"Our day-by-day experiences with the effectiveness of flexible markets as they adjust to, and correct, imbalances can readily lead us to the conclusion that once markets are purged of rigidities, macroeconomic disturbances will become a historical relic.
However, the penchant of humans for quirky, often irrational, behaviour gets in the way of this conclusion.
A discontinuity in valuation judgement, often the cause or consequence of a building and bursting of a bubble, can occasionally destabilize even the most liquid and flexible of markets.
I do not have much to add on this issue except to reiterate our need to better understand it."
Chairman Alan Greenspan Globalization and InnovationAt the Conference on Bank Structure and Competition, Sponsored by the Federal Reserve Bank of Chicago, Chicago, Illinois (via satellite) May 6, 2004
This paper gives an answer as to wether we are in Liquidity Trap and its corollary: is a crash in the cards already?
- Advertisement -
there are two complementary definitions of a Liquidity Trap. The classical which says that we are in a Liquidity Trap if the short-term rates are 0% and mine who says that we need the whole yield-curve to be at or below the yield curve of the Liquidity Trap.
The yield curve of the Liquidity Trap is the normal yield curve that goes through the point (0,0%).
Obviously my definition is more restrictive.
Let me first remind you what is my model of the yield curve and what I define as a Normal Yield Curve.
Model of the Yield Curve:
I define the shape of the yield curve in a novel fashion:
Forward rates are call options with strike 0% on the cash rate of the same time span. Long term rate are, as a consequence the result of the composition of options.
If that option is fairly valued the yield curve is normal.
Normal Yield Curve:
Long term assets are fairly priced compared to short term assets. There is equivalence between assets of different maturities.
Inverted Yield Curve:
Long-term rates are too low compared to short-term rates. Long-term assets are undervalued compared to liquidities. It is what Keynes termed liquidity preference. Under my definition a yield curve can be upward sloping and still be inverted.
Steep Yield Curve:
Long-term rates are too high compared with short-term rates. Assets assets of longer maturities are undervalued compared to assets of shorter maturities.
Chart of the Volatility of the 13 Weeks Treasury Bill:
Chart of the Volatility of the Yield of the 30 Years US Treasury Bond
The Yield Curve on Tuesday 16, 2009
Given the high volatility of long-term interest rates the yield curve is inverted (contrary to what most people believe.) and hence we are in a Keynes' Liquidity Trap.
The question remains: why then credit Market do function partially and why don't we have a crash?
The answer involve some sort of irrational exuberance:
What I say is that long-term interest rates may be overvalued or undervalued. Even if assets are correctly priced under the classical framework they can be or overvalued or undervalued under our framework.
For example in the case of an inverted yield curve our model says that a long-term asset that is correctly prices in the classical model is grossly overvalued under our model.
Gone is the perfection of the Market. There is hence no reason to mark assets to market.
If the yield curve is inverted, the investor should not buy long-term assets and stay liquid.
If the yield curve is normal he is indifferent between being liquid or invested.
If the yield curve is steep he should definitely be invested.
The implication of that framework is that thanks to the maximization of present value, the yield curve should have a tendency to move toward its equilibrium, the normal yield curve.
That said, we do observe protracted periods during which the yield curve stays inverted.
For example the yield curve has been inverted from the end of 1994 till July 2007 when the unstable equilibrium was disrupted but what is known as the sub prime debacle.
I see three reasons for that:
People might anticipate decreasing rates when making the decision to invest particularly when they have observed a long period of fall of interest rates, but that is taken in account by the diffusion process of interest rates.
II Legal Obligations:
Most of the funds and in particular pension funds must be invested in some class of long-term assets and saving on short term instrument is not an option for them. Because the pension funds have captive customers they do have an influence on the yield curve.
