This Time is Not So Different: The Euro Crisis and the 1840s

In the United States, the 1840s were "an era of fiscal crisis following a decade of fiscal exuberance," according to a paper by Arthur Grinath, JohnWallis, and Richard Sylla. This paper was written in 1997, but its insights into a sovereign debt crisis of long ago provide interesting parallels to today.

In the 1820s and 1830s, state governments made large investments in canals, railroads, and banks. New York and Ohio were the first two states to start canal projects. At first, the expected revenue from the projects was low or uncertain, so New York and Ohio raised taxes to service the canal debt. But the Erie and Ohio canals were highly successful, so subsequent canal construction was financed without corresponding tax increases. New York, Ohio, and other states expected internal improvement projects to produce future revenue, so they didn't feel the need to raise taxes when they began new projects. States were easily able to issue bonds to domestic and foreign (especially British) investors to finance their projects:

“Both state borrowers and lenders, foreign and domestic, anticipated that states could tax land if their bank and transportation projects failed. After 1836, increasing land values and taxable acreage were the common factor underlying state fiscal policies, bank investments, and transportation improvements nationwide. Northeastern states knew they had large amounts of untaxed land, rising in value. It was a fiscal reserve against which they could borrow to finance extensions of their transportation systems. Western states, north and south, were in the midst of the greatest land boom in American history. If northwestern states were uncertain about just when transportation investments would generate revenues, they nonetheless anticipated that many more, and more valuable, acres could soon be taxed. States were thus confident that property tax proceeds would provide adequate fiscal resources to service the debts they incurred. Investors in state bonds concurred.”

State government bonds were considered safe assets because it seemed inconceivable that a state government could default-- their investments were expected to be profitable, and even if they weren't, the states had plenty of potential to increase their tax revenue, especially since land value was rising. Grinath et al. quote Illinois Governor Ford as saying "Mere possibilities appeared to be highly probable, and probabilities wore the livery of certainty itself.”

Gary Gorton, Stefan Lewellen, and Andrew Metrick define a safe asset as one that is information-insensitive. "To the extent that debt is information-insensitive, it can be used efficiently as collateral in financial transactions, a role in finance that is analogous to the role of money in commerce." Gorton elaborates on this idea in an interview with the Region magazine, explaining that debt is "easiest to trade if you’re sure that neither party knows anything about the payoff on the debt." In other words, "The depositors believe that the collateral has the feature that nobody has any private information about it. We can all just believe that it’s all AAA."

In the 1830s, both the states and the investors in state bonds could "believe that it's all AAA" since, even if investment projects turned out not to generate much revenue, states had seemingly boundless untapped tax potential. Thus it was unnecessary for investors in state bonds to find information about the details of states' particular projects. State debt was information-insensitive, a useful property considering how slowly information traveled across the Atlantic in those days.  No need to calculate probabilities when probabilities wear the "livery of certainty itself."

Gorton says that the few really big crisis events in history come from a regime switch in which debt that is information-insensitive becomes information-sensitive. This is precisely what happened in the U.S. states. During the early 1830s expansion and boom of 1835, state debt was information-insensitive, especially as ever-rising land prices promised a large and growing fiscal reserve. But as several domestic and external factors combined to bring about the panic of 1837 and collapse of 1839, the strength of the fiscal reserve was challenged. As land values and property taxes fell, the quality of state's canal, bank, and railroad investment projects suddenly mattered for their ability to service their debt. The situation is described in another paper by Wallis and Namsuk Kim:

In July of 1839, the Morris Canal and Banking Company of New Jersey defaulted on Indiana, and the state quickly was forced to curtail construction on its network of canals and railroads. By the autumn, Illinois and Michigan were forced to slow or stop construction when investment banks defaulted on their obligations to the states. Land sales and land values in these northwestern states had been rising steadily through the 1830s. When transportation construction stopped, land values and property tax revenues began falling and, by late 1839, it was apparent that these states would soon have trouble servicing their debts. In January
of 1841, Indiana was the first state to default on interest payments.

