November 19, 2019

Refloating the Titanic

The Fed recently announced that it would ‘twist’ the yield curve.

“The Committee intends to purchase, by the end of June 2012, $400 billion of Treasury securities with remaining maturities of 6 years to 30 years and to sell an equal amount of Treasury securities with remaining maturities of 3 years or less.  This program should put downward pressure on longer-term interest rates and help make broader financial conditions more accommodative.”

No it is not a new idea.  The FED did so on at least one previous occasion.  Let’s take a short stroll down memory lane.

Back in 1960-1961, a recession had set in during which we were in need of easing our deficit in our Current Account Balance in our balance of Payments.  Lord Keynes’ ideas were still very dominant among economic policy makers.  Lower interest rates were needed to stimulate interest sensitive spending such as that on investment.  But that would lessen the net inflow of foreign capital from abroad making it more difficult to finance the Current Account deficit and would also put upward pressure on interest rates in the U.S. of A financial markets.  To borrow a phrase from our old friend Winnie the Pooh, Oh dear, what to do?

The geniuses at the FED (Federal Reserve System, specifically the FOMC), our central bank and custodian of monetary policy, thought long and hard till the light bulb of success went on and to paraphrase Professor Higgins in My Fair Lady, I think they got it…by George they have got it!.  What did they have?  Yes sireee, Operation Twist.  Some also called it Operation Nudge, and here is the way it was to work.

The FED would use open market operations to invert the yield curve which is the graph of the term structure of interest rates.  They would put downward pressure on long term interest rates to stimulate investment and the economy while at the same time drive up short term interest to maintain the net inflow of capital from abroad for balance of payments purposes.  Eureka!!

Recall that the FED had more recently tried to institute a similar policy, but to Alan Greenspan’s frustration, a “conundrum.” The FED failed to drive down the long term interest rates that it had worked so hard over the previous few years to drive up; in order to control what Greenspan referred to as “irrational exuberance” the cause of which he argued was the result of the “wealth effect”.  The “irrational exuberance” also caused asset bubbles that would have made Lawrence Welk green with envy.

We are now stalled in what some are calling the Great Recession, a major cause of which was the FED’s pricking the asset bubbles such as that in residential housing.  Is this progress, from “irrational exuberance” to “rational frustration”?  We do not need enemies when we have such friends.  Maybe the Austrian school zealots are right after all!

“The Expectations Hypothesis Analysis of the Term Structure of Interest Rates argues that the current long-term interest rates are heavily influenced by the expected future short-term interest rates.  In the absence of liquidity bias, long-term (really all rates except the very shortest) interest rates are the geometric average of expected future short-term interest rates.  For example, the geometric average of 3, 4, and 6 is the cube root of their product or the cube root of 72 = 4.16.  Simply put, if the market consensus believes that short-term interest rates will rise in the future, the current long-term interest rates should be higher than the current short-term interest rates and the yield curve should slope up and to the right.  Conversely, if the market consensus believes that short-term interest rates will fall in the future, the yield curve should slope down and to the right and short-term interest rates should be higher than long-term interest rates.”

Greenspan’s frustration with what he termed a conundrum, was due to the mistaken belief of the FED that by driving down short term interest rates, the longer term interest rates would also like Humpty Dumpty, come falling down.  Alas, they did not do so.  While the Fed has awesome power to influence interest rates, it must do so thru open market operations, the buying and selling of securities in its portfolio in order to overwhelm the expectations of the market as to what they believe short term interest rates will do over the future.

Recall that according to the dominant theory of the yield curve, the expectations theory, longer term interest rates are the geometric average of what the consensus of the market believes will be the future behavior of short term interest rates over the relevant period in question.

Unless the FED enters the market and buys or sells the appropriate maturities, the expectations of the market consensus will prevail.  An analogous situation existed during the period of the Bretton Woods fixed exchange rate system from just after the Second World War until it collapsed in the early 1970s.

The U.K. had trouble maintaining the agreed upon peg which they tried to maintain by selling Dollars and buying British Pounds.  They ran out of Dollars and other things such as gold to buy the Pounds which were in excess supply at the agreed upon pegged rate.  Their inability to maintain the peg led them to devalue the pound, i.e. to change the peg (depreciate the Pound or cheapen its price in terms of the Dollar) so that the quantity supplied of Pounds was no longer in excess of the demanded for Pounds.  The Dollar appreciated as a result and the Dollar price of the Pound fell several times from its long standing $5.00 per Pound Sterling.

Such occurrences were not conundrums then and are not now.  We know why they happen!

When the U.K. was experiencing large and persistent deficits in its Trade Balance in the Post WWII era, even as a member of the fixed exchange rate system often referred to as the Breton Woods IMF Fixed Exchange Rate System, they were allowed to devalue the British Pound (equivalent to depreciating the Pound in a floating exchange rate system) on a few occasions.  Net foreign exchange earnings initially fell, as the Pound value of their trade deficit increased…

The argument revolved around the issue of whether the then current exchange rate was above an unstable equilibrium.  In this range, due to a backward bending supply curve for foreign exchange, a price increase for the dollar (due to devaluing the Pound which means increasing the Pound price of the Dollar) would increase the shortage of Dollars, not decrease that shortage. Some argued that the British pound should be revalued upward and not devalued.

Hence, what is needed is more certainty that the tax climate will improve, that markets such as those for oil and derivative products such as gasoline will become more competitive and less directed by environmental concerns based on bad science and faulty economic reasoning, that the financial system and the Federal Reserve system will be purged of the influence of the investment banking gang.  Increased taxes for an unpopular health care program, more taxes to redistribute income, and more taxes to bail out the losers who have often forgotten the bounds of imprudent risk taking, will only serve to continue the economic malaise we are now suffering.

Strategic defaults, short sales of family housing, lengthening durations for unemployment, aU-6 unemployment of around 16%, a rising sovereign risk of the U.S. debt, and in general, fiddling while the economy burns, has caused us to coin a new term, TITANICY– or Titanacy, if you prefer.

It is the increased federal spending and the resulting higher federal government debt with the threat of higher taxes that only keeps our economy bumping along the bottom of the ocean of economic malaise as documentary after documentary describes the condition of the ill-fated Titanic.

Counting the economic rivets that have popped as the U.S. economy sunk into this Great Recession, like the Titanic, will not refloat the economy as it will not refloat the Titanic!  Telling us that we must pass his so called jobs bill NOW (read it later), when it consists of the same infertile schemes of the last two and one half years, is an act of TITANICY.

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Written by
Donald Byrne

DONALD BYRNE was a retired Professor of Economics at the University of Detroit Mercy and held a Ph.D. in Economics from the University of Notre Dame. He taught at other institutions, including: University of California-Berkeley, Notre Dame, Wayne State University, and Walsh College. In 2003, he helped launch an economics and finance oriented online newsletter: EconNewsLetter.com. He also served on several financial-institution boards and as a Visiting Scholar at the Federal Reserve Bank of Chicago. A devout Catholic and family man, Dr. Byrne passed into eternity on May 7, 2018. May God rest his soul.

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Written by Donald Byrne
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