Typically, we do not republish online the articles which we have printed in the physical issues. However, given the news today that the yield curve continues its inversion, the present essay is timely. In this article from the Summer 2019 edition of the Austro-Libertarian magazine, Ryan Griggs explains what yield curve inversion means from the perspective of Austrian Economics. Whereas mainstream analysts and television personalities notice the correlation between inversion and recession, only the Austrian school provides the theory necessary to understand the causality.
One of the most intriguing statistical relationships known across schools of thought is in the news recently. It’s called “yield curve inversion.” The phenomenon of yield curve inversion attracts a high level of attention because of its peculiar frequency. For reasons we’ll explore below, yield curves consistently—and uncomfortably—invert in the year leading up to economic recessions and depressions.
What is yield curve inversion? What, if anything, can we learn about it from the perspective of Austrian Economics? Does the Austrian view reveal anything we otherwise might miss? Do we gain any predictive capability if we think from the Austrian perspective?
In exploring the answers to these questions, we’ll review analytical tools necessary to identify where the US economy is in the business cycle and how to think about yield curve data from the Austrian perspective.
What is Yield Curve Inversion?
Individuals and institutions can lend money to the government by buying government debt. The instruments (such as a bond, bill, or note) with which you can buy government debt pay a regular income for the duration—called the maturity—of the instrument. This income, when calculated as a percentage of the purchase price of the instrument, is called the yield.
The yield curve is a graph of the various yields (on the y-axis) of Treasury debt instruments and their maturities (on the x-axis). The US Treasury sells debt—bills, notes, and bonds of varying maturities—for cash to fund government programs. The length of time to maturity ranges from one month to thirty years. For example, an individual might buy a ten-year Treasury bond (debt) that will pay a periodic income (yield) from the time of purchase for ten years (maturity). At the end of the ten years, the individual receives the face amount of the bond.
All of this is fancy language for: lending to the government, receiving interest payments from the government, and receiving back an agreed upon amount (the face amount) when the time comes for the government to repay the loan.
Usually, economists say that the yield on government debt is upward-sloping, meaning the curve rises as it goes from left to right. In other words, the yield is typically higher for instruments of longer maturity. Consider this graph of the yield on the ten-year, two-year, and three-month Treasury bonds.
Notice that the yield on the 10-year bond (blue line) generally remains higher than the yield on the two-year note (yellow line), which in turn remains higher than the yield on the three-month bill (green line). The idea is that if an investor is going to lend money to the government for a longer period of time, he needs to receive greater compensation than if he were to lend for a shorter period of time.
However, something strange happens every five to ten years or so: the yield curve “inverts.” Whereas a “normal” yield curve shows greater yields for longer maturities, an inverted yield curve shows greater yields for shorter maturities. In other words, yield curve inversion is the exception to the rule of greater yields for longer-term maturities that one would otherwise expect.
Yield Curve Inversion and Recession
Recall the significance of yield curve inversion: it has regularly preceded the historical incidence of economic recession. Professor Campbell Harvey of Duke University is credited for the discovery of this fact in his 1986 dissertation where he studied the four recessions in the period from 1960 to 1980. Indeed, the relationship has remained true, as the graph below illustrates:
The black line in the graph is the difference between the yield on the ten-year Treasury note and the three-month Treasury bill. In the academic literature—including studies published by the Fed itself—the ten-year/three-month yield difference has the strongest (statistically) predictive power. The dark black horizontal line represents zero. When the blue line goes beneath the black line, you have an inverted yield curve. The shaded rectangular areas represent recessions as identified by the National Bureau of Economic Research (NBER).
A few things to notice: first, almost every instance of recession is preceded by yield curve inversion; second, where there was a recession that was not preceded by yield curve inversion, yield curves at least approached inversion; third, as of this writing in early July 2019, the yield curve is inverted. In fact, the ten-year/three-month yield curves have been inverted since May 23, 2019, which means nearly two months of inversion as of this writing.
Correlation and Causation
Austrian-minded thinkers are properly suspicious of drawing causal conclusions from statistical correlations. Indeed, this emphasis on causal-realism may be the primary objection to mathematical, mainstream economic studies. Is this a legitimate objection to the observed correlation between yield curve inversion and recession? Should we stop short of drawing any causal conclusions?
Let’s be clear: yield curve inversion per se is not the cause of recession. An inverted yield curve is an empirical consequence of changes in the economy. The changes that precede an inverted yield curve are the true cause of recession.
In the January 2018 edition of his financial newsletter The Lara-Murphy Report, Austrian economist Robert Murphy puts it this way, “if you already believed in Austrian business cycle theory, then this pattern of an inverted yield curve ‘predicting’ a recession pops right out” (p. 13).
To understand why yield curve inversion “pops right out” if one already believes in Austrian business cycle theory (ABCT), we need to review what the theory is. ABCT states that an expansion in the money supplydefined as the sum of base money (i.e. currency) plus instantly redeemable claims to money at par (i.e. money substitutes)—beyond the total stock of base money initiates a business cycle (i.e. boom-bust cycle). Today, the commercial banking and Federal Reserve system expand the money supply through the loan market. That is, “new money” hits the economy for the first time in the form of credit. We call this sort of credit “unbacked,” since it doesn’t come out of any prior savings; rather, it’s been created “out of thin air.”
