Catechisms are useful, and not in just a religious context. Catechisms help organize a commonly accepted set of rules and understandings, which are the essence of institutional arrangements, both religious and secular. Groups function better when people are singing off the same song sheet, even as they sing different parts and sometimes, are way off key. We all hate rules, but we also demand rules, because rules simplify decision-making, defining acceptable bounds for choice and behavior.
For example, we drive on the right side of the road here in the United States, while in some countries, people drive on the left. Despite my parochial view that the left side is the wrong side, it really doesn’t matter which side is the prescribed side, as along as everybody knows which side it is. To ensure that everybody knows the basics, civilized societies must have a set of tests, or catechisms, to which everybody is supposed to know the right answers.
Unlike the case with religious catechisms, however, the answers to secular catechisms are constantly changing. And indeed, the questions themselves are constantly changing. In fact, figuring out changing answers to changing questions is the essence of what we do here at PIMCO: active portfolio management.
Monetary Catechism Class
Figuring out changing answers to changing questions is also the essence of active macroeconomic policy management. And catechism class happens when the chairman of the Fed testifies before Congress: legislators ask the same questions they asked him the previous time, and the world watches with baited breath to see if the chairman of the Fed changes his answers, or dares to suggest that, perhaps, a new set of questions would be appropriate.
I started going to monetary catechism class when Paul Volcker was chairman of the Fed. In fact, I actually went to Washington, along with Wall Street’s entire Fed watching fraternity, since such hearings weren’t carried on the boob tube in the early and mid-1980s, as is the case now. We’d all sit right behind Volcker in the hearing room, watching and smelling him smoke cigar after cigar, while listening to him repeatedly tell legislators that there were only two questions that mattered, and the answer to both was the same.
The questions were (1) “Why are interest rates still high when inflation is falling?” and (2) “Why can’t/won’t the Fed bring down all interest rates by cutting short-term interest rates?” Volcker’s answer was always, “because the budget deficit is too big.” Inflation might be falling, he would allow, but inflationary expectations were being held up, he’d argue, because of budget deficits, and the associated concern that Uncle Sam would, ultimately, print money to pay for them. In turn, such elevated inflationary expectations were, he’d preach, holding up long-term interest rates.
Therefore, he’d opine, the Fed couldn’t bring down long-term rates simply by cutting short-term interest rates. Indeed, lower short-term rates could, in the context of excessive budget deficits, actually generate higher, not lower long-term rates, he’d thunder, as Fed accommodation of excessive budget deficits would simply reinforce the inflationary expectations beget by such excessive budget deficits.
All of us Wall Streeters would rush out to the pay phones in the hall (yes, this was an ancient time before cell phones!) and call our offices/trading floors, relaying that Volcker was “very hawkish,” urging traders/investors to sell bonds. Budget deficits were bad, very bad, Volcker had said, and if he said it, we were not going to argue with him. After all, it was the duty of the bond market to impose discipline on those nasty deficit spenders. We worked for the “bond market vigilantes,” who were even more powerful than Volcker, and that by his own admission. The term structure of interest rates could not and would not come down, unless and until Congress slayed the deficit dragon.
It really was a simple syllogism: (1) fiscal deficits determine (2) long-term inflation expectations, which are (3) a more powerful force than short-term interest rates in (4) the determination of long-term interest rates. In real time, it didn’t matter whether it was true or not. If enough people believed it was true, and Volcker acted as if it were true – refusing to cut short-term interests unless and until Congress cut those damnable deficits — then it was true for trading purposes.
The Truth of the Matter
Remember, trading is not about truth, but about staying ahead of the consensus’ perception of truth. Perception is reality, until reality bites perception in the backside. As it repeatedly does when it comes to the thesis that fiscal policy dominates monetary policy in the determination of long-term interest rates. It simply isn’t true.
Long rates have moved in the same direction as short rates over eighty percent of the time over the last two decades, as shown in Figure 1 . Long rates have moved less than short rates, to be sure, with the yield curve flattening when the Fed is tightening, and steepening when the Fed is easing. But the direction of long rates has been dominated by the direction of short-term rates, under the monopoly control of the Fed.
