By Nathan Tankus, a student and research assistant at the University of Ottawa. He is currently a Visiting Researcher at the Fields Institute. You can follow him on Twitter at @NathanTankus
Since Bernanke started talking about “tapering off” Quantitative Easing, the bond markets have freaked out. This is a very logical reaction.
Before last month, it seemed like QE would go on indefinitely. Once that belief was shaken – even in the slightest fashion – everyone ran to the exits. Bernanke and other Federal Reserve economists appear bewildered by this phenomenon. The impression one gets from their follow-up comments is that they wished they could ask bond speculators “did you read the damn speech?” The answer, of course, is no and for good reason.
All investors need to know is the conditions under which QE (and for that matter, the Zero Interest Rate Policy) will be pursued has changed. Now the substantive change may actually be relatively minor, but that’s irrelevant to speculators. The reason is very simple: those holding assets with longer maturities will take huge capital losses with relatively small changes in interest rates (As a reminder: it is basic “bond math” that a change in interest rates send bond prices in the reverse direction. A rise in interest rates makes bond prices fall and a fall in interest rates make bond prices rise). It is better to exit now when those future changes are uncertain then take even more massive losses.
This is the logic behind the actual “liquidity trap” presented by Keynes in the general theory. Specifically, Chapter 15 entitled “The Psychological and Business Incentives To Liquidity.” Here he argues that every fall in the interest rate relative to what is commonly believed to be a “safe” rate increases the “risk of illiquidity”. The the “risk of illiquidity” is the risk of holding an asset not easily convertible into money at “book” value (this also means an asset is more or less “liquid” based on the relative easiness to convert into money “book” value). Further, rather then seeing interest as a return to “waiting”, Keynes argues that it is “a sort of insurance premium to offset the risk of loss on capital account”.
How can one evaluate the uncertainties relative to the “insurance”? By what has been subsequently known as “Keynes’s square rule”.
The square rule was defined by Keynes in this chapter as “an amount equal to the difference between the squares of the old rate of interest and the new” (mathematically represented as Δi = i2 ). If interest rates (at that maturity) are expected to rise faster then a squaring of itself, it means your capital losses (market price of the bond or investment) will fall faster then the increase in the rate of return (and vice versa).
Based on this understanding, a liquidity trap is not a short term rate of interest at zero but a uniform expectation that interest rates will rise to such an extent that the rate of return on a bond or equity won’t preserve your principal and thus a refusal by anyone but the central bank to buy bonds at such a high price (i.e., low interest rate).
Keynes says explicitly in chapter 15 that “what matters is not the absolute level of r but the degree of its divergence from what is considered a fairly safe level of r, having regard to those calculations of probability which are being relied on” (r being the rate of interest). Why this confusion has resulted has many complex historical reasons, not least of which is economists disinterest in actually reading and comprehending what was written more then five years before them.
A normally good economist has fallen into this trap by repeating an error Irving Fisher made over 80 years ago that Keynes’s argument was explicitly a response to (see Kregel’s enlightening account, and incidentally meticulous critique of Krugman, here) . Specifically, Bruce Bartlett argued that:
Because there is so much concern right now about the economic consequences of higher interest rates, which are almost universally viewed as negative, I would like to note that higher rates will raise the income of many middle-class people who tend to keep their savings in bonds, certificates of deposit and savings accounts that yield very little return.
Irving Fisher went further then this, arguing that increases an interest rates could always compensate for inflation. Still, the basic error is the same. What Bartlett is forgetting is that if the interest rate rises too fast those “middle-class people” will take much larger losses on the value of many of their assets then they will get back in interest (he has another argument based on textbook economics that I may respond to in another post). That is without even taking into account the higher borrowing costs that many would most likely face. Remember also that at such low interests rates “too fast” is actually a very small increase. To go back to Keynes:
If, however, the rate of interest is already as low as 2 per cent., the running yield will only offset a rise in it of as little as 0.04 per cent. per annum. This, indeed, is perhaps the chief obstacle to a fall in the rate of interest to a very low level. Unless reasons are believed to exist why future experience will be very different from past experience, a long-term rate of interest of (say) 2 per cent. leaves more to fear than to hope, and offers, at the same time, a running yield which is only sufficient to offset a very small measure of fear.
The “reason” in our current situation, whether justified or not, was Quantitative Easing. It is quite reasonable for participants to panic once the hope is removed and all that is left is fear. QE was bad policy but once it was done, it could only be ended very gradually. Tapering may prove to be as ad-hoc and inadvisable as QE itself.