March 01, 2011
Crowding Out Watch, Updated
I'm teaching the concept of portfolio crowding out in my intermediate macro course (handout with algebra here) now, and as I was going through the notes, I observed that last I had checked, there was (still!) little evidence of crowding out. Here's the graph, updated with data through 2/25 (that is, pretty much the same story as last time I discussed this, despite the hysterics).
Figure 1: Ten year constant maturity TIPS yields (blue), and observation for 2/25 (blue square); five year constant maturity TIPS yields (green), and observation for 2/25 (green circle); and ten year constant maturity yield adjusted by ten year median expected CPI inflation rate (red circles), observation for 2/25 (red open circle). NBER defined recession date shaded gray. Source: FREDII, Philadelphia Fed Survey of Professional Forecasters, NBER and author's calculations.
Relative to my September post, the ten year TIPS is slightly up, but the five year remains at zero (well, actually negative).
This means that whatever upward pressure there is on government interest rates due to the large supply of government debt, it is being offset by low demand from the private sector (or by demand from offshore sources).
Of course, the crowding out of investment phenomenon relies upon a variety of assumptions. It follows from a two asset model (money, bonds), with the right parameter values. With three assets, one can get "crowding in". And even if interest rates had risen, if investment depends upon income (or the change in income), one could still get a net increase in investment from a positive fiscal impulse.
Another implication of having interest rates at zero (at least the five year real) is that if fiscal policy is made more contractionary (as in some recent plans), then the contractionary impact should be large (this is just the mirror image of fiscal policy effectiveness in a liquidity trap). For more discussion/links of the economics, see here. For recent discussion of the impact by the economic research firms, see here and here. In his testimony today, Fed Chairman Bernanke indicated he believed the Moody's Analytics estimate was high, as it was described to him (although there was some back and forth on whether the estimates pertained to calender or fiscal years, and the magnitude of the cuts, so I'm not sure exactly how much of a difference there is in terms of per dollar impact).
Posted by Menzie Chinn at March 1, 2011 09:08 AMdigg this | reddit
The attempt to save the world with QE2 is dying, no matter what numbers show what miracles could happen or could have happened.
It is the natural consequence of de-cooperating world after overcooperation caused boom , bust and shock ( lehman to March 2009) which is still just starting to send out waves into geopolitics,and back to economics and individual decision making psychology.
Look what voters did in Ireland or in Hamburg. The rise of True Finns in Finland. The signs of coming austerity (de-cooperation) are unmistakable, and all over the place. Its coming to the USA as well, no matter what the government or FED does or does not.
Posted by: Ivars at March 1, 2011 12:28 PM
When you teach the concept of crowding out to your students, will you mention the potential impact of QE?
Posted by: David Pearson at March 1, 2011 12:48 PM
I'm never sure if you're quite serious when you write about this.
I mean, you do understand how the monetary system works, and that the money to buy government bonds comes from government spending, and that operational there can be no "crowding out", don't you?
Posted by: Jim Baird at March 1, 2011 12:59 PM
David Pearson: I have always mentioned the fact that the Fed can offset the effect; in the past by expansionary monetary policy shifting out the LM curve so the IS intersects along the flat portion of the LM curve. Or, in the current context by buying long term securities at the horizon for which interest rates are nonzero. The second is a bit harder because I have to introduce the idea of multiple interest rate horizons, which I have not yet done in the IS-LM context. But it's coming up in the next few lectures.
Jim Baird: I regret that I have no idea what you are saying. Please provide an equation so I can figure out what it is you're getting at.
Posted by: Menzie Chinn at March 1, 2011 01:12 PM
It is not the debt, but the spending, I think perhaps that is Mr. Bairds point. I.e., in a Ricardian or rational world, the borrowing does not matter, it is the spending..buying airplanes and throwing them in the ocean, my profs would say. And since a bunch of the spending is simply transfers, that is not costly either, in a macro sense. So whether there is debt, or it is monetized, is definitely irrelevant. Currently spending seems to be being restrained.
Posted by: pete at March 1, 2011 01:29 PM
"I mean, you do understand how the monetary system works, and that the money to buy government bonds comes from government spending, and that operational there can be no "crowding out", don't you?"