Short Rates Are The Dominant Driver of Long Rates,
Not The "Bond Market Vigilantes"
Source: Bloomberg Data
And the dominant determinant of short rates has been the pace of economic growth, in particular manufacturing sector growth, as proxied by the NAPM Index, shown in Figure 2 . In fact, short rates and the budget deficit (as a percent of GDP) have actually moved inversely over the last two decades, as shown in Figure 3 . Nothing surprising about this, actually, as both short-term interest rates and the budget deficits are cyclical, rising and falling with the pace of economic activity; so, too, are long-term rates.
Cyclical Movement In The Economy, Especially
In Manufacturing, Drives Fed-Induced
Changes In Short Rates
Source: National Association of Purchasing Managers, Bloomberg Data
Monetary Policy Can't Get Ahead Of The
Recessionary Curve, As Long As Fiscal Policy
Is Defying The Curve
Source: US Treasury, Bloomberg
Yes, it is probably true that budget deficits make long-term interest rates structurally higher than otherwise would be the case – absolutely and relative to short-term interest rates. The empirical evidence on this matter is less than “persuasive,” to use one of current Fed Chairman Greenspan’s favorite words. In cyclical time, however, it is a fact that long-term interest rates only go up, actually go up in a meaningful way, when the Fed hikes (or threatens to hike!) short-term interest rates.
Thus, fiscal policy as an active tool of counter-cyclical business cycle management is not inherently impotent, if monetary policy authorities are willing to accommodate such use of fiscal policy. The “bond market vigilantes” do not rule the world. They reign only when the Fed chooses to let them reign. And that’s what the Fed did under Volcker, with Greenspan carrying the tradition to this very day. In academic terms, this “bond market vigilante” paradigm is all about monetary policy dominating fiscal policy. It’s about the Fed exercising raw political power.
The Second Most Powerful Man In America
There is, in fact, a credible economic foundation for the Fed to want such power. Under Volcker, who had a secular disinflation objective, it was all about brute forcing a decelerating path for nominal GDP growth, “squeezing” the inflation (GDP deflator) wedge between nominal and real GDP growth. Thus, the Fed abhorred the notion of any fiscal stimulus that would tend to put upward pressure on real, and therefore nominal, GDP growth. Put differently, the Fed wanted an “output gap”: less than full employment (actual unemployment above the NAIRU, for you NAIRU fans).
As a political matter, the Fed couldn’t (wouldn’t) explain that (1) budget deficits were “holding up” long-term interest rates because (2) the Fed was “holding up” short-term interest rates, so as to (3) neuter the stimulative effect of budget deficits on real GDP growth, to (4) brute force a decelerating path for nominal GDP growth. That was the truth of the matter. The Fed and Volcker could have said so plainly. But as a matter of political marketing, it was much easier for the Fed to hide under the cover of the “bond market vigilantes,” who ostensibly were wrapped ‘round the axle of the secular inflation implications of budget deficits.
An argument can be made, and I have some sympathy for it, that Volcker’s end goal of global secular disinflation justified his sleight of truth means. Democracies are not inherently good at fighting inflation, and if the fight must be fought for the greater good, then a bit of white lying by the Fed might be moral. I’m not sure about this, but I do have sympathy for the argument.
Greenspan Ups Volcker's Ante
Under Greenspan, the economic foundation for the Fed’s disdain of fiscal deficits shifted in a very fundamental way from the Volcker era. While retaining its secular goal of disinflationary nominal GDP growth, the Fed took on a new goal: fostering a secular increase in the economy’s potential real GDP growth.
With that added mission, budget deficits came to be seen as doubly “bad” in the Fed’s eyes. Not only do budget deficits stimulate aggregate demand, “forcing” the Fed to run higher real short-term interest rates than otherwise would be the case, but they also “crowd out” private investment, thwarting a structural improvement in productivity growth (potential real GDP growth!) through what is known as “capital deepening.” Thus, the Greenspan Fed has actually been more “hawkish” about budget deficits than the Volcker Fed.
Put differently, Greenspan has sought to control both monetary and fiscal policy in the pursuit of his vision of a New Economy, while Volcker simply used monetary restraint to neuter fiscal policy’s stimulative effect on nominal GNP, if and when it was in conflict with the Fed’s secular disinflationary goal. Greenspan has played, and continues to play the role of Philosopher King, while Volcker was a policeman against inflation, using the “bond market vigilantes” as his baton.
