It would be wrong to blame the economics blogosphere's failure to foresee the 2008 credit crisis on complacency. Better to say that bloggers were distracted. Instead of sifting through sub-prime and CDO data, they were grappling with an entirely different threat, the impending Wile E. Coyote moment in the U.S. dollar. The perpetual racking-up of ever larger debts by the U.S. to the rest of the world for the sake of funding current consumption, and the eventual dollar collapse that this implied, was believed to be tripping point numero uno at the time. Look no further than Paul Krugman, who in September 2007 (in just his fourth blog post) had this to say:

The argument I and others have made is that the U.S. trade deficit is, fundamentally, not sustainable in the long run, which means that sooner or later the dollar has to decline a lot. But international investors have been buying U.S. bonds at real interest rates barely higher than those offered in euros or yen — in effect, they've been betting that the dollar won’t ever decline.

So, according to the story, one of these days there will be a Wile E. Coyote moment for the dollar: the moment when the cartoon character, who has run off a cliff, looks down and realizes that he’s standing on thin air – and plunges. In this case, investors suddenly realize that Stein’s Law applies — “If something cannot go on forever, it will stop” – and they realize they need to get out of dollars, causing the currency to plunge. Maybe the dollar’s Wile E. Coyote moment has arrived – although, again, I've been wrong about this so far. 

He wasn't alone in this belief.* As we all know, the U.S. did eventually run off a cliff—but it wasn't the cliff that everyone expected. Instead of a dollar crisis, we had a financial and banking crisis. As for the dollar, it has since raced to its highest point in more than a decade.

Since 2008 the ensuing slow recovery has dominated the blogosphere. And now we are hearing about an impending secular stagnation, a new macroeconomic dystopia that has been manufactured by many of the same folks who contributed to the debate surrounding the econ blogosphere's first great macroeconomic bogeyman, U.S. dollar imbalances.

Before allowing the sec stag story to scare our pants off, shouldn't we be asking what happened to the first bogeyman? Given the econ blogosphere's silence on the topic of U.S. dollar imbalances, one could be forgiven for assuming that these imbalances had been resolved. But they haven't. Sure, the U.S.'s current account deficits aren't as high as before. But the stock measure of U.S. indebtedness, its net international investment position (NIIP), continues to fall to increasingly negative levels. Ten years ago, when bloggers were focused on the issue, the U.S. owed $2 trillion more than foreigners owed it, about 15-20% of GDP. The NIIP now clocks in at 39% of GDP, or $7 trillion. See chart below. So if anything, the stock measures that worried so many economists in 2005 have only gotten worse.


What I have troubles understanding is why folks like Larry Summers are having so much success selling the world on their newest bogeyman—secular stagnation—when they have never properly atoned for the bland ending to their first story. Why has growing U.S. international indebtedness never led to a U.S. dollar collapse as predicted? What mistakes did these prognosticators make? Or should we think of the the dollar's Wile E.Coyote moment as just an extended one—for the last ten years the greenback has been hanging in air, not realizing that it's been slated for a collapse.  Reading through old blog posts and articles written circa 2006, the dollar's blithe disregard of its eventual demise was often met by invocations of Stein's law: "If something cannot go on forever, it will stop" or Rudi Dornbusch’s first corollary of Stein’s Law: “Something that can’t go on forever, can go on much longer than you think it will.” It could be that the doomsayers still invoke these quotations, but surely there's a statute of limitations on invocations of Wile E. Coyote.

If the creators of the first bogeyman are just the victims of awful timing, then the net stock data on which they initially based their initial pessimism has only worsened. This means that they should be doubling down on their warnings of impending dollar doom. Instead, we get a steady stream of warnings over a totally different macroeconomic disaster; secular stagnation.

The other side to the story is that maybe we aren't in the midst of the longest Wile E. Coyote moment ever. Maybe the U.S. dollar bears were wrong about imbalances all along.

The fact that foreigners are willing to perpetually buy U.S. financial assets and fund a reckless U.S. consumption binge seems, on the surface, to be a violation of the eternal rule of quid pro quo—an even exchange of one thing for another. In return for a mere promise of distant consumption, Americans are getting valuable foreign labour and goods. 

But what if something is missing to this story? Consider that a financial asset isn't a mere IOU. Rather, it is an IOU twinned with a durable consumption good. This very special good is called liquidity. Workers in the financial industry incur a significant amount of time and energy in fabricating this component. They expend this effort because people will pay good money to consume liquidity. Just like having a fire extinguisher or a revolver on hand provides a measure of relief, the possession of liquidity provides its owner with a stream of comfort.

