Real Interest Rates and Crowding Out: Reagan Era vs. Now

Recent commentary on whether real interest rates rose during the Reagan era tax cuts — Kling responding to Krugman — impelled me to look at the data…

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Figure 1: Ten year constant maturity Treasurys minus ten year expected inflation (Blue Chip; Philadelphia Fed Survey of Professional Forecasters) (blue line), and Ten year constant maturity TIPS (red line), 1975-2010. Nominal yields are average of three months in quarter; expected inflation generally pertains to mid-quarter month. NBER defined recession dates shaded gray. Source: St. Louis Fed FREDII, Philadelphia Fed, NBER and author’s calculations.

It appears to me that real interest rates were undeniably higher during the Reagan administration than during, say, the past four quarters of the Obama administration. The difference is 4.56 percentage points, and is statistically significant with p-value of 0.000, using Newey-West standard errors. (I know some people have argued that we should take into account Fed measures; I agree. But those only account for a relatively small proportion of interest rate levels [0].)

Nostalgia time: I remember taking an intermediate macro course at the time of Reagan’s election; the professor (James Duesenberry) predicted crowding out, particularly in business fixed investment (as I recall — my memory of this might be faulty after 30 years). As it turned out, crowding out occurred much more profoundly via net exports, as the dollar surged. When one looks at this alternative mode of “crowding out”, the crowding out argument looks even more, well, lacking of data-based evidence.

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Figure 2: Log real value of US dollar, broad index, 1975-2010. NBER defined recession dates shaded gray. Source: Federal Reserve Board, quarterly averages of monthly data.The difference is 17.4 percent (in log terms), and statistically significant at the 1% level.

Previous posts on crowding out: [1] [2]

Update, 9:25am Pacific, 3/18: Arnold Kling comments:

This is all well and good, and it has nothing whatsoever to do with what I was talking about. The topic was not crowding out. It was liquidity traps.

It seemed to me that Paul was saying that because interest rates have not been “soaring” that proves we are in a liquidity trap. My point was that this is not a very strong argument, because interest rates can fail to soar even when we are *not* in a liquidity trap.

I know what a real interest rate is. But the liquidity trap is primarily about the nominal interest rate.

Arnold Kling is right; he was speaking about the liquidity trap, and whether nominal interest rates could rise. I was merely looking at the separate, but related, issue of whether real interest rates are rising. But to address directly Kling’s point about nominal interest rates, here I present Figure 3.

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Figure 3: Ten year constant maturity Treasurys (blue line), and five year constant maturity Treasurys (purple line), three month Treasurys in secondary market (green line), 1975M01-2011M02. NBER defined recession dates shaded gray. Source: St. Louis Fed FREDII and NBER.Note that as of February (monthly average of daily data), ten year and five year constant maturity interest rates have never been lower, even during recessions. Obviously, the three month Treasurys are at rock bottom levels. Moving to even more recent data, encompassing March, one can see that the longer term yields have dropped again, and the one year constant maturity is also at rock bottom levels (Figure 4).

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Figure 4: Ten year constant maturity Treasurys (blue line), and five year constant maturity Treasurys (purple line), one year constant maturity Treasurys (pink line), and three month Treasurys in secondary market (green line), 1 Sep 2010-16 Mar 2011. NBER defined recession dates shaded gray. Source: St. Louis Fed FREDII and NBER.My question is if we are not in a liquidity trap now (in part due to unconventional monetary policy), then when would Kling interpret us as being in one? When five and ten year constant maturity rates were also at 30 bps?

Arnold Kling comments on crowding out specifically here.


Originally published at Econbrowser and reproduced here with permission.