And a right fine baton, Greenspan has found, in beating fiscal authorities into compliance with his vision of “crowding in” private investment via reduced budget deficits and then, budget surpluses. Greenspan hit President Clinton up side the head with the baton in 1993, convincing him that tax hikes, not fiscal stimulus, were the path to righteousness, which would be rewarded by falling long-term interest rates. And indeed, long-term interest rates fell some 100 basis points in 1993, a dramatic bull flattening of the yield curve as the Fed resolutely held the Fed funds rate at 3%. Greenspan looked brilliant, Clinton’s economic czar Bob Rubin looked brilliant, and Clinton looked brilliant: fiscal tightening produced lower long-term interest rates! And a strengthening economic recovery!
Now the truth of the matter was that the yield curve was historically steep at the beginning of 1993, as the Fed had been in a historically powerful easing posture since 1989; to wit, the Fed was running zero real short-term interest rates. Thus, the reason that Clinton’s fiscal austerity “worked” to bring down long-term interest rates was that Greenspan resisted any urge to hike short-term interest rates (his “reward” to Mr. Clinton for doing the “right” thing). Fiscal virtue generated its own reward of lower long-term interest rates was the argument, preached to this day by Mr. Rubin, who “brokered the deal” between Mr. Clinton and Mr. Greenspan. He never mentions, of course, that Greenspan doubled short-term interest rates in 1994, producing the worst bear market in long-term bonds in a generation, taking back all of the “reward” and then some for fiscal virtue in 1993.
The simple fact of that matter is that the big decline in long-term rates in 1993 was a bubble funded by leverage from Fed-enforced zero real short-term rates, and the consensus belief that the Fed would maintain those zero real short-term rates for a long, long time. The Fed didn’t in 1994, and long-term rates soared in sympathy with soaring short-term interest rates.
It was a brilliant Machiavellian tactic in Greenspan’s strategic mission of “crowding in” private sector investment, while “crowding out” public sector investment. And it set the stage for bigger and better things for Greenspan: his late-90s push for sufficient fiscal surpluses for sufficiently long, to (effectively) eliminate the existing stock of Federal debt, so as to “crowd in” yet more private sector investment.
All that “crowding in” would be facilitated, Greenspan preached, by the “bond market vigilantes,” who would throw down their swords, lowering long-term interest rates, reducing the cost of both debt and equity capital (via higher stock P/Es). Accordingly, he counseled fiscal authorities, both the White House and the Congress, that the first best use of evolving fiscal surpluses was to pay down debt, with tax cuts the second best use, and spending increases the worst best use.
That was conventional wisdom in Washington less than a year ago, despite the self-evident truth that what had been “crowded in” was an investment bubble that was blowing up. But that was just a flesh wound on the New Economy, Greenspan argued. Elevated structural productivity growth through technology-stoked investment, “crowded in” via budget surpluses, was his story, and he was sticking by it. After all, bartenders don’t take blame for hangovers.
Too Much Of A Good Thing Is Bad?
But they do worry. By January of this year, Mr. Greenspan developed angst about the possibility that that we’d get to the promised land of no federal debt too quickly, which would “force” Uncle Sam to start buying private sector assets to soak up the budget surplus. And that would be an abomination to the catechism of capitalism, which dictates that private sector assets be owned by the private sector.
Therefore, one week after George W. Bush hung his hat in the Oval Office, a sheer coincidence I’m sure, Mr. Greenspan urged Congress to enact secular tax cuts, so as to put the nation on a more manageable “glide path” to debt-free heaven. In speaking to Congress, Mr. Greenspan stressed that he was speaking for himself, not the Fed, a necessary soft shoe shimmy, given that the Fed is empowered by the Congress, not the other way ‘round. Congress took Mr. Greenspan’s “personal” counsel, of course, and enacted a secular cut in income tax rates, coincidently making the new Republican in the White House a happy man.
But given that the economy was slip sliding away in the wake of the busted investment bubble that had been “crowded in,” Democrats in Congress demanded some cyclical tax cutting as a quid pro quo for secular tax cutting. It wasn’t just a matter of putting Uncle Sam on a secular “glide path” towards freedom from debt, the “liberals” argued, but also about providing a cyclical lift to aggregate demand, Keynesian style.
And so it came to pass, income tax “rebates” for this year were born. Republicans were happy, even eager to go along; it was a small political price to pay for permanent income tax cuts, skewed towards the relatively well off. And even Mr. Greenspan had no real objection, even though he didn’t see any real need for cyclical fiscal stimulus. If such cyclical demand stimulus was needed, he could provide it with monetary policy, he assured one and all. But what the hey, he also said. A little cyclical fiscal stimulus might be worthwhile, as an insurance policy against the unlikely event that the economy proved less responsive than he expected to his monetary medicine, going into a deep and/or prolonged recession.
