Monday, June 14, 2010

Paul Krugman was dead wrong

On Friday, Paul Krugman wrote:
I wish I could believe in this Macroeconomic Advisers claim that there is a zero chance of a double-dip recession. But when they say that this probability
is estimated as a function of the term slope of interest rates, stock prices, payroll employment, personal income, and industrial production
I immediately lose all confidence.

When short-term interest rates are up against the zero lower bound, a positive term spread tells you nothing; as I explained a year and half ago, it’s something that has to happen given the fact that short rates can go up, but not down.

Failure to understand this point led to excess optimism in late 2008. I’m a bit surprised to see Macroeconomic Advisers falling into the same fallacy now.
In the second to last paragraph, he is referring to a previous blog post of his from December 27, 2008, in which he wrote:
I see that economists at the Cleveland Fed are taking some comfort from the positive slope of the yield curve. Long-term interest rates are higher than short-term rates, which is usually a sign that the economy will expand.

Not this time, I’m afraid. It’s all about the zero lower bound.

The reason for the historical relationship between the slope of the yield curve and the economy’s performance is that the long-term rate is, in effect, a prediction of future short-term rates. If investors expect the economy to contract, they also expect the Fed to cut rates, which tends to make the yield curve negatively sloped. If they expect the economy to expand, they expect the Fed to raise rates, making the yield curve positively sloped.

But here’s the thing: the Fed can’t cut rates from here, because they’re already zero. It can, however, raise rates. So the long-term rate has to be above the short-term rate, because under current conditions it’s like an option price: short rates might move up, but they can’t go down. ...

So sad to say, the yield curve doesn’t offer any comfort. It’s only telling us what we already know: that conventional monetary policy has literally hit bottom.
Paul Krugman may have been right in theory, but he was completely wrong in fact. As Frederic Mishkin has pointed out, the yield curve forecasts economic expansion or contraction roughly four quarters advance. Four quarters after Paul Krugman gave his "Not this time, I’m afraid" argument above, Real Gross Domestic Product showed economic expansion as shown here:

So, Paul Krugman was dead wrong. The economy returned to expansion exactly as the yield curve predicted. Furthermore, the yield curve is significantly steeper now than it was in December 2008. That means year-ahead prospects are even brighter now than they were then.

Paul Krugman is a natural economic pessimist. He's such a pessimist that when the economic data shows economic expansion, he tries to confuse his readers by implying that it doesn't.

No matter how Paul Krugman tries to spin it, the yield curve in December 2008 predicted mild economic expansion, and mild economic expansion is what we got. The yield curve is much steeper today.

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