directly to commodity and housing bubbles, and likely indirectly to an investment bubble in China and other countries. We live in the wake of that implosion today, unable to replicate the experiment.
A Negative Equilibrium Rate?
Could the equilibrium rate in the US be negative at present? Real interest rates have been deeply negative for long stretches of time since the 2000 bust, extending the trend set since 1983. During that time, there have been small bursts of deeply focused inflation, such as in oil, housing, and food. The general price level certainly suffered no real inflation, even despite a large fall in the dollar.
This all points to a resounding yes. But what does that yes mean? Why would it be so? Population growth is lower, but certainly not negative. Productivity growth remains positive too. That leaves us with explanations similar to those proposed in Japan years ago:
1. A simple glut of pessimism exists.
2. Balance sheets are so bad, with an ever-increasing amount of debt to be serviced, that the economy is unable to invest. This is a variant of Fisher's debt-deflation story.
3. The negative equilibrium rate is structural; for whatever reason, there aren't enough good investments remaining in the economy.
I won't discuss #1 further. It simply doesn't fit the declining equilibrium rates in the heady boom years, and expectations were for significant inflation even well into this collapse.
#2 has some merits. Corporate and household balance sheets had been very good prior to the collapse, but they're looking ugly now, so we find some support. However, prior face-slaps have failed, as the government has already rushed to provide staggering liquidity to the economy and banking system repeatedly. If investment continues to fail to respond, or inflation fails to result, this argument will gradually lose its credibility.
I find #3 very compelling.
Companies chose in aggregate to buy back stock with retained earnings rather than invest, even during the best years. It fits a gradually developed, persistent trend of the last 25 years. It explains the failures of face-slaps and recapitalization to date. Model behaviors of monetary policy based on the Taylor Rule tend towards liquidity traps.
I think these are strong indications that negative equilibrium rates are the result of capital accumulation due to recession-fighting monetary policy. It's also likely that this situation has been further exacerbated by the pegged currency and growth of China.
How to Escape (drawn heavily from Krugman's innovative work)
Unfortunately, now that we've hit the zero bound, it's a virtual certainty that the excellent returns we saw in prior years will not be repeated. A rise in equilibrium rates will not be uniformly kind to asset pricing, and it may take a long time to occur.
From a balance-sheet trap: The policy actions of the Bush and Obama administrations depend heavily on balance sheet problems being the fundamental trouble. By recapitalizing and repairing the balance sheets of banks through bank rescues or nationalization, they'll feel emboldened to lend to eager companies ready to invest profitably in their businesses. A temporary shock of demand and inflation from fiscal deficits could help the economy return to a better equilibrium.
The equilibrium real interest rate will then be higher by definition. Imagine a jump from -1% to 2%. A nominal fed funds rate of 0% and an inflation rate of 2% would flip from 1% below equilibrium to 3% below equilibrium. This could lead to a self-perpetuating increase in inflation rates if the Fed continues to peg rates at zero(though I personally suspect it would cause more capital accumulation, pushing the new equilibrium rate down).
The dollar would weaken markedly. Commodities and U.S. equities would be appealing choices.
From a structurally negative equilibrium rate: The best that fiscal and monetary policy can do in this case is make up for shortfalls in private investment and consumption by expanding the government, waiting for the causes of the depressed real interest rate to fade, and hoping the sovereign debt accrued by that point is not too severe.
All our policy actions to date would thus continue to be fairly ineffective because they don't -- and can't -- address the root issue. Deficits and monetization would persist for very long periods of time, and the best outcome we could hope for would be lessened unemployment and a little GDP growth as G expanded.
In this scenario, the interventions could also plausibly be detrimental, through several mechanisms:
• preventing destruction of capital through rescues of unprofitable companies and industries, delaying a rise in the equilibrium rate;
• calling into question the solvency of the sovereign, increasing risk premia and uncertainty;
• crowding out private investment and consumption to some degree, since perfect overlap between sovereign demand and slack resources is unlikely, and private readjustment would take time;
• worsening the trade deficit.
Holding insured cash or sovereign debt would seem to be the ideal investment, as it will gradually strengthen with negative real returns on everything else, but exactly what cash means if the sovereign itself is imperiled is a tough question. It may be that a fiat currency can be so demanded and critical to an economy that it becomes larger than the sovereign that originally issued it.
The only policy action I can imagine being beneficial in the short run in any case is one that runs counter to our every instinct: protectionism. A deliberate collapse in trade would almost certainly raise equilibrium rates, and probably dramatically. The arguments in favor of this are very strong, though it is and will always be a bad long-run choice.
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12 comments:
Great, great post NDK. This is such an important and neglected point: we WERE heading toward deflation in 2002, despite the fact that almost everyone in the mainstream scoffed at the very idea. The "cure" brought us to where we are today.
Thanks for your blog.
I like reason #3,
"The negative equilibrium rate is structural; for whatever reason, there aren't enough good investments remaining in the economy."