The Unlikely Event Becomes Reality
Which brings us to the here and now: the nation is in recession. Whether the economy was or was not in recession before the tragedy of September 11, I don’t know. In fact, nobody knows, because the precise dating of recessions is not a science but an art, practiced by the National Bureau of Economic Research (NBER) Business Cycle Dating Committee. And the NBER never forecasts recessions, but only dates them long after the fact.
Indeed, the NBER announced in April 1991 that a recession had begun in July 1990. And then in December 1991, the NBER announced that the recession had ended in March 1991, one month before it had declared that the economy had actually entered recession! Many economic wonks wag the finger at the NBER for such tardiness. I don’t. In dating business cycles, the NBER is not in the forecasting business, but rather the history business. And in writing history, it is more important to be right than quick.
In Congressional testimony since the tragedies of September 11, Mr. Greenspan has evoked precisely the same dictum with respect to enacting additional fiscal stimulus: it is more important to be right than quick. Philosophically, it’s hard to argue with that proposition. No reasonable person would advocate doing the wrong thing quickly or slowly.
In contrast, it is harder to argue that the right thing should be done slowly; if it’s right, it’s right, and should be done both quickly and boldly. A matter of a few weeks either way doesn’t matter, of course. And if that’s all Mr. Greenspan had in mind with his “more important to be right than quick” injunction, I have zero quarrel with him. Policy is more likely to be “right” if fiscal policy makers – who are politicians, after all – can be re-educated in the basic macroeconomics of counter-cyclical fiscal policy. And they need the re-education. After all, they’ve not had to really know such things for a long, long time, ever since Mr. Volcker and the “bond market vigilantes” established hegemony over fine-tuning of the business cycle.
I worry, however, that Mr. Greenspan’s plea to avoid undue haste in crafting a fiscal stimulus package is not just a matter of diluting politicians’ ignorance and penchant for mischief. More precisely, I worry that Mr. Greenspan has only accepted the inevitability of a fiscal stimulus package, but has not embraced either the efficacy or desirability of a fiscal stimulus package. More bluntly, I believe that Mr. Greenspan still believes that monetary policy should be the dominant and dominating counter-cyclical policy tool, aided and abetted by the “bond market vigilantes” policing fiscal policy authorities.
One key passage in Mr. Greenspan’s testimony a week ago yesterday underscores this unrepentant line of thinking:
“…in recent days, we’ve seen average corporate rates, BAA corporates, for example, rising fairly significantly. And while we don’t have as current data on mortgage interest rates, they lock in fairly closely to the 10-year yields. This suggests to me that we have to be quite careful. Because until we find out whether the rise in long-term rates is merely a reversal of the fairly pronounced decline in rates that occurred in the weeks previously, and hence is not a significant issue, or whether, as you (Senator Bayh) suggests, it might be a fiscal problem, until we found out, we are not going to know what the appropriate balance of fiscal policy, monetary policy, and indeed all polices concerned is. Because, as I discussed yesterday, we have to distinguish between gross and net stimulus.
Gross stimulus is relatively easy to calculate. We can just look at the extent to which we are expanding federal expenditures or cutting taxes and make reasonable judgments as to what the impact is. But until we can determine what the secondary effects on long-term interest rates are, and hence the negative effects on personal consumption expenditures, and as you point out, presumably on capital investment, we cannot make a judgment as to whether in fact a particular package of stimulus is indeed a stimulus.”
Well excuse me, Mr. Greenspan: the “bond market vigilantes” do not run the world. The Fed is fully capable of ensuring that a fiscal stimulus package is indeed a fiscal stimulus package, if it will commit to resisting any urge to hike short-term interest rates for an extended period of time. This is particularly the case right now, given the starting point of a historically steep yield curve. Thus, it is hard to avoid the conclusion that Mr. Greenspan simply is against a bold fiscal policy stimulus, and is using the “bond market vigilantes” as a billy club to thwart fiscal policy makers’ impulse to be bold.
There is, as Mr. Greenspan argues, a “right” way to construct a fiscal stimulus package. But the right way is not to be led by the nose by the “bond market vigilantes.” A stimulus package that is expected to “work” will, by definition, offend the “bond market vigilantes.” Put differently, long-term Treasury yields will naturally rise if/when credible prospects for recovery diminish the “safe” haven bid for long-term Treasuries.