Unfortunately, liquidity is never sold as a stand-alone product. Like a room with a view—you can't buy the view without also getting the room—people who want to own liquidity must simultaneously buy the attached financial asset.

It just so happens that the Yankees are the world's leading manufacturer of liquidity premia. This means that foreigners may be gobbling up such incredible amounts of American financial assets not because they have an urge for U.S. IOUs per se, but because they desire to consume the liquidity premia that go along with those IOUs. The U.S.'s NIIP, which is supposed to include only financial assets, is effectively being contaminated by consumption goods. Specifically, some portion of U.S.'s liabilities to the rest of the world is actually comprised of accumulated exports of liquidity premia. Rather than classifying these liquidity services as a stock of financial assets/liabilities, they should be reclassified as a flow of liquidity services and moved to the current account side of the U.S.'s balance of payments, along with the rest of the U.S.'s goods & services exports. This would have the effect of making the U.S.'s NIIP much less abysmal then it appears. Rather than Americans living beyond their means, this allows us to tell a story in which foreign goods and services are being bartered for liquidity premia which, like machines or wheat or apple pie, require the toil and sweat of American laborers to produce. This isn't an extravagant privilege, it's honest quid pro quo.**

We can argue about the size of the liquidity premia that the U.S. exports. On the one hand, these premia may outweigh the value of goods & services that the U.S. imports, indicating that rather than being profligate, Americans are tightwads. Or this number may be relatively small, indicating that while Americans are less spendthrift than is commonly assume, they still aren't models of prudence.

I'm not sure if the creators of the blogosphere's first great bogeyman would agree with any of this, since not only have they gone silent on the topic—they've switched to talking about a new bad guy.*** Interestingly, if exports of liquidity premia explain why the U.S.'s negative NIIP is not a catastrophe in the making but a stable equilibrium, those same liquidity premia can explain some of the stylized symptoms of so-called secular stagnation—namely persistently falling interest rates. 

Liquidity is static, it interferes with many of the supposedly clear signals we get from data. If liquidity led economists astray in the last decade by creating what seemed to be ominously extreme dollar stock imbalances, it may be leading them astray this decade by creating what seem to be ominously low real interest rates. The last thing we want is a repeat of the previous decade in which economists missed out on the big one because they were so focused on what, in hind sight, seems to have been a bogus threat.

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*Here is DeLong. It was one of Brad Setser's favorite topics. Non-bloggers including Rogoff and Summers also questioned the ability of the U.S. to generate perpetual current account deficits.
** The idea that the U.S. is exporting something unseen in the official data isn't a new idea. In this 2006 paper, Ricardo Hausmann and Federico Sturzenegger were one of the first to discuss the idea of "dark matter." This stuff is comprised of U.S. exports of expertise and knowledge, liquidity services, and insurance services. Ricardo and Hausmann believed that dark matter increased the value of U.S. assets held overseas, but it seems to me that dark matter, namely liquidity premia, does the opposite: it decreases the value of U.S. liabilities to foreigners.
*** At the time, Krugman, Setser, DeLong, and Hamilton criticized the dark matter idea. Buiter, publishing through Goldman Sachs, also criticized the idea here. 

In his first blog skirmish, Ben Bernanke took on Larry Summers' secular stagnation thesis, generating a slew of commentary by other bloggers. If the economy is in stagnation, the econ-blogosphere surely isn't.

I thought that Stephen Williamson had a good meta-criticism of the entire debate. Both Bernanke and Summers present the incredibly low yields on Treasury inflation protected securities (TIPS) as evidence of paltry real returns on capital. But as Williamson points out, their chosen signal is beset by static.

Government debt instruments like TIPS are useful as media of exchange, specifically as collateral, goes Williamson's argument. Those who own these instruments therefore enjoy a stream of liquidity services that gets embodied in their price as a liquidity premium. Rising TIPS prices (and falling yields) could therefore be entirely unrelated to returns on capital and wholly a function of widening liquidity premia. Bernanke and Summers can't make broad assumptions about returns on capital on the basis of market-driven yields without knowing something about these invisible premia. (Assiduous readers may remember that I've used a version of the liquidity premium argument to try to explain the three decade long bond bull market, as well as the odd twin bull markets in bond and equity prices.)

Riffing on Williamson, liquidity premia are a universal form of static that muddy not only bond rates but many of the supposedly clear signals we get from market prices. Equity investors, for instance, need to be careful about using price earnings ratios to infer anything about stock market valuations. The operating assumption behind something like Robert Shiller's cyclically adjusted PE (CAPE) measure is that rational investors apply a consistent multiple to stock earnings over time. When CAPE travels out of its historical average, investors are getting silly and stocks are over- or undervalued.

