In Defense of Paul Krugman: Ranking Austrian Economists, Banana Fungus Lovers and Econometricians

Paul "I Luv Banana Fungus" Krugman has posted at his blog that he is concerned that the economy may be going into a double dip recession.

I have stated many times that Krugman is clueless as far as business cycle theory is concerned, indeed he has admitted he prefers banana fungus to thinking about the subject, but he does watch data carefully. When he warns of a double dip, it is because he already sees the data turning.

Which brings us to the Cleveland Fed and two economists, Joseph G. Haubrich and Kent Cherny, who say a double dip is unlikely. And they specifically shout out Krugman for humiliation, for his call that we may be in for a double dip.

The method they use to attack Krugman is by way of one of my favorite indicators, the yield curve. They write:

Since last month, the yield curve has gotten a bit steeper, with long rates moving up as short rates held steady. The difference between these rates, the slope of the yield curve, has achieved some notoriety as a simple forecaster of economic growth. The rule of thumb is that an inverted yield curve (short rates above long rates) indicates a recession in about a year, and yield curve inversions have preceded each of the last seven recessions (as defined by the NBER). In particular, the yield curve inverted in August 2006, a bit more than a year before the current recession started in December, 2007. There have been two notable false positives: an inversion in late 1966 and a very flat curve in late 1998.

More generally, a flat curve indicates weak growth, and conversely, a steep curve indicates strong growth. One measure of slope, the spread between 10-year Treasury bonds and 3-month Treasury bills, bears out this relation, particularly when real GDP growth is lagged a year to line up growth with the spread that predicts it.

What they write here is generally true, and they go on to display charts to prove their point. They show charts that picture the steepness of the current curve, which to them, signals a strong growth period ahead.

But in approaching the yield curve in this econometric fashion without understanding the human decisions behind the curve, they make the great econometrician's error of failing to understand that there are no constants in the science of economics and that one does indeed need to understand the specific human activity driving the data.

In the case of a steep positively sloped yield curve, generally bankers borrow short-term and lend out long term and earn the spread--and at the same time put huge amounts of new money into the system. But this is during normal times. What we are experiencing now is a period of huge demand to hold cash balances (The huge excess reserves is one piece of evidence of this). Thus, very short term rates are low, not as much because there is easy money available from the Fed, but because no one wants to lend out long-term, including banks.

Therefore the trigger which causes the yield curve to act as a booster to a manipulated economic boom does not exist at the present time. Banks are not using the short term rates to borrow funds and lend them out further on the yield curve. They are keeping reserves safe and sound at the Fed (where they remain out of the monetary system). Thus, no money creation. The yield curve this time is as effective in helping create a boom as Umar Farouk Abdulmutallab's underwear bomb.

The Cleveland Fed'ers are, therefore, wrong in thinking the yield curve is going to boost growth. The money boosting feature of the yield curve is not kicking at this time. They almost seem to realize this themselves. At the end of their analysis, they write:

Of course, it might not be advisable to take these number quite so literally, for two reasons. (Not even counting Paul Krugman’s concerns.) First, this probability is itself subject to error, as is the case with all statistical estimates. Second, other researchers have postulated that the underlying determinants of the yield spread today are materially different from the determinants that generated yield spreads during prior decades. Differences could arise from changes in international capital flows and inflation expectations, for example. The bottom line is that yield curves contain important information for business cycle analysis, but, like other indicators, should be interpreted with caution.

Maybe it is just their style to hedge and say the exact opposite in closing to what they post as their analysis of the situation. Perhaps as econometricians they have been burnt so many times, they don't want to hang their balls out one more time.

Or perhaps, they just do not want to end up in as an embarrassing position as their colleagues at the New York Fed, McCarthy and Peach, who used a faulty economic model to proclaim there was no housing bubble.

As things stand now, if you want to understand where the economy is headed, Austrian business cycle theory will get you there first, banana fungus lovers will get there eventually and Fed econometricians will point you in the wrong direction.