How much Treasury yields will rise will depend, in large part, on whether the Fed is expected to jack short-term rates (alternatively, “take back easing”) when recovery is at hand. Thus, the “right” way for Congress to construct a fiscal stimulus is to (1) start with the presumption that, if successful, the vaunted “bond market vigilantes” will not like it; and (2) demand a pledge from the Fed to resist any urge to tighten in “solidarity” with the “bond market vigilantes.”
An Unrepentant Keynesian
Once those two matters are squared away, particularly the Fed “taking the pledge,” the right guideposts of a fiscal stimulus package are really quite simple:
It should be larger than what garden variety econometric models suggest is appropriate, as such models naturally cut off the extreme “tails” of probability distributions, and we are now tragically living in such an extreme outcome.
Stimulus-oriented changes in both taxes and spending (i.e., those not related to secularly enhancing homeland security) should have “sunset” provisions, so that they run off, expire or otherwise go away once a self-feeding cyclical recovery is firmly established.
Changes in taxation on the household sector should be geared to having the maximum “multiplier” effect, which as a practical matter, means that tax cuts should be targeted to those with the highest marginal propensity to consume.
Changes in taxation on the business sector should be geared to cushioning downward pressure on cash flow from the existing capital stock, not toward creating incentives for (“crowding in”) more investment.
Stimulus should be easy to administer, and quick acting, preferably before the Christmas shopping session and before corporations start implementing 2002 budgets, especially headcount budgets.
Turn those five “principles” into questions and you have a catechism for evaluating fiscal stimulus ideas in the “right” way, without getting wrapped ‘round the axel of the “bond market vigilantes.” In that spirit, I offer my own idea, and will subject it to the catechism test: a 3-6 month “holiday” in all payroll (social security) taxes, which is paid half and half by the employee and the employer – 7.65% on both sides.
It is large. The tax will raise some almost $700 billion this year, about 7% of GDP. Thus, a 3-6 month holiday from the tax would boost private sector cash flow by 1% - 3% of GDP, well above the 1% of GDP that conventional econometric models – and Greenspan – suggest is appropriate.
By definition, a payroll tax holiday has a sunset provision: the length of the holiday.
The payroll tax is a regressive tax on the household sector, with only 1.45% of both employee and employer levies applying to incomes above $80,400 (for Medicare). Thus, a holiday from the tax would put hard cold take-home cash into the hands of those who have a high marginal propensity to consume (those that live “pay check to pay check” to the scorn of rich people).
Since the business sector pays half the tax “on behalf” of their employees, a holiday from the tax would be an immediate boon to business cash flow. For example, a three-month holiday would juice business cash flow over $75 billion, a large number in the context of after-tax corporate profits of just under $600 billion in 2000.
To be sure, such cash flow relief would not be an incentive for future investment, but merely a boost to the return from past investment. But in a recession, creating incentives for future investment is not the name of the game; limiting cuts in prior investment in human capital – to wit, jobs – should be the objective.
A payroll tax holiday is exceedingly easy to administer: the nation’s human resource departments simply need to be informed to change a few lines of code in their computer systems. And it would be fast acting, with the stimulus arriving with the next paycheck cycle.
Bottom line: a payroll tax holiday passes all five principles in the catechism for the “right” fiscal stimulus.
The first objective of nay sayers will be, of course, that the idea would fly in the face of “lock-boxing” the Social Security surplus. Indeed, it would. But that lockbox has always been a myth wrapped in an enigma laced with obfuscation. Social Security benefits are a federal obligation, period, independent of the taxation scheme for paying them. It’s time for fiscal policy makers to speak the truth on this matter.
Future benefit liabilities are what they are, and would continue to accrue during a payroll tax holiday. The “accounting” outcome would simply be that the Social Security “trust funds” would “redeem” some of their non-marketable debt, the stock of which would still remain huge.
The Treasury would, of course, have to increase issuance of marketable debt to “take out” the trust funds’ non-marketable debt. That is, however, precisely what a proper cyclical Keynesian stimulus is all about: the government levering its balance sheet when the private sector is caught in the grips of the paradox of thrift, trying to de-lever its balance sheet. 1
Yes, I’m an unrepentant Keynesian.
Paul A. McCulley
September 28, 2001
1 See "A Responsible Word For Irresponsibility," Fed Focus, August 31, 2001.