Thoughts on the debt deal

This was definitely a compromise solution, but one in which each side calls the other the "winner".

I read quite a few lefty blogs, which is fine because, if you look at the graph showing my political and economic positions, I am a lefty. Now the lefty blogs are all saying that this is a victory for the Republicans. They're also critical of Obama. I've just watched John Stewart and that's pretty much what he said.

But I also check up on Redstate once in a while to look at how the other side feels and they are definitely unhappy too. "Cut, cap and balance" was their mantra and that was not achieved.

I guess the best place to check this is Wikipedia which, ironically (at least to many), has a more dispassionate and factual summary of what was achieved:

• Cut spending more than it increases the debt limit. In the first installment ("tranche"), $917 billion would be cut over 10 years in exchange for increasing the debt limit by $900 billion.
• The agreement establishes a joint committee of Congress that would produce debt reduction legislation by November 23, 2011 that would be immune from amendments or filibuster. The goal of the legislation is to cut at least $1.5 trillion over the coming 10 years and be passed by December 23, 2011. The committee would have 12 members, 6 from each party.
• Projected revenue from the committee's legislation must not exceed the revenue baseline produced by current law.
• The agreement specifies an incentive for Congress to act. If Congress fails to produce a deficit reduction bill with at least $1.2 trillion in cuts, then Congress can grant a $1.2 trillion increase in the debt ceiling but this would trigger across the board cuts ("sequestration") of spending equally split between defense and non defense programs. The across the board cuts would apply to mandatory and discretionary spending in the years 2013 to 2021 and be in an amount equal to the difference between $1.2 trillion and the amount of deficit reduction enacted from the joint committee. The sequestration mechanism is the same as the Balanced Budget Act of 1997. There are exemptions—across the board cuts would apply to Medicare, but not to Social Security, Medicaid, civil and military employee pay, or veterans.
• Congress must vote on a Balanced Budget Amendment between October 1, 2011 and the end of the year
• The debt ceiling may be increased an additional $1.5 trillion if either one of the following two conditions are met:
  
  1. A balanced budget amendment is sent to the states
  2. The joint committee cuts spending by a greater amount than the requested debt ceiling increase.

My understanding is that cuts were achieved and this was done without increasing tax revenue. This is therefore a broad conservative political victory. Conservatives, nevertheless, do not see this as a victory because it doesn't go far enough.

The reason for conservative unhappiness has more to do with their extreme ideological position. Since the onset on the Tea Party and their influence on Republican Party politics, the GOP has, amazingly, become even more ideologically conservative. Minarchism is now the default position of conservatives, which means that any form of government spending outside of military spending and law enforcement must be excised. This form of ideology, however, is backed up by a crazy form of patriotism that sees minarchism as the intended model explicitly advocated by the "founding fathers", which means that any different position (whether it be left wing or centrist) is automatically branded a threat worth "watering the tree of liberty for" (ie the blood of tyrants and patriots resulting from an armed struggle). Add to this the peculiarities of the US congressional system and the only real compromise position is the one which was passed.

As far as the effect on the broader economy, my understanding is that most of the cuts will come in after a two year period, which theoretically allows Obama some breathing space to run for a second term in 2012. The debt limit has been increased to allow for borrowing in the meantime and, all things being equal, should not require another increase until after the 2012 elections. "All things being equal" though is not a good phrase in these dark economic days. I have already predicted that the US will enter another downturn in 2012 and if this occurs the debt ceiling may need to be increased before the election, especially if unemployment ends up in the mid-teens, thus reducing government income tax revenue.

As for the Keynesian approach of pump priming the economy via deficits, this piece of legislation is of no help. My own call for a "Total War / New Deal" type economy (whereby large increases in government spending in health, education and alternative energy are accompanied by large tax increases) is even less likely to occur. Since the US economy's many structural flaws have not been addressed since the credit crunch of 2008, I thus have little faith that the free market will be able to generate jobs and economic growth in the short-medium term.

My Favourite Song

Ride - Leave Them All Behind from 43hk0804c26qsi8w on Vimeo.

