Posted by: Dirk | October 5, 2011

The yield curve in times of depression

Paul Krugman laments “the remarkably slow realization in the financial industry that the yield curve — the spread between short-term and long-term interest rate, often used as a leading indicator of recessions and recoveries — no longer has its usual meaning.” I share his head-scratching, especially since this fact has been known – and explained –  at least since 1937. In that year, JR Hicks published an article named “Mr Keynes and the Classics: A Suggested Interpretation”, which was cited 1,000+ times subsequently – which is rather a lot. The IS/LM model is built on the foundations of this paper. Let’s see what Hicks has to say about the yield curve (p. 154-5, my highlighting):

If the costs of holding money can be neglected, it will always be profitable to hold money rather than lend it out, if the rate of interest is not greater than zero. Consequently the rate of interest must always be positive. In an extreme case, the shortest short-term rate may perhaps be nearly zero. But if so, the long-term rate must lie above it, for the long rate has to allow for the risk that the short rate may rise during the currency of the loan, and it should be observed that the short rate can only rise, it cannot fall. This does not only mean that the long rate must be a sort of average of the probable short rates over its duration, and that this average must lie above the current short rate. There is also the more important risk to be considered, that the lender on long term may desire to have cash before the agreed date of repayment, and then, if the short rate has risen meanwhile, he may be involved in a substantial capital loss. It is this last risk which provides Mr. Keynes’ “speculative motive” and which ensures that the rate for loans of infinite duration (which he always has in mind as the rate of interest) cannot fall very near zero.

So, there you have it. When the financial industry finally figures out the part about the “substantial capital loss” we might be in deep trouble – but maybe not. If you want to test your knowledge of the LM side’s financial implications in an economy that hits the zero lower bound, be my guest.


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