It was a nasty spiral-- as infrastructure projects failed, land values and tax revenue fell further, eroding the states' fiscal positions, making it harder for them to issue bonds and forcing them to pay higher interest rates. This further deteriorated their fiscal positions, and led to suspensions of infrastructure projects and yet higher interest rates. This is similar to what happened in the eurozone, for example in Greece. In the early 2000s, Greece was able to run large deficits without facing high borrowing costs, because the growing economy made Greek sovereign debt information-insensitive. The economic crisis was a "regime change" making sovereign debt information-sensitive. Without the benefit of a fast-growing economy, the Greek government's ability to pay depending much more on its fiscal position, so borrowing rates rose, causing an even worse fiscal position.

The parallels with Greece continue. Many states found, when they tried to raise taxes, that they lacked the state capacity to do so. Property taxes were extremely politically unpopular, and states had trouble not only passing tax legislation but also implementing tax collection. In Maryland, for example, three counties refused to remit their share of the property tax imposed in 1841, and seven refused in 1842. It wasn't until 1845 that the tax was effectively implemented, allowing Maryland to resume debt service. Other states were even less successful in raising property taxes and ended up defaulting and repudiating their debt. Greece also faces a tax evasion problem and encountered serious public and political opposition to attempted austerity measures. In an earlier post I mentioned a paper by Mark Dincecco and Gabriel Katz called "State Capacity and Long Run Performance." State capacity refers a state's ability to tax and to provide public goods and services, called its extractive and productive capabilities, respectively. Dincecco and Katz write:

We argue that the implementation of uniform tax systems at the national level – which we call “fiscal centralization”– enabled European states to effectively fulfill their extractive role. This transformation typically occurred swiftly and permanently from 1789 onward. Similarly, we argue that the establishment of parliaments that could monitor public expenditures at regular intervals – called “limited government” – enabled them to effectively fulfill their productive role. This transformation typically occurred decades after fiscal centralization over the nineteenth century. By the mid-1800s, most European states had achieved “modern” extractive and productive capabilities, implying that they could gather large tax revenues and effectively channel funds toward non-military public services. We argue that these critical improvements in state capacity had strongly positive performance impacts. 

The institutional changes that Dincecco and Katz describe in the late 18th century Europe that brought about extractive capabilities include fiscal centralization and parliamentary, limited government. The U.S. states in the 1840s, and apparently some of the European states today, lack such state capacity, a fact which plays a role in the crises then and now.

Pennsylvania's canals were a financial disaster, so the state faced particularly high borrowing costs, until the Bank of the United States was rechartered as the Bank of the United States Pennsylvania (BUSP). The bank's charter included a promise to underwrite $6 to 8 million in state bond issues. The bank agreed to lend to Pennsylvania at 4%, and as a result, Pennsylvania bond yields in Philadelphia stayed very near to 4% for the next few years. Wallis and Kim write, "Deliberately or not, the BUSP pegged the price of Pennsylvania bonds as a result of its obligations to purchase state bonds over this 18-month period." This is similar to the ECB's Outright Monetary Transactions (OMT) policy, which, by promising to buy sovereign bonds of Eurozone member states, aims to bring down bond yields and lower borrowing costs for countries that face problems selling debt. Though the bank loan program in Pennsylvania was temporarily successful in helping Pennsylvania borrow at lower cost, when the BUSP closed down in 1841, Pennsylvania bond yields jumped immediately, from 6.01% in January 1841 to 9.5% in March.

What ultimately happened in the United States was that the debt crisis forced a change in the structure of public finance. States initiated constitutional restrictions on debt issue and instituted requirements that new spending be matched by new tax increases. The debt crisis in the euro area is also likely to change the structure of public finance, but not in the same way. The United States is both a monetary union and a fiscal union, so even though the states adopted balanced budget amendments, the federal government could still do countercyclical fiscal policy. The euro area is a monetary union without a fiscal union, so it would be very costly for states to institute such restrictions on deficit spending. One possibility is that the euro area will become more of a fiscal and/or banking union; or there may be other changes in the structure of public finance that I can't foresee.