A quick solution to the debtlocked Congress

It involves finding an average between the three constitutional bodies - the House, the Senate and the Executive.

The first thing to do is discern how much the difference between revenue and expenditure currently is. In 2011 Q1 it was $2.5231 trillion revenue and $3.7290 spending, a difference of -$1.2059 trillion. If we assume that that number has to be reduced to zero it should come as a result of spending cuts, taxation increases or a combination of both.

So what happens is that each member of the House is given a piece of paper. On that piece of paper they write down what percentage of this -$1.2059 Trillion should be paid for by spending cuts and what percentage by tax increases. I'm sure that right wing extremists are likely to nominate 100% cuts and 0% tax increases, while some lefties are likely to nominate 0% cuts and 100% tax increases. At the same time as members of the House do this, members of the Senate do as well. President Obama also does it.

Equal weighting is given to each of the three bodies (House, Senate, Executive) because they are equally weighted under the Constitution. The "averaging out" process would essentially be enforcing a mathematically based bipartisan compromise.

What happens then is that the average for cuts and tax increases is determined for the House. Let's say it is 61% cuts and 39% taxes. Let's say the Senate average is 46% cuts and 54% taxes. Now let's say that Obama goes for 40% cuts and 60% taxes.

This would mean that an average 49% of the three constitutional bodies say spending cuts while 51% want higher taxes. This would translate to $590.891 billion in spending cuts and $615.009 billion in new taxes (in annual terms). If you do the math, that would result in $3.138109 trillion revenue and $3.138109 trillion spending - a balanced budget.

Of course this voting structure would mean that the final number would have to be accepted by all parties before the vote is cast. This will allow members of congress to vote according to their ideology and please their voters, while at the same time creating a compromise solution.

It goes without saying that an increase in the debt ceiling would also accompany the bill.

America and the terrible, horrible, no good, very bad GDP data

The recent GDP figures paint a bleak picture. My spreadsheet does too:

There was a revision of past GDP performance and it was very bad. The graph above shows quarterly changes in Real GDP per capita, annualised. Of course the big hit was 2008 Q4 but notice that 2011 Q1 has gone negative. I don't think this is the beginning of an annual decline of Real GDP per Capita but it can certainly be seen to presage one later on.

A very sad thing to notice about the new release of these GDP figures is that Real GDP hasn't yet passed its previous peak yet.

Real GDP peaked in 2007 Q4 at $13.326 trillion, then bottomed out in 2009 Q2 at $12.6413 trillion and has grown since then to reach $13.2701 trillion in 2011 Q2. 15 quarters - nearly 4 years - in which real GDP remained below the peak. As far as my spreadsheet tells me, there is no other period in postwar US history where it has taken this long (and counting) for the economy to at least equal its previous peak. Both the 1974 and 1982 recessions took 9 quarters to reach this level.

On a side note, measuring per capita figures has been harder this year due to the work of the US Census. Monthly population figures have not been updated since December which has meant that 2011 per capita figures have had to rely upon mid monthly figures. Caveat Cognitor.

The 14th Amendment and the potential for economic disaster

The 14th Amendment of the US Constitution is currently being examined and touted as an important factor in the current debate about the government debt limit. I've blogged about this recently but I've had some more ideas about it. Here is the text again:

The validity of the public debt of the United States, authorized by law, including debts incurred for payment of pensions and bounties for services in suppressing insurrection or rebellion, shall not be questioned. But neither the United States nor any State shall assume or pay any debt or obligation incurred in aid of insurrection or rebellion against the United States, or any claim for the loss or emancipation of any slave. But all such debts, obligations and claims shall be held illegal and void.

Okay, the background of this amendment was post civil war. In its original context that first sentence guarantees the payment of debts incurred by the Federal Government in fighting and defeating the South. The second sentence, however, absolves the Federal Government from having to pay debts incurred by the Confederate States of America. The third sentence spells this out even more, permanently settling the question of Confederate debt.

