Tuesday, November 24, 2009

A 15 year cycle

Paul Krugman, building on his NYT column --

So does 1994 carry lessons for today? Well, I guess everything does. But the differences were large — and 1994 does not offer an example of bond vigilantes derailing a recovery: despite the vigilante attack, growth just kept on rolling.

The specifics of what happened --

Then as now there was a large “carry trade” motivated by the spread between long rates and short rates; when the long rate started to rise, there was a balance sheet squeeze that caused a stunning, albeit short-lived spike:

The context for Krugman's account is worth filling out because it has a strong implication for the relevance of the 1994 comparison -- the Fed was tightening like crazy in 1994 in reaction to the bond market. Here's the Fed's tabulation of the policy interest rate changes in 1994-95:

Increase Decrease Level
December 19: ... 25 5.50
July 6: ... 25 5.75
February 1: 50 ... 6.00

November 15: 75 ... 5.50
August 16: 50 ... 4.75
May 17: 50 ... 4.25
April 18: 25 ... 3.75
March 22: 25 ... 3.50
February 4: 25 ... 3.25

That's a 275 basis point increase in rates before they eased off. In other words, those bond market vigilantes got what they wanted. So if there's a 1994 message for today, it's that when the central bank responds to the vigilantes, interest rates come back down. But that's not that message that we want for 2009, right?

The bigger picture is that 1994 was arguably the beginning of the mess the world is in today. It confirmed Alan Greenspan's credentials as the man who would do what the bond market said, and so promoted the idea that Wall Street risk had declined for good. Because of the vigilante attack, growth just kept on rolling. Hence the piling into ever riskier stuff on the assumption that the macroeconomic risk was gone.

And here we are.

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