But not so fast. Since a stock's price embodies a varying liquidity premium, a rise in equity prices relative to earnings may be a function of changes in liquidity premia, not investor irrationality. Until we can independently price these liquidity services, CAPE is useless as a signal of over- or undervaluation, a point I've made before. Hush, all you Shiller CAPE acolytes.

Liquidity also interferes with another signal dear to economists and finance types alike; expectations surrounding future inflation. The most popular measure of inflation expectations is distilled by subtracting the nominal yield on 10-year Treasuries from the equivalent yield on 10-year TIPS. The residual is supposed to represent the value of inflation protection offered by TIPS. But it is a widely known fact that this measure is corrupted by the inferior liquidity in TIPS markets. See commentary here, here, and here. The upshot is that a widening in TIPS spreads—which is widely assumed to be an indicator of rising inflation expectations—could be due to a degeneration  improvement in the liquidity of TIPS relative to the liquidity of straight Treasuries.

Interestingly, the Cleveland Fed publishes a measure of inflation expectations that tries to "address the shortcomings" of rates derived from TIPS by turning to data from a different source: inflation swaps markets. In an inflation swap, one party pays the other a fixed rate on a nominal amount of cash while the other returns a floating rate linked to the CPI. Given the market price of this swap, we can extract the market's prediction for inflation. According to the people who compile the Cleveland Fed estimate, inflation swaps are less prone to changes in liquidity than TIPS yields, thus providing a true signal of inflation expectations.

But how can that be? Surely the prices of swaps and other derivatives are not established independently of market liquidity. After all, like stocks and bonds, derivatives are characterized by bid-ask spreads, buyers strikes, and runs. Sometimes they are easy to buy or sell, sometimes difficult. When I first thought about this, it wasn't immediately apparent to me what liquidity premia in derivative markets would look like. With bond and equity markets, its easy to determine the shape and direction of the premium. Since liquidity is valuable, buyers compete to own liquid stocks and bonds while sellers must be compensated for doing without them. A premium on top of a security's fundamental value develops to balance the market.

Derivatives are different. Take a call option, where the writer of the option, the seller, provides the purchaser of the option the right to buy some underlying security at a certain price. In theory, the more liquid the option, the higher the price the purchaser should be willing to pay for the option. After all, a liquid option can be sold much easier than an illiquid one, a benefit to the owner. But what about the seller? I risk repeating myself here, but a seller of a stock or bond will require a *higher* price if they are to part with a more liquid the security. However, in the case of the option, the writer (or seller) will be willing to accept a *lower* and inferior price on a liquid option. After all, the writer will face more difficulties backing out of their commitment (by re-selling the option) if it is illiquid than if it is liquid.

This creates a pricing conundrum. As liquidity improves, the option writer will be willing to sell for less and the purchaser willing to buy for more. Put differently, the value that the writer attributes to the option's liquidity and the concomitant liquidity premium this creates drives the option price down, while the value the purchaser attributes to that same liquidity engenders a liquidity premium that drives the option price up. What is the net effect?

I stumbled on a paper which provides an answer of sorts (pdf | RePEc). Drawing on data from OTC options markets, the authors finds that illiquid interest rate options trade at higher prices relative to more liquid options. This effect goes in the opposite direction to what is observed for stocks and bonds, where richer liquidity means a higher price. The authors' hypothesis is that the liquidity premium of an option is set by those investors who, on the margin, are most concerned over liquidity. Given the peculiarities of OTC option markets, this marginal investor will usually be the option writer (or seller), typically a dealer who is interested in reversing their trades and holding as little inventory as possible, thus instilling a preference for liquidity. Buyers, on the other hand, tend to be corporations who are willing to buy and hold for the long term and are therefore less concerned with a fast getaway. The net result is that for otherwise identical call options, the overriding urgency of dealers drives the price of the more liquid option down and illiquid one up.

Anyone who has dabbled in futures markets may see the similarity in the story just recounted to a much older idea, the theory of normal backwardation. The intuition behind normal backwardation is that a futures contract, much like a call option, has two counterparties, both of whom need to be rewarded with a decent expected return in order to encourage them to enter into what is otherwise a very risky bet. If both require this return, then how does an appropriate "risk premium" get embodied in a single futures price?