It's the first sentence that applies in this current situation. Obviously the framers of the amendment thought it important not just to guarantee payment of debt by the Federal Government in the successful waging of the civil war, but to make it part of the constitution itself via an amendment. This means that they intended the principle behind this amendment to have an ongoing application.

The question is, what does it mean by debt? Obviously this debt is public meaning that it is owed by the Federal Government. In short it is money owed, and money owed that has been authorized by law. In other words, it is money that the Federal Government owes creditors - so long as it has been authorized by law.

As I pointed out in my recent article, this naturally applies to government bonds. As of the 26th July 2011, the US Government owes $14,342,830,116,551.28 in public debt. But is "Public Debt" in 2011 the same as "Public Debt" in 1868? There is a broader application of this term: there is debt accrued by borrowing, and there is debt accrued by buying. For example, if a government office gets a local company to mow their lawns, they naturally have to pay this local company. If we expand this idea outwards, we see that the Federal Government has legal obligations to pay for goods and services delivered to them by private industry.

But what about entitlements? Are entitlements considered debt? I think not. Entitlements such as Medicare and Unemployment benefits are probably not considered "debt" in this situation. Sadly this means that the 14th amendment does NOT cover money spent on Medicare or other social services.

"Public debt authorized by law" has also been interpreted by various bloggers and experts recently as to apply simply to spending bills authorized by congress. Essentially it means that if congress has authorized spending, then this cannot be invalidated by a debt ceiling... hence the debt ceiling as it stands is unconstitutional. I'm not sure of this broad definition for a number of reasons. The first is that the amendment itself doesn't specify it. The second is that we are talking here about Public debt - debt owed to the Public, ie not the government.

If you take this second definition to be important - PUBLIC debt - then what to make of government spending bills authorized by law? Well so long as the PUBLIC get what they are owed, the 14th amendment will not be broken. But if the Federal Government decides to stop paying its own employees, that is completely different because the money owed to their employees is not public. There are approximately 2.8 million people employed by the Federal Government.

Here's a summary of my thinking on this issue:

• "Public Debt" means money owed to non Federal Government creditors.
  
• These creditors include those holding government bonds, as well as those who have sold goods and services to the government.
• The 14th Amendment prevents the Federal Government from defaulting on money it owes to bond holders.
• The 14th Amendment does not specify whether payment of money to bond holders needs to be paid "on time" or "later"
  
• The 14th Amendment prevents the Federal Government from defaulting on money it owes to private businesses and individuals for goods and services provided.
• The 14th Amendment does not specify whether payment of money to these private businesses and individuals needs to be paid "on time" or later".
• Money for those who qualify for government services and entitlements - such as unemployment benefits and Medicare services - are not considered "Public Debt" since they are not "owed" money they have directly invested or money they owed through the provision of goods and services.
  
• Under the constitution, Congress is responsible for all spending bills.
  
• A self imposed limit on the amount of debt the Federal Government can borrow is within the constitutional powers of Congress.
• The 14th Amendment does not prevent the Federal Government from defaulting on money it owes to itself on the bond market. Intragovernmental debt is not "Public Debt".
• The 14th Amendment does not prevent the Federal Government from defaulting on money it owes to itself via spending bills.
  
• Money owed to government employees and government departments is not "Public Debt".
  

So given that these are true, what happens if the debt ceiling is not passed? We need to assume here that without a debt ceiling, the Federal Government will be forced to spend only as much as it gets in tax revenue. Specifically what might happen here?

• The Federal Government will not default on paying back interest and principal on bonds owed to the Public.
• Social Security payments are likely to be defined as money owed to the Public, so payments will continue.
  
• The Federal Government will not default on paying back money owed to private businesses and individuals for goods and services provided.
• Delays in payments nevertheless may occur.
• The ordering of future goods and services from private businesses and individuals may be cut.
  
• Money for entitlements (Health Care, Unemployment benefits, etc) can be cut.
• Money for defense can be cut.
  