The excesses leading up to the current situation can be explained by something other then the constants of human nature -- greed, dishonesty, etc.
The lack of good investments made the growth of the FIRE (finance/insurance/real estate) sector of the economy look like the best thing possible. Toss in some financial innovation, and there you have it.
There has been quite a bit of asset destruction, with stocks cut from 1.5x GDP to .75 x GDP. Real estate has taken a 30%+ haircut.
I suppose no one knows what happens when you get into the twilight zone. How do we know that this isn't enough?
Well that wasn't that long of a hiatus.
I'm in #3 camp myself. Actually I increasingly believe that a lot of post WWII growth was the conversion to a massive petroleum economy and all the massive investments that entailed. I don't think it's a coincidence that US peak oil occurred in the mid-70s and much of our debt explosion was touched off only a few years later.
Computers/the internet did give us some respite but these things still haven't really revolutionized society yet. They are still used as more convenient analogs for older technologies/functions.
The faster we go to new energy sources/distribution and adopt futuristic mindsets the faster we'll be pulled out of this mess.
This is such an important and neglected point: we WERE heading toward deflation in 2002, despite the fact that almost everyone in the mainstream scoffed at the very idea.
The Fed unequivocally got it. I happen to agree the medicine prescribed was mercury with ground up leeches in it, but they got one diagnosis right.
There has been quite a bit of asset destruction, with stocks cut from 1.5x GDP to .75 x GDP. Real estate has taken a 30%+ haircut.
I suppose no one knows what happens when you get into the twilight zone. How do we know that this isn't enough?
I was once the world's worst trader, cap vandal. I'm not anymore, but only because I stopped trading.
But regardless of current prices, the key to remember is that if #3 is correct, the natural path of least resistance for asset valuation is down and it's likely to remain that way for awhile. In your stock valuation, for example, nominal GDP is likely to go down both due to deflation and investment shortfalls.
There will almost certainly be further explosions along the way, but the government has done a better job halting -- or postponing -- those than I'd thought likely.
The good news is, there's probably very fertile soil on the other side of the valley.
Everything changes if significant protectionism arises, as some commentators have asked about. That's a vastly tougher question. It changes so many parameters so violently that the outcome is hard to guess. I can allocate a neuron or two towards it but I don't anticipate having much confidence in my answer.
Actually I increasingly believe that a lot of post WWII growth was the conversion to a massive petroleum economy and all the massive investments that entailed. I don't think it's a coincidence that US peak oil occurred in the mid-70s and much of our debt explosion was touched off only a few years later.
It's an interesting idea, Mikkel. I would be sympathetic to the idea that the inflationary episode was touched off by US peak oil slowing growth and dropping equilibrium real interest rates while policy rates were much too low. Debt growth would be another plausible result.
Computers/the internet did give us some respite but these things still haven't really revolutionized society yet. They are still used as more convenient analogs for older technologies/functions.
The potential is phenomenal. What that means for economic growth or human society is unknowable, but probably really cool.
Well that wasn't that long of a hiatus.
It's yall's fault, and if you'd stop leaving constructive criticism, insight, and leading interesting questions, I'd get more real work done.
I'm glad you folks find the case for #3 compelling too. Well-reasoned dissent is more than welcome here, too. I personally rely far more heavily on the empirical evidence here than the theory, because the set of fundamental factors is still so ill understood. And I think the empirical evidence is quite strong.
The first flight's on the 20th, the closest I have to a hard break. If anyone in Tokyo, Kaohsiung, or Long Beach is reading, hide your good food.
Major question: are #2 (debt-deflation) and #3 (no good business opportunities) mutually exclusive? Can't both be true?
Minor nit: In marshalling your support for #3, be careful about the influence of the utterly distorted financial services net income and share repurcashes. You might want to limit the datapoint abotu stock repurchases to nonfinancial companies. This doesn't invalidate your point, of course.
Glad you're back with more incisive writing. I've always thought road trips were a perfect time to do heavy-duty thinking, so I think you may find the time is conducive to updating your blog.
jult52
Another thought: is the IT boom circa 2000 evidence for your #3? Here we have a genuinely innovative and transformational development. The paucity of alternatives to IT leads investors to bid equity prices to ridiculous levels.
jult52
Major question: are #2 (debt-deflation) and #3 (no good business opportunities) mutually exclusive? Can't both be true?
They're certainly not mutually exclusive, jult52, and you're wise to point that out. They might both be true in our current situation, though I remain skeptical about #2 given the Fed's largesse.
But any presence of #3 is of major importance when looking at ramifications of policy actions for investments and the economy.
Disposing of the dead banks and assets in that scenario becomes a necessary but insufficient measure: it needs to be done, but would yield no coupons in lending or growth. It might prevent more violent shocks, but there would be no higher level equilibrium to flip the economy back to.
If #3 is true, then regardless of other conditions, the ultimate solution is time, realignment, and a wrenching disposal of excess capacity.
