The economist: It’s a puzzlement
“It’s a puzzlement,” sang Yul Brenner in “The King and I,” as he tried to understand the differences between East and West. Alan Greenspan chose a different word in testimony before the House Finance Committee more than four years ago. He talked about the “conundrum” of the unanticipated behavior of world bond markets.
Long-term rates were falling, even though the Federal Reserve was increasing short-term rates, flattening and eventually inverting the yield curve (the spread between short and long rates on securities with a similar degree of risk).
Whether we call them puzzlements or conundrums, clearly something odd has been going on in the world economy over the last decade. Take, for example, the dot.com bubble of 10 years ago. Remember when we were being told that the price of technology stocks could only go up, that because technology and the Internet were integral to doing business in a global economy, the industry could only grow?
One of the most basic principles of economic theory is the Law of Downward Sloping Demand. As the price of a good falls, it becomes more affordable and, all other things being equal, people purchase more of it. When the price rises, the opposite occurs as people choose less expensive substitutes. Chicken replaces beef; beer replaces wine.
Back in the “olden days” when I studied economics at the University of Colorado, we learned of one exception to the relationship. During the potato famine in Ireland in the 1800s, potatoes became more and more expensive, but people still increased their purchase of them. What initially seemed to be a conundrum had a logical explanation. Potatoes, although more expensive than they had been, were all people could afford. Gradually they replaced meat, fruits and other vegetables. The Law of Price hadn’t been repealed.
Or, consider a more recent example, the bubble in the housing market, which occurred not just in America but around much of the industrial world. As home prices more than tripled between the first quarter of 1987 and the first quarter of 2006 — demand increased. Home sales rose from 3.8 million in 1987 to 6.5 million in 2006.
While part of the increase was due to a 25 percent increase in population and rising household income, we also convinced ourselves that prices could only go up, that the smart thing was to buy quickly while homes were relatively cheap. There was no need to save out of income. We were increasing our savings through our smart investment in real estate.
Higher prices brought an increase in the supply of housing on the market, as economic theory predicts. But, demand for homes, rather than falling after adjusting for rising incomes and population, as it would in a well behaved market, actually soared.
“It’s a puzzlement!” murmured the king. And, indeed it was, as bubbles always are in the aftermath, when sanity returns to the market.
Greenspan’s conundrum has a more logical explanation. The trade deficits that the U.S. has run with much of the rest of the world since 1982 has left those countries with enormous holdings of dollars, particularly in the ones that manage their exchange rate rather than allowing it to be determined by market forces. China is a good example. Governments accumulate huge quantities of dollars, creating a big demand for safe dollar-denominated investments, particularly Treasury bonds, driving up the price.
Since the interest rate is nothing more than the price of credit and moves in the opposite direction of the price of the bond, long rates fell even though the Fed was actively increasing rates at the short end of the spectrum. The Law of Price wasn’t repealed; the downward sloping demand curve was shifting outward.
One thing I’ve learned over the years is that the phrase, “This time it’s different,” is one of the most dangerous in economic analysis. There are times when the economy is a puzzlement, but apparent conundrums have a logical explanation if we examine them carefully and remember the economic fundamentals.