As I have pointed out, I don't think an arbitrary self-imposed debt limit set by Congress is somehow unconstitutional since Congress is responsible under the constitution for spending government money. Also, it won't be a case of a law passed earlier (the debt limit) being superseded by a law passed later (spending bills) since the earlier law was specifically designed to prevent something happening in the future.

So if the debt limit is not passed and is not declared unconstitutional, what we won't see is a default on government bonds but there is a chance that these payments might be delayed. This would be viewed by the market as a form of selective default. Similarly Social Security payments might end up being delayed, as would be money owed to government suppliers for goods and services owed.

But in order to ensure that these obligations are met (either straight away or over time), certain government departments would have to undergo a drastic reduction in spending. We would see the government either retrench or put on furlough tens of thousands of its employees, if not many, many more. Those with unemployment benefits would have them reduced or postponed indefinitely. Those awaiting or needing medical procedures covered by Medicare will have them delayed indefinitely with priority given only to the most severe cases.

As I pointed out in my previous post on this subject, the US Federal Government currently takes in revenue equivalent to 15% of GDP while its spending is equivalent to 25% of GDP. The 10% gap between revenue and spending is shored up by borrowing. If the debt limit is not raised then the Government will have to reduce its spending to meet its revenue. We would see a reduction in spending from 25% or GDP to 15% of GDP, which is a 40% cut in spending. If we assume that bondholders, social security recipients and government suppliers are protected by the 14th amendment then everything else covered by government spending will be cut.

Needless to say this will have a hugely negative effect upon the economy. With 10% of the economy suddenly halting, you could assume that GDP would drop by at least 10%. The knock-on effects, caused by the money multiplier going into reverse, could conceivably double this impact. And this would be the case even without defaulting.

Peak Oil: All signs point to yes

This diagram comes from The Oil Drum:

I was initiated into the world of Peak Oil some time in 2004. Initially I thought it was a bunch of scary tinfoil hat wearing nonsense - partly because some tinfoil hat wearing people were promoting it (not you Dave!). The deeper I dug, however, the more the evidence piled up. The tinfoil hats were replaced by serious looking academics with qualifications from reputable universities and experience working in petroleum geology. They pointed out that data consistently showed that individual oil fields had an oil production rate like a bell curve, and that less and less oil comes out once the "peak" of the curve has been reached  - which usually comes when the oil field is half empty.

The problem was, and still is, that many are under the false understanding that oil supplies will simply run out suddenly. They are buoyed by market reports showing that oil reserves have another 100 years production left in them. Thus they are ignorant of the fact that, when the majority of the world's oil fields reach 50%, worldwide production will drop.

The graph above shows very clearly that this moment has arrived. Depending upon which metric you use, oil production has either reached a plateau now, or reached one about five years ago.

Being an econophile before I understood Peak Oil, I naturally assumed that price signals would motivate the market to increase production. Yet if an increase in production is geologically impossible what happens when demand increases? When supply is constrained and cannot rise to market demands, what happens?

Simple: Production remains the same, while prices skyrocket. The graph above shows this phenomenon so clearly that you would have to be cognitively deficient not to notice. Some time in 2004 the price of oil begins to rise due to increased demand. This demand was not met by an increase in production, as the graph shows. Oil production then simply sits at the same level for some years. Oil producers are literally unable to pump the stuff out fast enough to meet demand. Oil prices double from their 2004 levels. Then they triple. Then they reach a peak in 2008 before demand destruction hits - the Global Financial Crisis.

Since then prices have dropped. But notice that they have begun skyrocketing again.

Many years ago I blogged about a "perfect economic storm" to hit the US. While I didn't know the date I knew that it would happen. I knew that Peak Oil would be the major cause. What I didn't realise was the extent by which the US economy had over-geared itself and when this occurred I became far more worried than I had before. It was as though I had predicted the arrival of the largest category 5 hurricane in history, only to realise that it would be a category 6 hurricane (which doesn't exist of course, but that's not the point).

If there's anyone out there who is still doubtful about Peak Oil, remember this: If an increase in price doesn't lead to an increase in production, then there is something preventing an increase in production. If this phenomenon is experienced worldwide by many different and disparate sources, then production must be limited by more than just human choices.

