Category: Interesting External Papers

I mentioned the Panic of 1825 briefly yesterday.

More detail is available from the St. Louis Fed: main article by Larry Neal and commentary by Michael D. Bordo.

The more things change …

These problems started with the Treasury itself, confronted by the difficulties of servicing the huge government debt accumulated during the Napoleonic Wars … They were compounded by the response of the London capital market, which produced a bewildering array of new financial assets to its customers to replace the high-yielding government debt now being retired.
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Only as more information came in or as investors began to pull out of higher risk investments and seek safer, better quality assets did price differences begin to show up.
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The credit collapse led to widespread bank failures (73 out of the 770 banks in England and even three out of the 36 in Scotland) and a massive wave of bankruptcies in the rest of the economy, reaching an unprecedented peak in April 1826. The Bank of England and the London private banks joined forces for once by blaming both the speculative boom and the subsequent credit collapse on excessive note issue by the country banks. They argued that the ease of note issue had encouraged the more careless or unscrupulous partners in country banks to invest in highrisk, high-return financial ventures such as the Poyais scrip that were being offered on the London capital market.
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Asymmetric information is the term applied to the usual situation in which borrowers know more about the actual investment projects they are carrying out than do the lenders. Lenders, knowing this, charge a premium proportional to the uncertainty they feel about the borrowers in question. This situation, in turn, creates an adverse selection problem, in which higher-quality borrowers are reluctant to pay the high interest rates imposed by the market, while lower-quality borrowers are willing to accept the rates and to default if their ventures fail.
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The coup de grâce occurs when higher-risk borrowers are asked to provide collateral for additional loans, and the financial collapse decreases the value of their collateral. The outcome is a general wave of bankruptcies.

Update, 2007-09-20: It is interesting to contrast the 1825 bail-out of the banking house of Sir Peter Pole with the 2007 bail-out of Northern Rock. In testimony to parliament, BoE Governor King stated:

U.K. banking laws prevented the central bank from a covert rescue of Northern Rock Plc, which it would have preferred.“The bank would have preferred to have acted covertly as lender as last resort, to have lent to Northern Rock without publishing it,” King told a parliamentary committee in London today. “As a result of the market abuses directive (of 2005) we were unable to carry that out.”

Prof. Hamilton at Econbrowser commented on a speech by Bernanke in which variability of inflation expectations was discussed. JDH went on to reference a very good academic paper, The Excess Sensitivity of Long-Term Interest Rates: Evidence and Implications for Macroeconomic Models in which these effects are quantified.

Of course, that paper is nearly four years old now. In the interim, there have been expressions of regret for the disappearance of bond market vigilantes; this apparent disappearance is probably due also to indiscrimate buying by the Chinese as much as anything else. Also, probably, due to the fact that idiots such as myself, who have been saying for years that inflation of 2%-ish should mean Canadian 10-year-yields of 4.75-5.25%-ish have had our heads handed to us on a 3.75% plate.

Anyway, the paper is a good one. Abstract:

This paper demonstrates that long-term forward interest rates in the U.S. often react considerably to surprises in macroeconomic data releases and monetary policy announcements. This behavior is inconsistent with the assumption of many macroeconomic models that the long-run properties of the economy are time-invariant and perfectly known by all economic agents. Under those conditions, the shocks we consider would have only transitory effects on short-term interest rates, and hence would not generate large responses in forward rates. Our empirical findings suggest that private agents adjust their expectations of the long-run inflation rate in response to macroeconomic and monetary policy surprises. Consistent with our hypothesis, forward rates derived from inflation-indexed Treasury debt show little sensitivity to these shocks, indicating that the response of nominal forward rates is mostly driven by inflation compensation. In addition, we find that in the U.K., where the long-run inflation target is known by the private sector, long-term forward rates have not demonstrated excess sensitivity since the Bank of England achieved independence in mid-1997. We present an alternative model in which agents’ perceptions of long-run inflation are not completely anchored, which fits all of our empirical results.

I can’t stand it any more! I read something interesting on the Internet and then have trouble finding it later! So from now on, I’m going to keep a list: International Capital Flows and U.S. Interest Rates, Francis E. Warnock, Veronica Cacdac Warnock.

Abstract: Foreign flows have an economically large and statistically significant impact on longterm interest rates. Controlling for various macroeconomic factors we estimate that had there been no foreign flows into U.S. bonds over the past year, the 10-year Treasury yield would currently be 150 basis points higher; even a step-down to average inflows would imply an increase of 105 basis points. The impact of the headline-making foreign official flows—a relatively small subset of total foreign accumulation of U.S. bonds—is also significant but markedly smaller. Our results are robust to a number of alternative specifications.