Ghost Stories
You are deep in the woods and all you hear are the crickets. Every time a leaf rustles or a twig snaps you jump a little. The fire is getting low and you’re out of marshmallows and almost ready for bed, when that one friend who thinks his practical jokes are way funnier than they are grabs a flashlight and says it’s time for scary stories. You gulp. You’ve always been jumpy and you’re not looking forward to the ‘man, I got you so bad’ comments from the aforementioned obnoxious friend, but you’re not going to say anything. “Now everyone, I’m going to tell you a story about the most terrifying thing in this world,” he flicks on the flashlight under his chin, “…Bubbles.”
It turns out, your obnoxious friend is an econ geek (like me, except as much as I hate scary stories the scariest part of that whole thing to me is the idea that I would be camping in the first place). So, what’s so scary about bubbles? The Dirty Bubble is Mermaid Man and Barnacle Boy’s arch nemesis, but besides that, they shouldn’t be that scary.
Why is an economic bubble really scary? Well, because it’s a bubble. It starts small and then it gets bigger and bigger and then it pops. Maybe likening it to a balloon is a little bit better, because you can hear the noise in your head. You can also think if bubbles as hot potato, but you don’t always know you’re playing and also you’re not in kindergarten and if you’re holding the potato when the timer goes off, you’re out of the game (or maybe bankrupt). Bubbles can be created illegally (stock pump and dumps where crooked traders drive the price up by generating demand and then flooding the market with all of their shares once the price is sufficiently high), but they can also just happen in the market. In 2008, banks were giving out sub-prime loans because the price of houses kept going up. If the person foreclosed, they could just sell it again. And they could even sell that person’s debt to another investor, with the houses as collateral. But then it turned out the houses weren’t worth as much as the market price at the time, and when prices stopped going up the bubble popped and people were left with a lot of property that wasn’t worth nearly as much as the money they had borrowed.
Another bubble example is bitcoin (or cryptocurrencies more generally). Most economists will agree that bitcoin has a fundamental value of zero; a survey from the Initiative on Global Markets (a program of the University of Chicago Booth School of Business) had 79% of respondents from an expert panel agree or strongly agree with the statement “A bitcoin’s value derives solely from the belief that others will want to use it for trade, which implies that its purchasing power is likely to fluctuate over time to a degree that will limit its usefulness.” In another survey conducted 4 years later, only 4% of respondents agreed or strongly agreed that “Bitcoin has a fundamental value of over $1000 dollars.” In the same survey, no respondents strongly agreed and only 26% agreed that “The best forecast for the value of Bitcoin is its current price.” Popular theory tells us that while bubbles may persist for a long time, ultimately, they will pop, which is why many economists are skeptical about cryptocurrencies. That doesn’t mean that making money in the cryptocurrency market is necessarily impossible; just risky because we really can’t say when the bubble will pop.
So that’s what bubbles are; now the question is why they happen So that’s what bubbles are; now the question is why they happen. Former Fed Chair Alan Greenspan speculated that the dotcom bubble of the ‘90s was caused by “irrational exuberance.” The theoretical model that best describes the concept is John Maynard Keynes’ concept of “animal spirits, which essentially says that people are not capable of processing all of the possible relevant information to make the most rational decisions. An element of uncertainty will always exist, and so people will be guided by their intuition and by doing the best they can. Keynes’ theory directly undercuts the theory of rational expectations but also snubs its nose at the standard assumptions economists make about perfect information and foresight. Economic actors have neither. Bubbles are created when animal spirits drive the economy away from the long run market equilibrium, possibly because of a misperceived change in fundamental value or the long run equilibrium, and possibly because those actors believe they can pass the potato before the timer goes off.
Get rich quick/get rich(er?) slow
Perhaps you heard some buzz in the news this week about the yield curve (before the stock market dropped a lot of points, at least). Bond yields tell you the rate of return on your money, and the yield curve plots those curves against the bond’s maturity. If you have no idea what bonds really are, trust me, you’re not alone; here’s a mini crash course:
When a bank loans you money, they charge you interest. You can think of interest as the cost of money: it costs eight bucks to rent a pair of bowling shoes for an hour and 8% of the amount you borrowed to rent some money for a little bit. When you buy a bond, you are loaning them your money. The seller takes your money, and at the date of maturity they give you back what they borrowed (the principal) plus the interest. Basically you buy a bond for a certain amount of money and are paid interest on that bond up until it matures, at which time you are paid back any outstanding interest and the initial amount you paid. It’s a more official version of you giving a friend 20 bucks if they say they’ll give you back 25 next week.
When the yield curve is created, it uses the market value of on-the-run bonds (if your refrigerator is running you’d better go catch it, if your bond is running that means its part of the most recently issued group of bonds of a given maturity), and plots those against the maturity. If you’re interested, you can check out the treasury yield data here.
The interest rate on a bond factors in three key premiums: risk premium, liquidity premium, and term premium.