Scientists have proven the existence of Peak Oil. The evidence is clear and unambiguous. Moreover it has been experienced by the entire world economy for the past 7-8 years. What more evidence is needed?

And until we wean ourselves off oil, the lag on economic growth will continue. Policy decisions needed to be made in 2004 and weren't. They need to be made NOW.

Some simple facts about the Utøya shooting

The perpetrator:

• Opposed Muslim immigration.
• Was once a member of a dominant conservative political party.
• Espoused anti-government sentiments.
• Hated Marxism.
• Detonated a bomb near the office of the Prime minister, who belongs to a left-wing political party.
• Shot and killed at least 86 young people who were members of the left-wing political party.
  

In short, he is a classic right-wing extremist in the same mould as Timothy McVeigh.

While I don't deny that left wing extremists exist and have also perpetrated violence upon people, I would just like to point out the simple fact that, at least in the West, violence caused by left-wing extremists has been dwarfed by the violence of right-wing extremists. And when you consider the fact that it is the right-wing who are espousing all sorts of radical views using violent rhetoric, you can understand why.

Note: The words "Marxist Hunter" appear on the patch on his left arm in the picture above.

It's so gratifying to leave you wallowing in the mess you've made

Not good news:

Negotiations over a broad deficit reduction plan collapsed in acrimony on Friday after House Speaker John A. Boehner suddenly broke off talks with President Barack Obama, raising the risk of an economy-shaking default.

The epic clash between the White House and Congressional Republicans came a week before the government hits its borrowing ceiling, and set off sharp accusations from both sides about unwillingness to compromise.

A visibly angry President Obama, in a hastily scheduled White House news conference, demanded that Congressional leaders come to the White House on Saturday morning.

“I want them here at 11 a.m. tomorrow,” Mr. Obama said. “They are going to have to explain to me how it is that we are going to avoid default.”

Anyone who has played Sim City 2000 will remember the importance of maintaining a tight budget. But if your city in the game gets to a point where you're running out of money you have a number of serious choices to make in order to balance the budget. One option you have is to cut funding to roads. When you do so, this guy (your roads and transport secretary) pops up and yells at you:

What happens then? As time goes by your roads begin to crack up and become unusable. This is turn reduces economic activity and your own tax revenue even further. It's a short term solution but ends up costing you far more in the longer term. It's a sure fire way to lose to game.

Then, of course, there is that Simpsons episode where Homer becomes the town's sanitation commissioner. He manages to gain this position through an election campaign where he simultaneously lies about the incumbent (and even defames him) and gives outrageous promises to the voters, all with Bono's consent. When the scheme blows up in his face (the yearly sanitation budget is used up in a matter of weeks) he resorts to a scheme whereby funds are generated by taking the trash from various US cities and storing it underneath Springfield. This, of course, turns the town into a smelly, garbage infested hell hole. An emergency meeting is held in the town hall and the people unanimously vote for the previous commissioner (Ray Patterson, voiced by Steve Martin) to retake the job. Patterson saunters on stage to music and then says this:

Oh gosh. You know, I'm not much on speeches, but it's so gratifying to... leave you wallowing in the mess you've made. You're screwed, thank you, bye.

I have to say that part of me wants to call the Republicans' bluff and not raise the debt ceiling. To be honest with you it would be the easiest and quickest way for them to achieve their ideological ends. I have already pointed out that such an action would cut federal government spending by around 40% and represent a cut in spending from about 25% of GDP to around 15% of GDP. According to historical notes on the US budget, the last time the US government was that small was 1951 - in other words the Republicans have a once-in-a-lifetime chance to shrink the government to its lowest level in 60 years. Moreover, this would not lead to debt default, as the 14th Amendment protects bondholders.