New money creation by the cartelized banking system constitutes an increase in the supply of loanable funds in the economy. An increase in supply tends to reduce price. In this case, monetary expansion causes a reduction in interest rates. Lower interest rates mean “cheap money” for entrepreneurs in credit-intensive lines of production. The investment of funds due to artificially deflated interest rates is called malinvestment.
Earlier recipients of unbacked credit (i.e. fiduciary media) benefit, because they exercise greater purchasing power at present over the price structure that prevailed in the past. This creates a tendency for wealth centralization around the privileged participants in the system. In other words, fractional reserve banking contributes directly to inequality.
However, the situation is not sustainable. Eventually, the fractional reserve banking system will fail to provide enough new money to finance the production initiated in the artificially low interest rate environment. In other words, a policy of insufficient quantitative easing, and especially a policy of quantitative tightening (money supply reduction), can trigger a “liquidity trap” or the perception of a sharp shortage of credit. Rising interest rates can alter the perceived profitability of ventures undertaken during the expansion. This leads to the correction, bust, or recession phase in ABCT where asset values are recalculated and title to production goods change hands to entrepreneurs in superior financial condition (who were not misled into malinvestment during the boom).
In other words, malinvestment is liquidated during the recession to the extent that monetary policy allows the market to adjust. The economy may re-enter a boom phase if the system inflates the money supply enough to accommodate the demand for continued malinvestment (hence the term “policy accommodation”).
The connection between ABCT to yield curve inversion appears when we realize that changes in the money supply from the cartelized banking system most directly affect the yield on short-term debts. Per ABCT, an increase in the money supply (according to the Austrian definition of money and perfect substitutes for it) causes a decrease in interest rates (yields) on relatively short-term instruments, whereas a decrease in the money supply causes an increase in yields on those same instruments. Accordingly, change in the change of the money supply (i.e. the rate of acceleration or deceleration) likewise affect the yield on short-term debt more than the yield on long-term debt.
Put differently, in expansionary times, the banking cartel applies disproportionate downward pressure on short-term rates. In times of quantitative tightening, where the pace of new money creation by the banking cartel is either slowing or decreasing at an absolute level relative to the level of real resources in the economy, that downward pressure reduces.
It might also be the case that the pace of new money creation, even if positive and rising, could be insufficient to finance in-progress malinvestments. In other words, scarcity of real resources can catch up with the banking cartel’s expansionary activity, causing a “liquidity trap” even in times of monetary expansion.
Therefore, we might expect the following to happen if ABCT is correct. During expansionary times, yield curves will be “normal,” where the yields on longer-term debts are higher than the yields on short-term debts. However, when the banking cartel reduces the rate of monetary expansion, or outright reverses it (decreasing the money supply), the yield on short-term debts should jump up, potentially to the point where they exceed the yield on their longer-term counterparts.
Data from the time period around 1980 to the present illustrates this theoretical process quite well:
Notice which line—the yellow line representing the yield on the ten-year note versus the black line representing the yield on the three-month bill—is most volatile. Just prior to the three recessions (Q3-1990 to Q1-1991, Q1-2001 to Q-4-2001, and Q4-2007 to Q2-2009), you can clearly see the yield on the shorter-term debt (the three-month bill) jumping up compared to a relatively stable yield on the longer-term debt (the ten-year note). If ABCT is correct, this is an indication of monetary tightening (either in the form of a deceleration in monetary growth or an absolute reduction in money supply), sufficient scarcity of real resources to maintain the expansion, or both.
In other words, the empirical data seem to conform with the theory. Short-term rates seem more volatile relative to long-term rates, suggesting that they’re more strongly influenced by the activities of the banking cartel.
Tightening monetary policy causes a reduction in the flow of new money into the economy. Malinvestments that previously appeared income-generating due to an artificial reduction in the cost of financing are exposed as capital-consuming. The period of liquidation where control of these previously misallocated assets is reshuffled to different entrepreneurs is the corrective recession.
Yield curve inversion is precisely the sort of empirical observation the Austrian theorist would expect in a period of decelerating growth in, or absolute reduction of, the money supply. Furthermore, it follows naturally that a period of correction (recession) would follow any period of cartel-induced, non-expansionary changes in the money supply.
In his 2004 doctoral dissertation at Auburn University, Mises Institute Fellow and Professor Paul Cwik analyzes alternative theoretical frameworks for understanding the phenomenon of yield curve inversion, including a literature review of ninety-five academic articles on the subject. By grounding his analysis of yield curves and the business cycle in time preference, Professor Cwik explains how to use ABCT to explain each of the recessions identified by NBER as they relate to yield curves since World War II. In particular, Cwik explains how recessions that were not preceded by an actual yield curve inversion, still fit the theory.