Dude, sure there can be, even in the neo-chartalist framework that you're undoubtedly proffering. At reasonably full employment, a finite supply of real resources means that increased government spending will result in higher prices or higher interest rates.
Posted by: E at March 1, 2011 03:41 PM
Right. The gov't borrowed an additional $4.5 Trillion in the last 3 years and there was no effect. No resources were claimed by gov't that private firms might have used.
Wow, that Bernanke can monetize with such exquisite talent.
Posted by: Bryce at March 1, 2011 06:48 PM
Econbrowser "Exchange Rates: Two Stylized Facts and Yet Another (Consequent) Puzzle"
When assessing a currency exchange rate linked with interest rates.This is the transcript of the imperfections recorded between exchange rates,risks premia,interest rates.
"A risk-based explanation for the empirical regularities requires a story of some sort of reversal of the risk premium – the securities of the high-interest rate country must be relatively riskier in the short-run, but expected to be less risky than the other country's securities in the more distant future. It may be difficult to rationalize this pattern by focusing on the risk premium required by a single agent in each economy, as many theoretical models do. Instead, a full explanation may require interaction of more than one type of agent and perhaps also requires introducing some sort of “stickiness” in the financial markets -- delayed reaction to news, slow adjustment of expectations, liquidity constraints, momentum trading, or other sorts of imperfections."
Savings rushing to purchase incremental addition of public debts? (money has to come from somewhere Friedman, MC Kenzie)
ECB statistics pocket book Households incomes,saving and investment (households savings Q1 Q2 Q3 2010, are decreasing whilst public debts are increasing).
Whilst households savings are decreasing banks profits and liquidities are increasing (for banks to post such large profits in a very weak business environment,money has to come from somewhere).
http://www.ecb.int/pub/pdf/stapobo/spb201102en.pdf (P 23)
Needs are not for hysterics,but much more for sanity.
Posted by: ppcm at March 1, 2011 11:52 PM
Govt borrowed and spent 4.5 trillion Bryce.
Posted by: joe at March 2, 2011 12:32 AM
MC, I think the true source of crowding out is not the flow of new additions to debt, but the stock of existing debt. Sorry, no equation comes to mind.
Posted by: The Arthurian at March 2, 2011 02:45 AM
I think people don't get this is an empirical test: if rates or expectations for rates are going up, then one can sense crowding out. And this disconnect means to me people are responding to a gut feeling.
I've tried thinking about this from that other perspective. I think commenters are confusing the specific phenomenon of "portfolio crowding out" with something more in the Austrian model, that low rates lead to "malinvestment." There is then a tendency to put that idea with the "bubble" in treasuries, though they aren't the same ideas at all. Neither of these make much sense to me, but I think that's what they're saying.
As to the former, there isn't much investment going on by the private sector and yet low rates are supposed to make longer term, more circuitous investments artificially desirable. We should be seeing lots of corporate borrowing enticed by artificially low rates to be "malinvested" in projects that only can pay off because of the low rates. Not happening because the economy sucks and thus any investment looks lousy. A simple test of this idea is the argument - seen in the comments here - that the Fed caused the housing bubble with low rates (because those low rates made bad investments look good). They are essentially arguing two sides of the same coin: low rates cause malinvestment and low rates crowd out malinvestment.
I found this, by a guy who teaches at a university in polisci / econ:
"Now you are a corporation who needs a very expensive piece of equipment and you do not have enough profits saved up to buy this machine. Not buying this machine will mean that your business will come to a dead stop because you will not be able to make a component of your product. So you issue bonds. The problem is that your bonds are competing against a ton of safe government bonds. In tough economic times there is a “flight to safety,” which means investors are more likely to buy “safe” bonds than regular corporate bonds. In order to get people to buy your bonds, you must offer a high rate of interest to entice them away from the government bonds. But this raises what is called “the cost of capital.” This means that the corporation will have to make more money on their product to pay the higher interest rate than they would if they did not have to compete with government bonds."
