Arnold Kling  

Morning Commentary

PRINT
Is Zero a Lower Bound for Inte... Fight!...

negative interest rates; FDIC thoughts on the housing bubble in 2004; Cecilia Rouse over Austan Goolsbee?; Greg Mankiw's Macro Quiz

1. Financial markets blew through the liquidity trap yesterday, as 30-day Treasury rates dropped below zero. I think of this as a collateral squeeze. Let's say that you had bought stock on margin, your stocks had gone down, and the broker demands that you put up more collateral, in the form of Treasuries. In theory, it might be cheaper for you to put up cash, but they don't have a system for processing cash as collateral--it's never been used before. So you wind up joining the bidding for Treasuries, helping to drive the rate below zero.

In reality, it is not individual investors meeting margin calls who are bidding down the interest rate on Treasuries. It is institutions being forced to put up collateral on transactions such as credit default swaps.

The main point is not so much that Treasury rates can be permanelty negative--that is an extremely temporary anomaly that can be fixed by adjusting trading practices. The more important point is that Treasury rates are being distorted by the value of Treasuries as collateral. So the spread between Treasuries and anything else (including other Treasuries that are inflation-indexed--thanks to Tyler Cowen for the pointer) needs to be interpreted with great caution.

2. Russ Roberts unearthed an article written by Cynthia Angell, a senior economist at hte FDIC, that appeared in a publication called FDIC Outlook in the first quarter of 2004. The article was entitled Housing Bubble Concerns and the Outlook for Mortgage Credit Quality. Just the title and the timing of the publication alone suggest that industry executives and regulators had plenty of time to think about the issue before home prices peaked.

Overall, the article's tone is mixed.


The history of U.S. home prices suggests a clear potential for home prices to decline in individual markets, particularly in cities that have shown wide price swings in the past and where prices recently have risen dramatically. However, this same history also strongly suggests that it is highly unlikely that home prices will fall precipitously across the entire country--even if rising interest rates raise the cost of mortgage borrowing and reduce housing affordability. Further, a significant price decline does not inevitably follow a sharp rise in local home prices. In many cases, the aftermath of a housing boom has been characterized by slower sales and price stabilization until the underlying fundamentals have a chance to catch up with market prices.

I should add that the phrase "it is highly unlikely that home prices will fall precipitously across the entire country" is actually still true. Prices have fallen precipitously in plenty of places, but not everywhere.

In any case, the article goes on to raise concerns about the extent of mortgage indebtedness.


more than three-quarters of currently outstanding mortgage debt has been originated in the past three years, thanks primarily to robust home purchase and refinance activity facilitated by record low mortgage rates. With these loans underwritten on the basis of recent high collateral values, a decline in home values in some markets could lead to default activity and losses to residential lenders. In particular, high-risk borrowers may default in increasing numbers should interest rates rise and home prices fall.

...The amount of household credit debt is not worrisome in itself, but its concentration among high-credit-risk households may pose additional risk to residential lenders.

The article also notes with concern the surge in subprime lending and in mortgages with low down payments.

In the years following the publication of this article, FDIC-insured banks would increase by hundreds of billions of dollars their exposure to subprime and low-down-payment loans in local markets that had experienced unsustainably large increases in house prices. This increased risk exposure took place right under the nose of the FDIC, albeit partially hidden through the use of senior-subordinated structures that were rated AA or AAA and through the creation of Structured Investment Vehicles (SIVs) that moved the risk off balance sheet. Still, the inability of the FDIC to follow up the early warning in the article with any regulatory action is an indication that regulatory failure can happen as readily as market failure.

3. Megan McArdle is dismayed by a rumor that Austan Goolsbee is being passed over as CEA chair, perhaps in favor of Cecilia Rouse. This is reminiscent of the Clinton Administration, where by passing over Paul Krugman they caused tremendous outrage (well....Paul was really outraged), instead going with Laura Tyson, who in the event was an outstanding choice. Megan knows Prof. Goolsbee better than I do, but my instinct about him is that he may lack a talent for the lateral relationship-building that is necessary to be effective in non-academic organizations.

Ms. Rouse appears to have dedicated much of her scholarly work to studying the returns to schooling. Not surprisingly (were you expecting Obama to name a Charles Murray disciple?), her research supports the proposition that the apparent returns to schooling are not due to ability alone, and that schooling itself has a significant return across all ability levels.

I see no reason to doubt her qualifications for CEA chair. Her work has not focused on macro, but when it comes to dealing with the current crisis, do we really care that she does not have a track record of producing Euler equations or calibrating general equilibrium models?

4. Greg Mankiw asks,


You observe an economy sinking in recession. As this occurs, real interest rates are rising, and the currency is strengthening. What shock, or set of shocks, could have caused these events?

As far as the currency goes, I vote for the "tallest pygmy" explanation. As bad as things look here, where are they looking better? Japan? Western Europe? Russia? Emerging markets?

The main shock is a tremendous increase in the risk premium, in every country and in every market. That seems to cause a flood of money into U.S. Treasury securities, which raises the value of the dollar and lowers exactly one set of nominal interest rates--those on regular (not inflation-indexed) Treasuries. All other rates rise, the stock market crashes, and expected deflation ensues. Real rates are through the roof.


Comments and Sharing





COMMENTS (6 to date)
MattYoung writes:

The tallest pygmy theory is equivalent to the global currency of last resort.

The problem is that the global economy performs very differently right now than the US economy, so distortion and incomplete markets are the order of the day, evidently.

aaron writes:

Are rates falling elsewhere?

kebko writes:

A koan:

You observe a blog where the comments have been disabled & the blogger then poses an open question to the readers. What could have caused this series of events?

ionides writes:

Using an IS/LM framework, if the LM curve shifts left, interest rates will rise and employment will fall. Rising interest rates will make domestic bonds attractive to foreign investers, and their demand for dollars to purchase the bonds will raise the value of the domestic currency.

What causes the LM curve to shift left? A declining money supply. But if the Fed is pursuing expansive monetary policy this, they cannot be the source of this shift. Perhaps the money multipler is shrinking, reflecting the fact that banks are lending less, and have a higher ratio of reserves to deposits. And perhaps the public has a higher demand for currency, which is therefore not available to support deposit expansion.

John Thacker writes:

Not surprisingly (were you expecting Obama to name a Charles Murray disciple?), her research supports the proposition that the apparent returns to schooling are not due to ability alone, and that schooling itself has a significant return across all ability levels.

On the other hand, her work does support the idea that vouchers make nearby public schools better as well, which could be controversial with some Democratic supporters.

Steve Sailer writes:

The U.S. Dollar is backed by more nuclear missiles and aircraft carrier groups than anybody else's currency.

Comments for this entry have been closed
Return to top