And it's not as though such a move wouldn't be popular, at least initially. There are many in the US who claim that the Federal Government has no real input into the economy. "Let's shut her down!" some would say, confident that such a move would have no real impact upon the economy and society in general. And as for all those pesky civil servants out of a job, well they weren't doing anything really important anyway. And it's not as though we can't afford to pay them unemployment benefits since such benefits would disappear anyway for everyone once the great spending cut occurs. And with so many people unemployed and not receiving benefits, they would then be able to get off their collective lazy asses and find jobs. Then the economy would start booming again.

Of course these sentiments are nonsense. Anyone with any understanding of the complexity of economics, the effect of government programs and the problems besetting the unemployed would know that such a gigantic cut in government spending would have only a negative impact upon the US. It would cause social and economic pandemonium.

And yet part of me wants to the GOP to do it. I do admit that there is some perverse pleasure in watching an economic collapse unfolding, in the same way that people hang around and watch the aftereffects of an accident.

Nevertheless I do have a rather pragmatic reason for wanting this to occur - the disaster that it brings on the nation (and the rest of the world) will be so damaging that no one would take hard-line conservatism seriously ever again. The disaster would be so horrible that Obama would be re-elected by a landslide and the Republicans would be utterly humiliated in Congressional elections. More than that, hard-line conservatism throughout the world would be discredited in the same way as communism was discredited after the collapse of communism.

And why? Conservatives have painted themselves into a corner. They are just so angry that things like Medicare, NASA, unemployment benefits and the Department of Education exist. It's not just that they don't like big government, it's that they so strongly believe that their understanding of limited government was the same thing believed by the founding fathers that anything, anything which suggests slightly higher government tax revenue or spending is immediately cause for revolution and "watering the tree of liberty". In the words of Grover Norquist, "I don't want to abolish government. I simply want to reduce it to the size where I can drag it into the bathroom and drown it in the bathtub."

Of course I see such people as not just hard-line but extremist. Their ideology has regressed so far that even Ronald Reagan, patron saint of Conservatives, would be labeled a "Republican in Name Only" for many of his policies.

And so this is why part of me wants the Republicans to follow through with the extremist ideology that now controls their party - it would allow them the chance to finally do what they've always wanted to do while simultaneously proving to the rest of America and the world the utter stupidity and unworkability of their policies. Their fate would be to disappear from the political landscape for a long, long time. The world would then become a much better place.

And as their doom descends and the party faithful shrink in horror at what they've done and seek to make amends, the voice of Ray Patterson calls out to them:

It's so gratifying to leave you wallowing in the mess you've made. You're screwed, thank you, bye.

A response to New Deal Democrat

"New Deal Democrat" at the Boondad blog took the time to examine my latest recession indicator and question some of the methodologies and outcomes. NDD actually contacted me a while ago and expressed some of his opinions over these issues so the fact that he has blogged about it is not only welcome but also allows me a chance to respond.

NDD specifically has an issue with using real 10 year bond rates as a recessionary indicator. The reason is that the relationship between negative real 10 year bond rates and an eventual recession appears to break down in before 1953. Now the reason why I did not use any pre-1953 data in my study is because the 10 year bond rate series (GS10)  available at the St Louis Fed only starts in 1953, while seasonally adjusted inflation (CPIAUCSL) starts in 1947. NDD, however, has pointed out that a discontinued government bond data series called LTGOVTBD has data going back to 1925, and that because both GS10 and LTGOVTBD follow each other closely from 1953 to 2006 (when the series was discontinued) it is therefore a good proxy. Add to the fact that non-seasonally adjusted inflation figures (CPIAUCNS) begin in 1913 and you have the beginnings of a pre 1953 data series that could confirm or deny my assertion that negative real 10 year bond rates will always lead to recession.

And the conclusion that NDD has come up with is that they don't always lead to a recession. And here is the salient graph:

When looking at this graph, understand that whenever the red line is higher than the blue one, then that is an example of negative real 10 year bond rates (or, more specifically, negative real long term bond rates). As you can see, there are seven instances since 1925.

Now of course what I have done is to average out the results over three months. This is what we get in the first instance:

1925 and 1926 see some low rates but the only negative result occurs in January 1926. So what happens after? A recession in October 1926. Hmmm.