At this point, we can answer the causation-correlation objection. While Austrians are appropriately suspicious of statistical correlation, in this case we also know the theory responsible for the observed empirical phenomena. There is a legitimate link between monetary theory, specifically of the Misesian variety, and yield curve fluctuations. In fact, the historical data seems to fit the theory quite well.
The Yield Curve Today
We can now turn to the present state of the economy. We saw that yield curves are currently inverted. What could be causing this? A peek at the Fed’s balance sheet might help us understand:
Notice that since late 2017, the value of the Fed’s assets has declined. This is due to a Fed policy whereby a certain amount of maturing Treasury bonds and mortgagebacked securities are allowed to “roll off” the balance sheet (currently $45 billion per month as of this writing). In other words, when it comes time for Treasury debt to mature, the Fed is accepting payment of the face amount from the commercial bank that originally sold it. This has a downsizing effect on the rate of growth of the money supply. Notice too that the Fed has never reduced the size of its balance sheet this aggressively. It is safe to say that the magnitude of this particular method of “quantitative tightening” is historically unprecedented.
I believe that this policy has had the effect of reducing the rate of new money creation, thereby applying upward pressure on short-term interest rates (like the yield on the three-month Treasury bill). This, in part, has led to the yield curve inversion—specifically with respect to the 10-year note and three-month bill. If the banking cartel continues to slow the rate of new money creation, this may cause the yield curve to remain “durably” inverted. Durable yield curve inversion of a period of three months has an extremely strong record of predicting a recession (liquidation period) within 12 to 18 months of the inversion.
In a 2006 Federal Reserve Bank of New York publication titled Current Issues in Economics and Finance, authors Arturo Estrella and Mary Turbin published an article called “The Yield Curve as Leading Indicator: Some Practical Issues.” Estrella and Turbin provide the following graphic, which counts the number of months that yield curves inverted in the year prior to recessions since 1968:
Three months of yield curve inversion is the historical minimum for what counts as a recession signal. As of this writing, we are in the second consecutive month of inversion. If the yield curve remains inverted through August 2019 and we do not have a recession by the end of August 2020, it would be the first time that we had a durable yield curve inversion without a corresponding recession within a year’s time. Unlike most predictions from mainstream economists, this one—albeit somewhat qualified and nuanced—is not based on mere statistical correlation alone, but on ABCT.
An Austrian analysis of yield curve inversion would be incomplete without addressing the philosophical connections. First, it should be glaringly obvious that the source of economy-wide, general recession, and the yield curve inversions that precede it, is the fractional reserve banking system. Throughout this article I have referred to “the banking cartel” for this reason. Fractional reserve banking is inherently unstable and economically inefficacious. For it to persist, a cartel of force to exclude competition and harmonize activities across those involved is necessary.
In the recent Spring 2019 edition of The Quarterly Journal of Austrian Economics, Robert Murphy chimes in on the recent academic debate on the sustainability of fractional reserve banking, recounting Mises’ sentiment on this point (bold added for emphasis):
Thus, even though in principle Mises’s theory of the boom-bust cycle is fundamentally about new quantities of money hitting the loan market early on, in practice the explanation revolves around newly-created fiduciary media being lent into the market. That is why Mises described his explanation as the “circulation credit theory of the trade cycle.” When we understand how Mises thought (in principle) newly mined gold could conceivably set in motion the boom-bust cycle, it becomes crystal clear that he thought any amount of newly-issued fiduciary mediai.e., a credit expansion—would do the same. (Remember, our earlier quotation shows Mises claiming that “[i]ssuance of additional fiduciary media, no matter what its quantity may be, always sets in motion’ the processes that cause the unsustainable boom.”) Thus there are no caveats or other conditions to consider, on this narrow question. Mises thought fractional reserve banking per se would set in motion the business cycle.
Therefore, the phenomenon of yield curve inversion and its predictive power should be understood as a consequence of statist intervention into money and banking. Without the injection of new fiduciary media (i.e. credit that functions as a money substitute) into the economy at various, unequal points, we would not experience the economy-wide, downward pressure on short term interest rates. Likewise, without the initial injection, we would forego the systematic reversal of this process that culminates, first, in the yield curve inversion and, second, in the recessionary correction.
By adopting the Austrian method in our analysis of financial markets, we can do what conventional analysts cannot. Not only can we provide nuanced analytical predictions about the state of the economy and its theoretical location in the business cycle, but we can do so without reliance on mere statistical correlation alone. Furthermore, the analysis integrates with political and legal philosophy, allowing us to appropriately categorize the predictive relationship between yield curves and recession as fundamentally statist in origin—specifically due to the arrangement of legally privileged commercial banks under the regulatory auspices of the Federal Reserve cartel.
The banking cartel saddles the public with calculational chaos through legal validation of fractional reserve banking and financial protection for the privileged industry participants. Without the cartel, the general, dramatic economic swings would diminish. Fortunately, in the midst of this sub-optimal financial environment, Austrian theory provides an analytical framework to help make sense of things. The relationship between specific yield curves combined with information about Federal Reserve activity can guide our understanding of where we are in the business cycle. More generally, an Austrian interpretation of yield curve inversion is an example of the usefulness and applicability of Austrian economics for the every-man.