Risk premium
A general rule of thumb for any investment is “high risk, high return.” That’s not limited to just your traditional, high brow investments. I know the rules on what happens in Vegas, but I’m a Jersey Girl, so I’ll take my cue from Atlantic City. When you play Roulette, you ‘invest’ your bet. If you invest on red or black, you have a 50% chance of losing your investment, and a fifty percent chance of doubling it. If you put your investment on a specific number, you have a 97% chance of losing your money, but a 3% chance of getting it back 35 fold. If you watch shark tank, you’ll know that the investors demand more equity when the company is in a less secure place; if the company does succeed, the sharks stand to make a whole lot more. For a bond, if an investment is riskier, the yield needs to be higher. Treasury bonds are generally considered one of the safest investments, so the risk premium on the bond is zero or very close.
Liquidity Premium
An asset’s liquidity is how easily it can be turned to cash. A bond that is easily sold in secondary markets is a lot more liquid. If a bond is going to tie up your money for a long time, you need to get a higher return on it. The risk premium applies to specifically to the risk of the issuer defaulting, but that does not mean that other risks don’t exist. You might need your money quickly for any number of reasons; maybe there’s some kind of emergency and you need it for hospital bills or home repairs. Or maybe the reason is happier, like you get engaged and you want to use the money to fund your wedding. Either way, if you aren’t going to have that money for a long time, the issuer is going to have to compensate you. That being said, the liquidity premium is also fairly close to zero on treasury bonds, as well, because the secondary market for treasury bonds is fairly active.
Term Premium
The term premium is the only one of the three premiums that applies to treasury bonds. Like the liquidity premium, the term premium is demanded by consumers in part because time holds a risk element. A lot can happen in a decade (or 2 or 3). The fashionable opinion on monetary policy may change, causing inflation to rise, meaning the money will be worth less than what you banked on (pun not intended until I edited and realized I made it). Even though you can sell those treasury bonds, unless you know something everyone else doesn’t, the market is going to make that bond worth exactly as much as it would be to you. In addition, the value of other assets that you could have invested in instead, such as real estate or precious metals, might sky rocket. Again, even though the bond is liquid, if you try to sell your bond to get in on the ground floor of something that is about to boom, you have to assume that the market is trying to do the same thing. Exchange rates may also change drastically; that might affect purchasing power even if the overall inflation rate stays constant depending on how much of your income you devote to imported goods.
Another reason for the term premium is the discounted utility of future consumption. If you don’t have the money until the future, you can’t spend it now. Spending money makes you happy. Sitting around thinking about all of the things you could spend your money on if only you had it (a nice dinner out…a sensible four door sedan…your own castle) makes you less happy
So, what does that tell us about the yield curve: an upward sloping yield curve is a normal yield curve, both by standard terminology and by logic. As the maturity goes up, the yield should be higher, because of the term premium. When the yield curve flattens, the difference between yield on a short term and long-term investment decreases. When we get an inverted yield curve long term yield is lower than short-term yield. The inverted yield curve both freaks people out and signals that people are already freaked. If long-term yields are low, it means that demand for those secure long term investments are high, driving the price up (and thus the yield down). That means that investors want to get their money somewhere safe, and that fear of dropping interest rates makes them want to secure a good long-term rate while they can. If people are expecting interest rates to fall in the future, then they believe that the fed is holding them high now; dropping to a lower rate would indicate expansionary monetary policy. The fed enacts expansionary monetary policy because the economy is in a recession. So people who are expecting the fed to lower the interest rate think the fed is expecting a recession (which means they are likely expecting a recession). Short-term investments become less appealing, driving the yield up to get people to buy them, while increased demand from people looking to get put their money somewhere safe for the long term drive the long term yield down.
Also, the inverted yield curve is partially scary because it tells us that people are scared. What people think will be happening in the economy is a huge governing force. Why? Animal spirits. (See, look, the things I prattle on about are useful). An inverted yield curve tells us that people are nervous about making investments, and if people are nervous about investing, the economy slows down. According to the Cleveland Fed, each of the last seven economic recessions have been preceded by an inverted yield curve; only once, in 1966, did the yield curve invert without a recession following.
Besides normal and inverted yield curves, a third type, the flat yield curve, not only exists, but represent where the economy is now. The flat yield curve suggests a the some movement toward long term investment and the same expectation of dropping interest rates. That said, a very recent study in Bloomberg showed that flat yield curves do not necessarily spell trouble. The sharpness of the movement, the article said, might be some cause for concern, but the data is far less conclusive when it comes to movement than shape.
Recommended Reading
Stress Relievers
“Does a Flattening Yield Curve Mean Recession?”
Look, I can’t tell you if these people are right or wrong, all I can tell you is that the existence of smart people who don’t think we’re headed toward economic collapse makes me feel better.
Campfire Stories
“Consumer Confidence is Lifting the Economy, but for How Much Longer”
Schiller’s fascinating take on consumer spending and bubbles.