The second and third instances occur during the New Deal era:

Actually what is notable from this graph is the sheer height that real long term bond rates hit during the depression - peaking at 14.27% in March 1932. If anything this is pretty solid evidence that real 10 year bond rates can operate as a "window" for the economy to grow: too low and the economy crashes, too high and the economy crashes.

As you can see, real bond rates return to more reasonable levels around 1934. The key date here is March 1933 when the Emergency Banking Act was passed. Another important date was June 1933 when Glass-Steagall was passed. Both of these acts resulted in an increase in the money supply and a subsequent move out of deflation. By December 1933, prices began inflating again. This is important to realise in the data in the graph above since the presence of inflation again reduced real long term bond rates from the stratosphere of 14% to around 3% by December 1933.

Of course the graph then shows that in 1934, inflation had reached a point where real long term bond rates had turned negative. They turn negative again for a short time in 1935, and then negative again 1937... which, um, then turns into another recession.

I suppose I could argue that the instances of negative real long term bond rates in 1934, 1935 and 1937 were the cause of the 1937 recession. I think that is not an unreasonable assumption to make, especially the 1937 instance. We need to remember though that the massive hangover of debt and deflation that typified the great depression's stratospheric real long term bond rates needed a little bit more than a few months of negative long term rates to balance against. Nevertheless, if my "window" theory is true, then it could possibly be said that the US economy might've avoided the 1937 recession had real ten year bond rates always remained positive from 1934 onwards. In short, too much inflation was created.

After all, you could put out a house fire with a fire hose, but if you immerse the burning house in the sea, you still end up damaging it badly.

Okay, so let's move on to the war and post-war years:

So as you can see, the war brought about a huge drop in real 10 year bond rates. A recession occurs in February 1945, and then another huge drop in real ten year bond rates occurs during 1946-1949. In fact that period has the deepest recorded period of negative real long term bond rates (which peaks at -16.96% in April 1947). Then another recession hits in November 1948. Then another period of negative rates hits between 1950-1952, followed by a recession in 1953. Beyond this point my data series kicks in.

The first thing to look at here is the effect of the war, specifically the effect of a Total war economy upon the United States. This graph shows what I'm talking about:

source

Between Japan's attack on Pearl Harbor and the demobilisation of forces in 1946, the US government effectively quadrupled in size. This was due to massive spending to create a war machine capable of defeating Japan and Germany. The growth in the size of government was not "added onto" the economy, but effectively "crowded out" the private sector. The US government increased taxation and went on a massive borrowing spree to fund the war.

Now this is very important for us to understand. In my analysis of real long term bond rates, we're not just looking at causal relationships but also the effect of such causal relationships to the wider economy. Long term bond rates are an indication of how the market is acting at a certain time. If the government is 10% of the economy then the private sector is 90% of the economy, which means that any negative long term bond rates are being experienced by that 90%. But in the war years we see an increase in the size of government and a decrease in the size of the private sector. This means that the negative real long term bond rates during this period are only experienced by around 55% to 60% of the economy. Thus the effect would be less - hence the lack of recession until 1945.

As for the period of negative real long term bond rates between 1946 and 1949, these end up presaging the 1948-49 recession.

In short while the pre-1953 data is essential to examine, I do not think that it rules out the correlation and causation effect at all. Two huge events - The Great Depression and World War 2 - are enough to affect the quality of the data under examination.

There is another issue: Is LTGOVTBD a good proxy for GS10? Just because they correlate when they are measured concurrently doesn't mean that the same correlation existed pre-GS10. Long term government bond rates hardly move much at all between 1925 to 1956, despite the huge swings in inflation and deflation in this period. They do not exhibit the same ups and downs which typify GS10 rates. this makes me think that LTGOVTBD rates, at least in the early days, were pegged by government order. GS10, especially from the 60s onward, seem to move according to the actions of the market.

And finally an answer to a commenter at Boondad who points out:

You cannot calculate CURRENT "real long term interest rates." It's a fallacy.