None other than John Maynard Keynes hypothesized that the two counterparties to a futures trade are not entirely symmetrical. Hedgers, say farmers (who are normally short futures), simply want a guaranteed market for their goods come harvest and are willing to provide speculators with the extra return necessary to induce them to enter into a long futures position. Farmers create this inducement by setting the current price of a futures contract a little bit below the expected spot price upon delivery, thus providing speculators with a promise of extra capital returns, or a risk premium. That's why Keynes said that futures markets are normally backwardated.

Options writers who desire the comforts of liquidity are playing the same game as farmers who desire a guaranteed price. They are inducing counterparties to take the other side of the deal, in this case the liquid one, by pricing liquid options more advantageously than illiquid but otherwise identical options. And while I don't know the peculiarities of the various counterparties to an inflation swap, I don't see why the same logic that applies to options wouldn't apply to swaps.

So returning to the main thread of this post, just as the signals given off by TIPS spreads are beset by interference arising from liquidity phenomena, the signals given off by inflation swaps are also corrupted. A widening in inflation swap spreads could be due to changing liquidity preference among a certain class of swap counterparties, not to any underlying change in inflation expectations. Its not a clear cut world.

What about the most holy of signals given off by derivative markets: the odds of default as implied by credit default swap spreads? A CDS is supposed to indicate the pure credit risk premium on an underlying security. But if the marginal counterparty on one side of a credit default swap deal is typically more interested in liquidity than the other counterparty, then CDS prices will include a liquidity component. According to the paper behind the following links ( pdf | RePEc ), it is the sellers of credit default swaps, not the buyers, who typically earn compensation for liquidity, the theory being that sellers are long-term players with more wealth than buyers. The paper's conclusion is that CDS spreads cannot be used as frictionless measures of default risk.

Liquidity is like static, it blurs the picture. The clarity of the indicators mentioned in this post—Bernanke & Summers' real interest rates, stock market price earnings ratios, inflation expectations implied by both TIPS and swap markets, and finally the odds of default implied in corporate default swap spreads—are all contaminated by liquidity premia that vary in size over time. Models created by both economists and financial analysts contain abstract variables that map to these external data sources. I doubt that this data is irrevocably damaged by liquidity, but it may be warped enough that we should be wary about drawing strong conclusions from models that depend on them as input.

Before I slide too far into economic nihilism, there may be a way to resuscitate the purity of these indicators. If we can calculate the precise size of liquidity premia in the various markets mentioned above, then we can clean up the real signals these markets give off by removing the liquidity static.

One way to go about calculating the size of a liquidity premium is by polling the owners of a given security how much they must be compensated for doing without the benefits of that security's liquidity for a period of time. Symmetrically, a potential owner of that security's liquidity is queried to determine how much they are willing to pay to own those services. The price at which these two meet represents the pure liquidity premium. Problem solved. We can now get a pure real interest rate, a precise measure of inflation expectations, a true measure of credit default odds, or a liquidity-adjusted price-to-earnings multiple.

Unfortunately, its not that easy. The only way to properly discover the price at which a buyer and seller of a particular instrument's liquidity services will meet is by fashioning a financial contract between them,  a financial derivative. These derivatives will trade in a market for liquidity or 'moneyness' that might look something like this. And therein lies the paradox. Much like the option and CDS of our previous example, this new derivative will itself be characterized by its own liquidity premium, thus impairing its ability to provide a clean measure of the original instrument's liquidity premium. We could fashion a second derivative contract to measure the liquidity premium of the first derivative contract, but that too will be compromised by its own liquidity premium, taking us down into an infinite loop of imprecision.

So... back to economic nihilism. Either that or a more healthy skepticism of those who confidently declare the economy to be in stagnation or the stock market to be a bubble. After all, there's a lot of static out there.

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Note: David Beckworth has also written about the difficulties of using bond yields as indicators of secular stagnation. (1)(2)(3). And now Nick Rowe has a post on secular stagnation and liquidity.

The Cider Mill, by Robin Moline

In general, the real price of land has been increasing all over the world, especially since the early 1990s. (Japan and Germany are the exception). The recent credit crisis hurt this trend in a few countries like Ireland, Spain, Netherlands, and the US, but in other countries like Belgium, Canada, Sweden, and Australia the secular rise in housing prices remains intact.

A popular explanation for the rise in land prices are the various versions of the secular stagnation thesis advocated by folks like Paul Krugman and Larry Summers. According to Krugman, if the natural rate of interest has become persistently negative—i.e. new capital projects are expected to yield a negative return—then investors will look to existing durable assets like gold or land that yield no less than a 0% return. The prices of these goods will be bid upwards, bubble-like. Or, as Summers puts it, if the return on capital is below the economy's growth rate, then intrinsically valueless ponzi assets may be recruited as stores of value to bridge the distance between an individual's present and the future. (Krugman and Summers's ideas are a bit hard to follow, but Nick Rowe has a bunch of helpful posts on these ideas).