This illogic embodies the contradiction: government is always a better creditor than a company and lower government rates generally mean lower corporate rates but that is stood on its head for reasons not clear but which seem to be just inchoate bad feelings. In a regular economy, low government rates encourages more borrowing not less.
To give some credit, I assume people fixate on the "worry" and "uncertainty" as chilling investment. Again, we know the big worry: a fight to safety. To that is added stuff the markets should be pricing: inflation fears and default fears and that shows next to zilch worry. I suppose one could add a tiny bit of fear about future tax increases but that's an inchoate maybe and if there is a real fear it would show in prices.
As to a treasury bubble, people are intentionally buying treasuries in the knowledge they will go down in value as the economy improves and rates go up. That's the opposite of a bubble; you'd have to be hoping rates would be going down so your investment would be worth more, not to mention that you have the US government's guaranty at whatever yield you bought in at. It's not a bubble but an inverse bubble in which people are being driven by worry to safety.
Sorry for taking so much space. I wanted to think this through for myself.
Posted by: jonathan at March 2, 2011 08:00 AM
"This means that whatever upward pressure there is on government interest rates due to the large supply of government debt"
Instead of "debt" I assume you meant to say "spending on goods and services" here....the relationship between debt while holding spending constant is not clear...and in rational or Ricardian world is zero.
Posted by: pete at March 2, 2011 08:48 AM
If you had a pencil you were NOT USING and I "borrowed" a dollar from you and then bought the pencil from you with the dollar, have I crowded out your financial position? Do you understand what Jim is saying now? And Bryce, if the private sector is not using the resource (like the pencil in this case) it does not crowd out any real resources. Now, if Menzie and I both wanted the pencil and it was the only one available, we could get into a bidding war. This is a case of real resource constraints and could lead to inflation. As long as there are real resources available (such as labor) the government can buy those resources without any crowding out (financial or real). No equations necessary; just common sense.
Posted by: markg at March 2, 2011 08:54 AM
Menzie: Just out of curiosity, how would you approach teaching John Taylor's viewpoint here, which takes a rather pointed view of the role of expectations:
Posted by: Robert Bell at March 2, 2011 10:50 AM
Crowding out can't be explained by the IS=LM model. And crowding out isn't confined to the public sector monopolizing borrowing.
John Maynard Keynes gives the impression that a commercial bank is an intermediary type of financial institution serving to join the saver with the borrower when he states that it is an “optical illusion” to assume that “a depositor and his bank can somehow contrive between them to perform an operation by which savings can disappear into the banking system so that they are lost to investment, or, contrariwise, that the banking system can make it possible for investment to occur, to which no savings corresponds.”
In almost every instance in which Keynes wrote the term "bank in the General Theory it is necessary to substitute the term financial intermediary in order to make his statements correct.
In the Keyesian system, S+I by definition, and in the national income accounts, S+I + (G-Tn).
In the payments approach, the gross amont of monetary savings effected in a given period may be represented by the following equation:
S+I-Ib + [(G-Gb) - Tn] + (Se-Sb) + Dx + St + Sd + St
I: gross private domestic real investment plus net foreeigh real investment
Ib: that part of I financed through commercial (and Reserve) bank credit
G: expenditures of governments for the purchase of goods & services
Gb: that part of G financed through commercial (and Reserve) bank credit
Tn: government income from tax sources disposed of on goods & services
Se: the total volume of monetary savings in existence at the end of a given period. This includes the sum of: (1) time & savings depoists in the commericla bnks; (2) currency hoards; & (3) that part of demand deposits owned by the nonbank public which constitutues savings
Sb: the total volume of monetary savings in existence at the beginning of the given period (the compoentns are the same as for Se.)
Ds: the volume of dissaving, that is the voume of monetary savings effected during the period which was spent on or lent to finance consumption
St: the net volume ofmonetary svaings absorbed in financial investment
Sd: the net volume of monetary savings absorbed in effecting duplicative transactions
St: the net volume of monetary savings absorbed in making transfer payments
Of all the items in the above equation, only (I-Ib), (G-Gb) & Ds consitute a utilization of savings in such a way as to contribute to GDP. It will be noted, in contrast to the income-expenditure or national income concept of savings, that the itesm Ib & gb have been subtracted fromt he itesm I & G respectively.