To calculate a CURRENT "real long term interest rate," you would need to know what "inflation" (CPI, whatever) WILL BE over the next TEN YEARS while you collect your 10-Year Treasury Coupons. You don't know that.

I think this commentator has got it wrong because the interest rate, while certainly applicable over a ten year period, is determined by what the market wants at the time. So while it has a long term function it also has a short term indicative effect. Bond rates go up when investors see bonds less as less attractive to other investments (such as shares) and go down when the market is running away from something. This can be seen during late 2008 when bond rates plunged to 2.42% during the credit crunch after being 4.1% 5 months before. The idea is that the interest rates of government bonds is a  way of measuring market sentiment and activity. 10 year bonds are thus a good measurement of what is going on at the time that they are invested in.

And my argument is that when investors put money into ten year bonds they are essentially investing in something "safe". But when inflation exceeds that "safe" investment, things go wrong and a recession follows. This will be because a calculation of your return on interest will be less than the increase in consumer prices. In other words, the amount of money you gain from such an investment will be less than your increase in spending. Thus a recession. And if my "window" theory is correct, a recession will also occur when the amount of money you gain from an investment will be more than offset by a decrease in income from other sources.

US Recession Indicators - July 2011

According to data from negative Real Interest Rates, another US recession is likely to occur between 2011 Q4 and 2012 Q4, with 2012 Q1 the most likely... See below.

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Net Monetary Base vs Inflation (spread)

The growth of the Net Monetary base (M0 minus excess reserves) over inflation has been above the historical average since September 2010 and has increased even further with a June reading of 598. This is an increase from last month's reading of 540.

Since the introduction of QE2 in November 2010, the net monetary base has increased faster than inflation.

Note: A negative result implies that inflation is growing faster than the money supply, an event which indicates that a recession will occur within 1 to 36 months (with an average of 12 months)
Note: All recessions are preceded by a negative result.

Data Series:
St Louis Fed

AMBNS
EXCRESNS
CPIAUCSL
GDPC1
POP

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Federal Funds Rate vs 10 Year Bond Rate (spread)

The 10 Year Bond Rate has decreased markedly from 3.46% in April to 3.17% in May and 3.00% in June. The Federal Funds rate remains at near zero. As a result the June spread comes in at 291 basis points, well above the historical average but a decrease from the previous readings.

Note: A negative result implies a highly restrictive monetary environment, an event which indicates that a recession will occur within 4 to 39 months (with an average of 22 months).
Note: If both the first and second graphs are negative at the same time it indicates that a recession will occur within 1 to 21 months (with an average of 11 months).
Note: All recessions are preceded by a negative result.

Data Series:
St Louis Fed

FEDFUNDS
GS10
GDPC1
POP

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Real 10 Year Bond Rates Rates

Again a tweak to my reporting in this area after discovering that a three monthly average was better than a monthly result. I have also decided to call this indicator "Real 10 Year Bond Rates" rather than "Real Interest Rates" since the latter term can be used to refer to the Federal Funds Rate.

Real ten year bond rates came in at -0.12% in June. As I have pointed out before, all experiences of negative 10 year bond rates since the 1950s have resulted in an eventual recession.

If we take previous instances of negative real bond rates into account, a recession will start between 2011 Q4 and 2012 Q4, with 2012 Q1 the most likely. These previous experiences also indicate that unemployment will also likely peak between 12.1% and 18.7%, with a result around 16.9% the most likely.

Note: Real Interest Rates based upon 10 year Bonds can indicate how the value of money is determined in comparison with the market's safest investment. A negative result implies that inflation is eroding the savings of those who have invested in 10 Year Bonds. A negative result over a three month average indicates that a recession may occur between 4-18 months, with an average of 8½ months and a median of 6 months.
Note: Not all recessions are preceded by negative real 10 year bond rates. Nevertheless all instances of negative 10 year bond rates (since the 1950s) have been followed by a recession.

Data Series:
St Louis Fed

GS10
CPIAUCSL
GDPC1
POP

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Archive of Historical graphs.

Real Interest Rate historical graph archive.

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