In short, these theories explain the paradoxical conjunction of bubbles with a sluggish economy and low inflation.

I think that a better explanation for the rise in real land prices is the emergence of large liquidity premium on land. This premium isn't an irrational "bubble" phenomenon. Rather, over the last decade or two finance and real estate professionals have put in large amounts of time, sweat, and tears to improve the underlying infrastructure that facilitates the transfer of residential land. A few of these improvements include the optimization of the mortgage lending process by the adoption of automated underwriting systems, the development of mortgage scoring, higher loan-to-value ratios on mortgage loans, and the creation of the mortgage-backed securities market.

All these improvements mean that your parcel of land is not like your grandfather's parcel—it can be sold off, parceled up, rented out, collateralized, and re-hypothecated faster than ever. In short, land has become more like cash. Whereas in the past the purchase of a house made you dramatically less liquid, these days that same house impairs your liquidity position much less.

Like any other asset owner, land owners expect to enjoy three services: a pecuniary return such as capital appreciation, a non-pecuniary consumption yield, and liquidity services. In a world in which arbitrage ensures that all assets provide roughly the same return, any improvement in the liquidity services provided by land reduces the amount of capital appreciation people expect to earn on their land parcel (we'll assume the consumption return is constant). This reduction in expected capital appreciation comes about via a rise in land prices now relative to their expected future price. So the steady improvements in the liquidity services thrown off by land have created a stepwise rise in land prices. This rise might appear to be a bubble, but it's only the market's warm response to the finance industry's consistent upgrades to the mechanisms that facilitate transfers of land.

If you believe John Maynard Keynes, what we're seeing now is just a reversion to ancient times. In Chapter 17 of his General Theory, Keynes wrote: "It may be that in certain historic environments the possession of land has been characterized by a high liquidity-premium in the minds of owners of wealth..." He goes on to note that the high liquidity premiums formerly attaching to the ownership of land are now attached to money. It may be the case that in modern times these liquidity premia are detaching from traditional forms of money like deposits and returning to land, the evidence being the rise of land prices and decline in traditional deposit banking.

When a market bursts, the stagnation thesis has it that people have spontaneously switched from one bubble to a new one, or that the underlying features of the economy (i.e the negative natural interest rate) have changed. If land price increases are being driven by improvements in liquidity services rather than low-to-negative rates of return and resulting bubble-seeking behavior, than snap-backs may occur when the underlying architecture supporting that liquidity fails. Alternatively, different networks of finance professionals may be working hard to build up their own asset's liquidity, thus competing away the liquidity premium of the incumbent asset.

Here's an interesting data point: While almost every western nation experienced a housing price boom between the mid 1990s and 2008, Germany somehow missed the boat.

From the Economist's very useful housing price chart tool.

Was Germany somehow exempt from the stagnation that other Western nation's face? Perhaps Germans selected a different bubble asset than land? Or did the underlying mechanics governing the liquidity of the German market for residential land stay constant whereas those of most nation's improved?

We know that while MBS markets were deepening all over the world, German law did not permit MBS issuance until 1997, putting it far behind the mortgage slicing & dicing eight-ball. Rather, German residential real estate finance continued to be underpinned the centuries old pfandrief, or covered bond. While  the originator of an MBS can parcel away mortgages into a bankrupt-remote entity, the assets underlying a pfandriefe are required by law to stay on the issuer's balance sheet. The mortgages comprising MBS often have up to 100% loan-to-value ratios, but German law requires that pfandbriefe be backed by mortgage loans with a maximum of 60% of the home's "lending value" (lending value is more conservative than market value), which in practice means that Germans often have to put up 60-70% cash to buy a home. Such high requirements would surely stifle the liquidity of residential land, especially compared to places like Canada where permitted LTVs went from 80% to 100% in the space of ten years.

So while Keynes's liquidity premium may have migrated back to land in much of the western world, this doesn't seem to be the case in Germany. There are surely advantages to having avoided a rise in housing prices. On the other other hand, owning a liquid house rather than an illiquid one is a boon—it provides an individual with a fluid asset for dealing with an uncertain future. From this perspective, any attempt to stifle some asset's liquidity by limiting the finance industry's ability to innovate reduces the range of coping mechanisms that  a society is presented with.

P.S. I already wrote versions of this post. Here are these ideas applied to equity markets, here they are applied to bond markets. Same idea, different day, different market.