III Vested Interest
This is what I consider the most important and troublesome and which was at the origin of the sub prime debacle, is that the job of employees of banks and financial institutions is to transform short-term loans into long-term investments. When the yield curve is inverted the employee, as agent of the shareholder should say: "Look I can't do my job in a profitable way. Fire me till the yield curve returns to normal." which was precisely what Alan Greenspan expected when he jacked up short-term interest rates, at the middle of 2004, in order to avoid the dreaded Liquidity Trap (confer. lower).
but bankers like any other living creature (Yes, they are human beings!) have an animal spirit. That animal spirit prevented them to stay idle:
"Even apart from the instability due to speculation, there is the instability due to the characteristic of human nature that a large proportion of our positive activities depend on spontaneous optimism rather than on a mathematical expectation, whether moral or hedonistic or economic.
Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as a result of animal spirits-of a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities.
Enterprise only pretends to itself to be mainly actuated by the statements in its own prospectus, however candid and sincere. Only a little more than an expedition to the South Pole, is it based on an exact calculation of benefits to come.
Thus if the animal spirits are dimmed and the spontaneous optimism falters, leaving us to depend on nothing but a mathematical expectation, enterprise will fade and die;-though fears of loss may have a basis no more reasonable than hopes of profit had before."
John Maynard Keynes The General Theory of Employment Interest and Money The State of Long Term Expectations, Chapter IIV 13 December 1935
The interest of the shareholder and that of his agent diverge. The agent starts to make unprofitable investments in order to justify his salary. This is why the sub prime mess was so widespread. The responsibility of the shareholder is to make sure his agent works for him not against him and giving high compensation packages, golden parachutes and stock options is not an acceptable proxy for due diligence. The reason why they collectively behaved so recklessly was that there was no other worthwhile investments and, chasing rates instead of staying liquids which is what net present value maximization would lead, they promoted sub-prime mortgages to investment grade securities with a AAA rating.
The banker "intends only his own security; and by directing that industry in such a manner as its produce may be of the greatest value, he intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention."
Adam Smith An Inquiry into the Nature and Causes of the Wealth of Nations IV.2.9March 9, 1776
"I made a mistake in presuming that the self-interests of organizations, specifically banks and others, were such as that they were best capable of protecting their own shareholders and their equity in the firms."
Alan Greenspan Answering a Question bt Representative Henry A. Waxman Testimony at the House Oversight and Government Reform CommitteeOctober 23, 2008
Anyway, whatever the cause, an inverted yield curve is an unstable equilibrium.
"The measure of success attained by Wall Street, regarded as an institution of which the proper social purpose is to direct new investment into the most profitable channels in terms of future yield, cannot be claimed as one of the outstanding triumphs of laissez-faire capitalism-which is not surprising, if I am right in thinking that the best brains of Wall Street have been in fact directed towards a different object."
John Maynard Keynes The General Theory of Employment, Credit and Money Chapter 12: The State of Long-Term Expectation, VI.
What we see here is that the only cause of the stupid behaviour of the banker and the fund manager is an inverted yield curve that cause them to do something that is against the maximisation of present value.
The yield curve being inverted they must be doing something stupid again!
The answer is simple: they are buying AAA corporate bonds. They were enticed to do so by the barbaric Quantitative Easing of Chairman Benjamin Shalom Bernanke who sunk them into liquidities when the Market was precisely soaked with it, as it was already in a Liquidity Trap.
The $12 trillion question is: "When will the Market receive a shock that will push it out of its unstable equilibrium into the chaos?"
No one has the answer:
"But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade?
And how do we factor that assessment into monetary policy?
We as central bankers need not be concerned if a collapsing financial asset bubble does not threaten to impair the real economy, its production, jobs, and price stability.
Indeed, the sharp stock market break of 1987 had few negative consequences for the economy. But we should not underestimate or become complacent about the complexity of the interactions of asset markets and the economy.
Thus, evaluating shifts in balance sheets generally, and in asset prices particularly, must be an integral part of the development of monetary policy."
Chairman Alan Greenspan At the Annual Dinner and Francis Boyer Lecture The American Enterprise Institute for Public Policy Research, Washington, D.C. December 5, 1996
But I am sure that the minute it happens you will see it on The Tube.
All of This is True Until the Poor Becomes Richer Relatively to the Rich.