A Specific Application of Employment, Interest and Money
An Inquiry in the Nature and Causes of the Great Depression
Plea for a New World Economic Order
Part One: Greenspan Conundrum and Income Wealth Disparities
This text although somehow difficult is a simplified version for OpEdNews of a research paper that will soon be published on my site, among other works: http://www.yield-curve.net/
"The composition of this book has been for the author a long struggle of escape, and so must the reading of it be for most readers if the author's assault upon them is to be successful,-a struggle of escape from habitual modes
of thought and expression.
The ideas which are here expressed so laboriously are extremely simple
and should be obvious.
The difficulty lies, not in the new ideas, but in escaping from the old ones,
which ramify, for those brought up as most of us have been,
into every corner of our minds."
John Maynard Keynes
The General Theory of Employment, Credit and Money
13 December 1935
This tract makes a critical analysis of credit based, free market economy, Capitalism, and proves that its dysfunctions are the result of the existence of credit. It shows that income / wealth disparity, cause and consequence of credit,is the first order hidden variable, possibly the only one, of economic development.
It solves most of the puzzles of macro economy: among which, Unemployment, Under Development, International Division of Labor, Business Cycles, Stagflation, Greenspan Conundrum, Deflation and Keynes' Liquidity Trap...
It shows that no fiscal or monetary policy, including the barbaric Quantitative Easing will get us out of depression.
The Credit Free, Free Market economy is the solution that will correct all of those dysfunctions.
In This Age of Turbulence The People Wants an Exit Strategy out of Credit, an Adventure in a New World Economic Order.
Long-Term Behavior of Interest Rates:
As we can see on the following charts long-term interest rate are following a secular downward trend since 1981.
Long-Term Trend of the Yield of the 30 Years US Treasury Bond
"There is little doubt that, with the breakup of the Soviet Union and the integration of China and India into the global trading market,
more of the world's productive capacity
is being tapped to satisfy global demands for goods and services.
Concurrently, greater integration of financial markets has meant that a larger share of the world's pool of savings is being deployed in cross-border financing of investment. The favorable inflation performance across a broad range of countries resulting from enlarged global goods, services and financial capacity has doubtless contributed to expectations of lower inflation in the years ahead and lower inflation risk premiums.
But none of this is new and hence it is difficult to attribute the long-term interest rate declines of the last nine months to glacially increasing globalization.For the moment, the broadly unanticipated behavior of
world bond markets remains a conundrum.
Bond price movements may be a short-term aberration, but it will be some time before we are able to better judge the forces underlying recent experience."
Chairman Alan Greenspan
Federal Reserve Board's semiannual Monetary Policy Report to the Congress
Before the Committee on Banking, Housing, and Urban Affairs, U.S. Senate
February 16, 2005
The Yield Curve:
The yield curve is a curve that Plot yield of debt of the same risk (except for the interest rate risk) against their maturity.
Yield Curve of the US Treasuries
Understanding it is paramount to understanding both economy and finance because it is what presides on all of our investments and saving decisions.
Model of the Yield Curve:
We are going to define the shape of the yield curve in a novel fashion:
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.
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.
What we 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. We see three reasons for that:
One is 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.
The second is that 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.
The third cause, 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 in order to avoid the dreaded Liquidity Trap (cf. lower). 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."
"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."
An Inquiry into the Nature and Causes of the Wealth of Nations IV.2.9
March 9, 1776
Answering a Question bt Representative Henry A. Waxman
Testimony at the House Oversight and Government Reform Committee
October 23, 2008
Anyway, whatever the cause, an inverted yield curve is an instable 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.
It is hence easy to understand monetary policy:
A monetary policy is neutral when the yield curve is normal. The central bank gives no incentive to either stay liquid or buy long-term assets.
A monetary policy is said to be restrictive if the yield curve is inverted. The banks incite people to stay liquid rather than invest (on MBS for example).
A monetary policy is proactive when the curve is steep the monetary authority gives incitement to buy long-term assets rather than being liquid.