The utilzation of bank credit to fiance real investment or government deficits does not constitute a utilization of savings, since bank financing is accomplished thou the creation of new money.
Leland J. Pritchard - Ph.D, economics, Chicago, 1933, MS statistics, Syracuse
The 1966 paradigm cannot be explained in any other way.
Posted by: flow5 at March 2, 2011 11:16 AM
markg, you are mostly describing "transactional crowding out"; if government creates more demand, like through spending, and if you assume the supply of money isn't also growing, then more demand chases the same products and thus government could crowd out private purchasers.
Portfolio crowding is a somewhat different way of looking at it because issuing bonds - as opposed to a big stimulus spending package - is related more to "wealth" because bonds are in a sort of literal sense wealth. Portfolio crowding out means the government has issued bonds and that has caused interest rates to rise because the market prices the cost of financing the government debt higher. What Prof. Chinn is saying is that we have a simple test for portfolio crowding out and that says it isn't happening. This is a purely empirical issue, not one of ideology: rates have not gone up so there is no portfolio crowding out.
Posted by: jonathan at March 2, 2011 11:33 AM
The malinvestment generated by the artificially low interest rates [negative in real terms] currently takes many forms.
The traditional ones of over-investment in homes & autos is still going on: housing prices & auto production capacity would be significantly lower than currently if we had market interest rates. Other companies undertaking projects that depend on very low interest rates are also going to find them unprofitable when market rates eventually assert themselves.
There are probably other examples that aren't so obvious. Low interest rates are exacerbated in the instance of student loan by explicit subsidies, inducing many students to be too casual about what they study & how long the stay in school. [We may well have more social scientists--including economists--already than is optimal.] They have the luxury of easily going into debt studying stuff that will never profit them or anybody.
Finally, artificially low interest rates lull gov'ts into taking on Brobdingnagian quantities of debt under the illusion that it is cheap. Greece did this under the influence of Greenspan & the Asian central banks in the previous decade. The US is doing it now.
Posted by: Bryce at March 2, 2011 12:22 PM
Bonds are certainly not in any literal, and certanily not real sense wealth. They are indeed assets, but of course they are offset by future tax liabilities. Now there may be a illusion of wealth, i.e., ignoring the future taxes. The veil of money adds nothing real to the economy unless it is by fooling folks into mistaking nominal for real values in the short run.
It is not the debt, it is the spending on real goods and services which may crowd out, since there is less stuff for the rest of us to use. If the govt is building highways and bombs, then we can't build factories with that material to build Teslas and Ipads.
Posted by: pete at March 2, 2011 01:58 PM
If crowding out doesn't exist, I don't understand why you think QE works.
Posted by: Anonymous at March 2, 2011 04:22 PM
Robert Bell: It's true that imposing model consistent expectations (what is the feasible counterpart to rational expectations) as pioneered in by Taylor (1993) often leads to smaller multipliers. So perhaps the Moody's Analytics multipliers can be criticized on that count (as is true of Macroeconomic Advisers). But this doesn't mean the multipliers are zero; the Fed's big macroeconometric model with model consistent expectations (FRB/US) has multipliers. The multipliers become very small sometimes when one enters the world of DSGE's, as in Taylor's work with the Smets/Wieland et al. model. Here again, some DSGE's (like the IMF's GIMF) have pretty big multipliers. So, all part of the debate that has been discussed at length here on Econbrowser (go to the multiplier category, and you'll see the relevant posts).
Posted by: Menzie Chinn at March 2, 2011 06:05 PM
Menzie: Thanks, that makes sense.
Posted by: Robert Bell at March 3, 2011 06:08 AM
pete, to explain, the definition I gave you is the definition put in very simple words. You can argue with the idea behind there because it comes from a simple model - as Prof. Chinn has stated many times - but that's the definition. I find it kind of silly to use the word "portfolio" and to talk about "wealth effects," but they're just trying to differentiate two channels by which government action can "crowd out."