Europeans' Biggest Problem

The European Commission's Eurobarometer survey monitors public opinion on a variety of political and economic issues across European Union member states. One question on the Eurobarometer survey asks:

Personally, what are the two most important issues you are facing at the moment? 

This question was only asked in May 2012. For the EU as a whole, by far the most common response was rising prices/inflation. In fact, 45% of people in 2012 said that inflation was one of the top two most important issues they were facing. The pie graph below shows, for the EU as a whole, the responses people chose. Only 15% of people chose the financial situation of their household as a top issue. Health and social security also had a mere 15%. I was stunned that three times as many people consider inflation a top issue as consider health and social security a top issue.

In the graphs below, the results are broken down by country. First I show the percent of respondents in each country who choose inflation as a top-two issue. Then for a few countries, I show the percent who choose inflation and the percent who choose unemployment. In twelve countries (including Austria, France, and Germany), at least half of respondents say that inflation is a top-two issue. Sweden is a major outlier-- only 5% think that inflation is a top-two issue. The next lowest is Greece, at 26%. Sweden and Greece did have the lowest inflation in the EU in May 2012, but really just about ALL countries in the EU had (and still have) low or reasonable inflation.

Half of Germans and French thought that rising prices were a top issue, even when inflation was just 2.5%. The EC Consumer Survey, asks people how much they think prices have risen in the past 12 months. In May 2012, 28% of German, 36% of French, and 40% of Austrians thought that prices had risen "a lot."

Neil Irwin recently wrote that "The leading economies of the industrialized nations may not have a lot in common, but they are all afflicted by this: Inflation is too low." Even though inflation is too low, a lot of people think it is high-- and think that rising prices personally affect them more than unemployment. Public opinion is a powerful force, so we see policymakers being more reluctant to raise inflation when it it too low, than to lower it when it is too high.

Monetary Policy and Equity Prices at the Zero Lower Bound

A recent Wall Street Journal article by Jon Hilsenrath raises the question of what will happen to stock and bond prices when the Fed ends its bond-buying program. Tim Duy responds that "Fears of an imminent policy-driven collapse in equity prices are likely greatly over-exaggerated." Duy plots time series of the S&P500 alongside time series of the fed funds rate, noting "it strikes me that previous instances of tighter monetary policy did not trigger immediate widespread declines in equities."

Of course, these previous instances of tighter monetary policy occurred away from the zero lower bound (ZLB), with the target fed funds rate well above zero. Since the end of 2008, with the target fed funds rate at effectively zero, the Fed has attempted to influence interest rates through non-traditional actions such as forward guidance and balance sheet expansion aimed at altering long-term interest rates. If non-traditional expansionary monetary policy has a different effect on equity prices than traditional policy, than non-traditional contractionary monetary policy (i.e. and end to bond-buying) could have a different effect on equity prices than raising the fed funds rate.

How do equity prices react to monetary policy at the ZLB? This is the subject of a Federal Reserve Discussion Series paper by Michael Kiley, "The Response of Equity Prices to Movements in Long-term Interest Rates Associated With Monetary Policy Statements: Before and After the Zero Lower Bound." Kiley studies the impact on equity prices (S&P500) of a monetary policy action that would reduce the 10-year Treasury yield by 100 basis points, both before and during the ZLB era. The key finding is:

Implementation of our identification strategy suggests that, prior to 2009, monetary policy actions that would reduce the 10-year Treasury yield by 100 basis points were associated with a 6- to 9-percent increase in equity prices. In contrast, similar-sized declines in the 10-year Treasury yield associated with monetary policy actions since the end of 2008 have been accompanied by increases in equity prices of 1-½ to 3-percent - a notably smaller association.

The identification strategy is an event-study combined with instrumental variables, focusing on changes in interest rates and equity prices in 30-minute windows around FOMC announcements. The results suggest that non-traditional monetary policy has substantially different--less intense--effects on equity prices than traditional monetary policy. The study only focuses on expansionary actions at the ZLB, by necessity, but if expansionary policy at the ZLB does not cause equity prices to rise as much, then maybe contractionary policy at the ZLB will not cause equity prices to fall as much.
Kiley adds this note:

It is possible that FOMC announcements in the ZLB period have communicated more information about the economic outlook than about the policy stance: If FOMC communications provided previously unappreciated information about the outlook, then it is possible that such information would attenuate the response of equity prices to a policy announcement (because, for example, announcements communicating an easing in policy also communicated a worse economic outlook, with the former factor boosting equity prices and the latter factor depressing equity prices.)