Any monetary policy that would depart from neutral would give rise to the possibility of arbitrages and excessive returns for the banks. They are making enough money, as it stands, they don't need to be even more subsidized by the FED.
Keynes' Liquidity Trap:
Keynes Liquidity Trap occurs when, and that is a departure from the classical definition, the yield curve is inverted, people withdraw from holding long-term assets if the short-term interest rates reached 0% monetary authority have no way of enticing people to invest long-term. Because these investments are central to money creation in a Capitalist economy it causes its systemic collapse.
Hence we define the yield curve of Keynes Liquidity Trap as the normal yield curve that goes through ( 0, 0.00%). As with any normal yield curve, the higher the volatility, the steeper the curve and the higher the long-term rates.
We have proven that the Markets can have protracted periods of inverted yield curve. So the effective yield curve can be for some time below the Keynes' Liquidity Trap yield curve.
When in normal time I=S (Investments=Savings), in a Liquidity Trap S stays higher or even grows. I dwindles to 0 and so does the demand for good and services. Savings stay in liquid assets and are therefore not invested on long-term assets.
The minimum rate at which the capital market is ready to supply is greater than the rate of the demand for investment. The market does not clear by lowering the long-term rates.
Expecting that market forces will solve the problem is simply hilarious: there is no market.
If money is the blood of an economy, in a capitalist economy the credit market is its heart.
Mechanism of a Depression:
We have seen that the Depression starts with a disruption of capital markets which stop to clear. What is interesting is to understad why it won't adjust. In a normal crisis assets and investments lose value so their return increase and there is a new equilibrium. In the case of the Liquidity Trap because of the break down of the financial system the demand goes down at the same rate or even faster that the value of assets so the return on investment never goes up to the minimum yield on long-term savings.
Hence the cause of the Liquidity Trap and hence of all the present economic turmoil resides in the fall of long-term interest rates.
In order to understand the root of the crisis we need to understand the cause of that trend.
Income / Wealth Distribution Does Matter:
One of the premises of economist regarding the Capitalist system is that income / wealth distribution does not matter. And that income repartition is optimal when left to the Market. This is so true that all the economic aggregates that are published are averages never standard deviations.
Monetarist theory takes the money supply as one without recognizing that what one does with his money varies with his income and his wealth.
Usage of Money:
The use of marginal revenue by the rich goes almost 100% to savings his propensity to save is close to 1 his propensity to consume is close to 0. In a normal economy nearly all of these savings are channeled into long term investments in fact globally only the bank reserves are liquidities that are not funneled into investment.
The usage of his marginal revenue is completely different. Any money he receives goes to consumption. His propensity to save is close to 0 his propensity to consume is close to 1.
Because of the existence of credit income wealth disparities keep increasing:
Discrimination and Class Struggle:
Credit market discriminates against the poor: the richer you are the most credit you can have and the more profit you can generate. If you are poorer you get higher rate, a lower amount of credit and most of the time it is geared to consumption and not investments the credit you get makes you poorer. If you are even poorer than that you will not be even given the advantage of saying hello to your banker. This what they call equal opportunity, we suppose.
Where it shows that it is a class struggle is that according to your wealth you pay a risk premium. The poorer you are the higher the risk premium.
Who pays that risk premium? Those who do repay their credit. Obviously those who don't do not pay their risk premium. So this risk premia are tantamount to a collective punishment that only the best pupils of the class will have to endure.
Credit market goes against anything that a democratic and capitalist society pretends to defend.
Income Wealth Disparity:
In a capitalist society capital is the most important factor of production. With it you can buy all other factors of production. If you have no access to credit free enterprise is and stays a dream. With credit the notion of equal opportunity is the biggest lie man has invented and believed in. The American Dream is for 80% of the population a nightmare.
The poor gets poorer because not only they can't invest but also their bargaining position is weak when it comes to wage and salaries (the more options you have the stronger you are).
"The income gap between the rich and the rest of the US population has become so wide, and is growing so fast, that it might eventually threaten the stability of democratic capitalism itself."
Chairman Alan Greenspan
The Economic Outlook
Before the Joint Economic Committee, U.S. Congress
June 9, 2005