Another thought: is the IT boom circa 2000 evidence for your #3? Here we have a genuinely innovative and transformational development. The paucity of alternatives to IT leads investors to bid equity prices to ridiculous levels.
I think it's plausible. It led to an enormous spurt of growth and overcapacity that hasn't come close to dissipating even today(see LVLT, for example, or any subset of the chip industry).
Not only that, but the equal access to markets and free information the Internet engendered absolutely crushed a ton of business models and margins, and they aren't coming back. We wallpapered, floorboarded, and tranched that fact for awhile, but now the true redundancy is shining through.
I think investment will be depressed for a long, long, long time, and when it comes back, America won't be the focus point.
Glad you're back with more incisive writing. I've always thought road trips were a perfect time to do heavy-duty thinking, so I think you may find the time is conducive to updating your blog.
I'm always worried it's a little too archaic for most readers, no matter how important I think it is. Searching for the right balance of meat, bone, and fat still, even though potato chips are apparently the most popular food out there. Oh well.
Interesting post and comments. Here is what I glean from all this:
> There is overcapacity and a lack of investment opportunities in the U.S.
> Globalization is a big reason for the above. High U.S. wages and decreased communication costs (Internet) have eroded U.S. earning power.
> U.S. consumption finally collapsed under the weight of too much debt as a percentage of disposable income.
> Europe and Japan are experiencing similar problems to the U.S. Developing economies are suffering from the other side.
> Globalization is the root cause of our problems, in combination with the fact that our financial rules and regulations are not globally oriented.
> Free trade vs protectionism is a false choice. Trade and international finance need to be more effectively regulated. "Protectionism" has a lot of negative connotations, but we do need to regulate commerce and finance in ways that may be considered protectionist if viewed narrowly.
> A broader vision will emerge as countries and the international community sort through the mess. War may be involved (hot or cold).
I agree with you on #3. Clearly technology has been a productivity accelerator, but in doing so (coupled with wage arbitrage) creates a numerator and denominator issue as in 4Q - http://www.bls.gov/news.release/pdf/prod2.pdf)
Bernanke back in 2005 speaks to the ratehr dismal performance of US productivity since the 70s. Whether or not this supports the peak oil thesis of the 70s?
(http://www.federalreserve.gov/BoardDocs/Speeches/2005/20050119/default.htm).
Finally, I am struck by the idea of modeling or targeting an unknowable. An unsophisticate might call this hocus pocus. The exercise while interesting seems a lot like the stuff about okun's law and GDP gap analysis. It makes sense only in that it is torn from the Krugman cloth.
It would seem to me the absolute level of debt is a key consideration in any analysis. Accomidative policy itself must have a natural bound, rates notwithstanding, and whether that is 100% of debt/GDP, 200% or something else is an open question (the problem being compicated by the self reinforcing distortion of more debt yielding expanding GDP and the need for ever lower rates to maintian debt service ratios).
Perhaps it is peak debt that is the proximate cause? Constant stimulation is an unnatural act. Even more so when there is no reliable growth opportunities. This makes The old Europe comment even more ironic.
apologies, did not read the next post whcih speaks to the point!
interesting, a couple things come to mind. i can't remember my google password, this is babar ganesh, i have posted before.
> is the IT boom circa 2000 evidence for your #3...
i think in 2000 many people would have said that we would have a better system for electronic cash and that this would enable "productive" i.e. "gdp-enhancing" activities over the "internet". we aren't there foreseeably, however. i don't see the true potential of networked technology coming through until we are. of course we will end up with interdependencies and structures that will knock us down again, probably into a luddite hell.
> ... total level of debt in the system
the measure of total level of debt still seems very crude to me but the image in my head is of a network of debt (ie nodes and edges, with a net value at each node), with a time dimension as well. it would be interesting to model this directly as a network. in any case, if you take this picture as an intuition, in order to decrease debt in the system you will want to disentangle loops and you will want to give cash to leaf nodes. the strategy toward banks is that we have given money to nodes in the middle in order to keep them from going below zero; this has done nothing but alleviate pressure. (predictably.) does my mental picture make any sense?
ndk,
I'd like to expand on the idea of overcapacity which is central to your explanations and policy prescriptions.
Yes, there's over capacity but at what prices. There's overcapacity of cars at 30 thousand dollars, electronics costing thousands, and apartments in the 100's of thousands. But half that price and there's a dearth of all these items.
Say's law is incomplete in that sense. Supply will create it's own demand in general, but if the price of the created items is too high in dollar terms, demand won't be forthcoming.
Financial system was able to fool the world into thinking it's much bigger than it actually is. China has built the productive capacity to serve the world that was a giant, but in reality he's turning out to be a short person.
Worthless pieces of paper were exchanged for real tangible items.
Destruction of overcapacity is inevitable if the dollar retains it's value in real terms. It's simply unprofitable to build an aforementioned car if it's price is now $15 thou. But that's all the world can afford once the illusion of credit bubble has been dispelled. Hence the factory will be shut.
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