But you clearly don't see the connection, which is that there is no crowding out visible at all and thus your statement about no money being available for building Teslas is just plain wrong. It is. Think it through. I can't even tell what your assumption is, but it seems to be that there is a fixed amount of money. If there were, think about the direction that pushes interest rates.
As for "malinvestment," my point was that low government rates should be encouraging malinvestment by Austrian theory. This is the main driver of malinvestment, the "artificial" setting of an interest rate below the "natural" rate. We aren't seeing it. And we aren't seeing any rise in interest or inflation expectations - especially if you don't look at world commodity prices.
Posted by: jonathan at March 3, 2011 08:18 AM
I think I am agreeing that there is no effect because government spending is relatively flat, and that the crowding out is the spending, not the borrowing. Think of it this way, if all govt was just transfers, just social security for instance, and we borrowed to pay that, then for sure there would be no crowding out, simply taking a dollar from pete and giving it to jonathan. It is when there is spending on stuff, like bridges to nowhere, that the crowding out occurs.
Posted by: pete at March 3, 2011 10:58 AM
You do realize that the fed is buying up longer term securities in an attempt to hold down the yield curve?
Because of this any arguments /from/ the yield curve are specious.
Posted by: Doc Merlin at March 3, 2011 02:03 PM
Robert Bell John Taylor seems to believe that if he repeats his claim often enough it will somehow become true. He points out that there is an important distinction between budget authority and actual outlays. And he's right. But for someone that was supposed to have held a high government position he seems to have bungled the distinction. Contrary to what Taylor seems to believe, companies anticipate business based on budget authority rather than actual outlays. The actual outlays (Treasury disbursements) don't happen until the economic activity in the private sector has already been completed. He's just confused.
And get this line:
The high unemployment we are experiencing now is due to low private investment rather than low government spending. By reducing some uncertainty and the threats of exploding debt, the House spending proposal will encourage private investment.
More intellectual confusion. The relevant question isn't what caused today's high unemployment. His claim that it is due to low private sector investment may or may not be true; but identifying the cause is irrelevant to identifying the cure. Private sector investment fell because private sector demand is weak. What Taylor needs to demonstrate is that increasing government sector demand will not increase aggregate demand. Just telling us that a downturn in private sector demand is what caused the recession is an intellectual dead end.
He also claims that reducing uncertainty about exploding debt will increase private investment. So does this mean he supports tax increases? Somehow I don't think so even though tax increases would undoubtedly reduce uncertainty about exploding debt.
As to the whole rational expectations argument, I'm sorry but this may square with how some people form their personal inflation expectations, but as a practical matter it is not how inflation expectations get institutionalized into the real economy. In practice inflation expectations are realized in the economy through wage negotiations, and typically those are based on adaptive expectations and not rational expectations. Show me a wage contract that bases future wage growth on the writings of some arcane economists at the University of Minnesota. Wage contracts base future wages on adaptive expectations based on experience with recent inflation.
Posted by: 2slugbaits at March 3, 2011 03:45 PM
What two asset world? Money and bonds are the same thing, have you ever heard of financial intermediation? When banks purchase newly issued bonds, both bonds and money are created. They are the same thing, not two seperate assets. When the government taxes you, they take your deposits and the assets (bonds) that back them.
Loans create deposits, the demand of money creates its own supply, as long as borrowers are credit worthy. How can financial markets get crowded out, if money is created by a pen stroke? Goods markets and finance markets do not operate in the same fashion. The loanable funds theory is bunk. In financial markets, quantity does not affect the price.
Everyone talks as if we operate in a commodity money or fiat money world, what happened to credit money. Borrowing and lending has no impact on interest rates. The Fed controls short rates and long-rates are an expectation of the movement of future short rates.
Basil Moore disproved crowding out and IS-LM more than 20 years ago. The federal reserve controls the interest rate, not the quantity of money.
If neo-classical economists don't want to learn anything about finance or money that is fine. But that means that you should never talk about assets, debt, crowding out, debt-to-gdp ratios, financial institutions, the financial crisis, equilibrium, fiscal sustainability or anything else that you don't know anything about.
Posted by: BD at March 17, 2011 07:49 AM