Correspondingly, when the FOMC announces the end of its bond-buying program, that could communicate both a tightening in policy and a better economic outlook. If the announcement makes market participants realize that the economic outlook is better than they thought, that would help boost equity prices. The big question is how much tightening it will indicate. Scaling back asset purchases is tightening in and of itself, but probably not enough to cause a collapse in equity prices. But if the announcement also makes market participants expect a series of interest rate hikes to soon follow, then the depressing effect on equity prices will be much greater. Tim Duy adds in another post that "A challenge for the Fed is that asset purchases are at least in part a communications device that signals commitment to a given policy path. Thus, the Federal Reserve will need to take care to avoid the impression of imminent rate hikes as they scale back asset purchases."

Treasury and MBS Markets as QE Continues

Today the Fed announced that "To support a stronger economic recovery and to help ensure that inflation, over time, is at the rate most consistent with its dual mandate, the Committee decided to continue purchasing additional agency mortgage-backed securities at a pace of $40 billion per month and longer-term Treasury securities at a pace of $45 billion per month."

In February, in response to questions by the House Financial Services Committee, Fed Chairman Ben Bernanke said that the asset purchase programs have not disrupted the markets for longer-term Treasuries or for mortgage-backed securities. The New York Fed followed up on this in the latest Survey of Primary Dealers, from March 2013. Primary dealers are trading counterparties of the New York Fed, and play an important role in implementing the asset purchase program. They are obligated to participate in open market operations and to provide the New York Fed's trading desk with market information and analysis. The primary dealers are surveyed each month to help the FOMC evaluate market expectations about the outlook for the economic and financial conditions and monetary policy.

One question from the survey asked: How would you rate market functioning in longer-term Treasury and agency MBS securities markets today relative to the worst and best conditions you have seen since the beginning of 2009? 

Here is a tabulation of the responses:

Most of the dealers agree that conditions in the Treasury market are relatively good. Fifteen out of the 21 dealers rate conditions at 4 or 5 on a five-point scale. In the agency MBS market, conditions are a bit more iffy, though 4 is still the modal response. It looks like most of the dealers agree with Bernanke.

The survey also asked about expectations for the change in the amount of domestic securities held in the System Open Market Account (SOMA) portfolio over the next few years. I plotted the 25th, 50th, and 75th percentiles for expected cumulative changes in treasury holdings and in agency debt and MBS holdings below. Both types of asset holdings are expected to level off in the second half of 2014. But agency debt and MBS holdings are expected to start declining more quickly and rapidly than treasury holdings, which are expected to hold steady through the end of 2015 before beginning to decline.

Respondents were allowed to give written comments on their predictions:

"Some dealers assumed that future declines in the SOMA portfolio would be due to halting reinvestments only, while some dealers assumed halting reinvestments combined with sales. Several dealers expected such declines in the SOMA portfolio to occur at a fixed time before or after the first interest rate increase. Several dealers mentioned their views were based on the June 2011 exit principles while several others mentioned the FOMC will likely review its exit strategy, citing recent communication from Federal Reserve officials...
Some dealers expected sales of agency MBS securities to be a part of the exit strategy from accommodative policy. Some others thought that sales are unlikely or do not expect them to occur, with several mentioning that sufficient tightening could be brought about through other tools, including raising the interest rate paid on excess reserves (IOER) as well as temporary reserve draining."

Expected SOMA holdings at the end of 2014 are contingent on the level of unemployment by the end of this year. The blue bars show the probability distribution over holdings if the unemployment rate is less than 7.4% by the end of 2013. The red bars are if the unemployment rate is between 7.4 and 7.7%, and the green bars are if the unemployment rate is above 7.7%.