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A Puzzling Facet of the Recent Financial Panic

December 15, 2008Robert Higgs

Tags Booms and BustsFinancial MarketsPrivate Property

In my 1997 article "Regime Uncertainty," which now appears in slightly revised form as the first chapter of my 2006 book Depression, War, and Cold War, I presented several different kinds of evidence in support of my hypothesis about the rise, fall, and consequences of regime uncertainty: a traditional historical narrative of relevant events; a compilation of important menacing statutes; the findings of a number of contemporary public-opinion surveys; and, perhaps most important, data on the spreads between the yields on high-grade corporate bonds for various terms to maturity.

I examined the bond-yield data because, I argued, one ought to see a widening of the spreads when investors adopted an altered view of the future security of private-property rights. Although as of, say, 1936, one might have been sufficiently confident of receiving the promised interest and principal on a corporate bond due in one year, the New Deal's threats to the security of private-property rights would have led investors to demand a risk premium on bonds of longer term; and, other things being the same, that risk premium ought to have been greater the longer the term to maturity, if one expected that the New Deal was likely to transform the US economic order ultimately into something that approximated full-fledged socialism or fascism (as many businessmen and investors at the time said they expected).

The data on high-grade corporate bond yields (available for the first quarter of each year) do show that through the first quarter of 1934 — that is, before the onset of the so-called Second New Deal — the spreads were extremely narrow; in other words, the yield curve was virtually flat. They then increased enormously during the following two years. Though fluctuating, the spreads remained extraordinarily wide through the first quarter of 1941, after which they fell precipitously. By the early 1950s, the spreads had virtually disappeared; that is, the yield curve had become flat again, as it had been before 1935. The rise and fall of the huge spreads corresponded precisely with the emergence and the withering away, respectively, of the Second New Deal — Franklin D. Roosevelt's jihad against the big capitalists.

In view of this analysis, I thought that it might be instructive to see what has happened recently to the corporate-bond spreads. Perhaps, again, they would reflect the onset of regime uncertainty. So far, however, they have not done so.

The data do show, however, a bizarre variation between mid-September and mid-October 2008. During that period, the effective yield on the bond due in 2 years leaped substantially above the yield on bonds of longer term to maturity, whether they were due in 5, 10, or 20 years.

I do not know what to make of this odd, transitory deviation from a normal yield curve.

If we were looking at very liquid instruments, such as the 3-month Treasury bill, we might expect to see a panic cause an abrupt collapse of effective yield; indeed, that is what we have seen, with the collapse occurring at the same time that the 2-year corporate bond yield moved sharply in the opposite direction.

Did fearful investors suddenly shift from holding 2-year corporates to holding T-bills, thereby driving down the price of these corporate bonds and, equivalently, driving up their effective yield? Such a move might seem compatible with the onset of regime uncertainty. But the relative steadiness of the yield on longer-term corporates is not consistent with this view. Why would investors fearful of regime change leap out of only the relatively short-term corporates, not the longer-term corporates as well? I am puzzled.

I am aware, of course, that these recent gyrations in the corporate-bond yield spreads may have nothing to do with regime uncertainty. The aberration of mid-September to mid-October may spring from altogether difference sources. My mind is open.

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