Regime Uncertainty: Are Interest-Rate Movements Consistent with the Hypothesis?
By Robert Higgs • Tuesday August 24, 2010 11:04 AM PDT • 27 Comments
Regime uncertainty has gained increasing recognition as the current economic troubles have persisted with little or no improvement since the economy reached a cyclical trough early in 2009. As described in my 1997 paper, regime uncertainty pertains to
the likelihood that investors’ private property rights in their capital and the income it yields will be attenuated further by government action. Such attenuations can arise from many sources, ranging from simple tax-rate increases, to the imposition of new kinds of taxes, to outright confiscation of private property. Many intermediate threats can arise from various sorts of regulation, for instance, of securities markets, labor markets, and product markets. In any event, the security of private property rights rests not so much on the letter of the law as on the character of the government that enforces, or threatens, presumptive rights.
In the latter half of the 1930s, many investors feared that the government would destroy the private enterprise system and replace it with fascism, socialism, or some other extreme transformation of the existing economic order.
In testing my hypothesis, I marshaled three distinct types of evidence: historical documentation of government actions and public reactions; findings of public opinion surveys, especially surveys of businessmen; and evidence from financial markets. The latter seems to some observers, especially to economists, to be the most telling because it is relatively “hard” and quantitative. In any event, it is the sort of evidence economists are accustomed to analyzing.
My most striking financial evidence for the New Deal episode pertains to the yield curve for corporate bonds, that is, to the spreads between the effective yields on high-grade corporate bonds with various terms to maturity. I found that this yield curve became suddenly much steeper sometime between the first quarter of 1934 and the first quarter of 1935 (a period when the New Deal lurched from its first, or business tolerant, phase to its second, or business hostile, phase) and remained very steep until sometime between the first quarter of 1941 and the first quarter of 1942 (a period when the New Deal handed over the reins to the military and the big businessmen who, along with the president himself, ran the war-command economy for the duration). I interpreted these extreme spreads as risk premiums on longer-term investments caused by regime uncertainty.
Given the extraordinary scale and scope of the actions the government has taken since mid-2008 and the many expressions of uncertainty (and hence of unwillingness to undertake long-term investments) voiced by businessmen and others as a result of this flurry—bailouts, unprecedented monetary policies, surges in government spending, and tremendous regulatory undertakings in health care and financial markets, among other things— one wonders whether the corporate bond yield curve shows the same kind of movement it displayed in the face of the regime uncertainty that prevailed from 1935 to 1941.
To pursue this matter, I have examined a number of series on corporate bond yields, by term to maturity, that I constructed from data available at Bondsonline.com. (Normally, when economists analyze “the yield curve,” they use data on U.S. Treasury securities. I caution against using such data for the purpose under discussion here. To analyze risks to private property rights as manifested by the risk premiums in bond yields, one must use private bonds, not government bonds.)
I find that back in 2008, before the onset of the financial panic in September, the corporate bond yield curve was rather flat – that is, the yields increased only slightly with term to maturity. At the lower end of the yield curve, yield spreads were tending to narrow slightly until late September. When the panic hit, yields became extremely volatile, especially for the bonds with 2 years to maturity (the shortest term in the data), and remained volatile for almost a year. After mid-2009, the volatility diminished greatly.
Examining these data, I find that once this dust had settled, the yield curve for corporate bonds had become substantially steeper. For example, the spread between corporate bonds with 5 years to maturity and corporate bonds with 2 years to maturity increased from roughly 1 percentage point or less before the financial crisis to roughly 2 percentage points since mid-2009. Similar changes occurred in the spread between the bonds with 10 years to maturity or 20 years to maturity and the bonds with 2 years to maturity: the former increased from roughly 1 percentage point to 2-3 percentage points; the latter increased from roughly 2 percentage points to roughly 4 percentage points or more.
Similarly, at the upper end of the yield curve, the spreads widened: between the bonds with 10 years to maturity and those with 5 years to maturity, from roughly a fraction of 1 percentage point to roughly more than 1 percentage point; between bonds with 20 years to maturity and those with 5 years to maturity from roughly 1 percentage point or less to 2-3 percentage points. Finally, the spread between the bonds with 20 years to maturity and those with 10 years to maturity increased from less than 1 percentage point before the crisis to 1-2 percentage points since mid-2009.
Thus, corporate bond yields have exhibited three distinct periods: pre-crisis stability with a shallow yield curve; extreme volatility of the yield curve, including some inversions in the latter part of 2008; and post-crisis stability with a much steeper yield curve since mid-2009.
Thus, just as the steep yield curve for the New Deal years corresponds precisely with the so-called Second New Deal, when Roosevelt and his leading subordinates and advisers went on the warpath against investors as a class, the recent transition corresponds to the volatility associated with the period of frenetic government action and financial market fluctuations between September 2008 and the middle of 2009, leaving in its wake a much steeper yield curve.
I view these financial data as consistent with the hypothesis of recently heightened regime uncertainty. Of course, they do not “prove” that it is true, just as the striking data I found for the 1930s do not “prove” the hypothesis as applied to that episode. But in economic history, one looks above all for the correspondence of various forms of evidence with the interpretation one places on the observations. In the current episode, as during that of the latter 1930s, we find that (1) a great deal of direct testimony by businessmen and investors, (2) an account of the government’s ideological character and the historical narrative of what the government has done and, and (3) the bond-market evidence (as well as the movements of the stock market, although they are more difficult to interpret) all conform with a hypothesis that places significant weight on regime uncertainty.
In any event, these preliminary explorations certainly show that the hypothesis should not be dismissed out of hand because it is not “scientific” or because it is not part of the mainstream macroeconomist’s customary style of mathematical modeling. If mainstream analysts continue to disregard the role of regime uncertainty in the major depressions of the modern era, especially in accounting for their extraordinary duration, then they will only demonstrate the poverty of their own mode of analysis.
The following graphs show the data on yield spreads that I have discussed above.
Tags: American History, Austrian School of economics, Bailouts, Budget and Tax Policy, Business, Corporatism, Economics, Employment, Fascism, Free Market, Government subsidies, Great Depression, Labor, Liberty, Money and Banking, Nationalization, Property Rights, Socialism, Taxation, Unemployment 
How does regime uncertainty, especially that caused by the “second phase” of the New Deal, account for the fact that there was a business boom between 1935 and 1936 (which ended with the recession of 1937)? In other words, it seems as if between 1935 and 1936 regime uncertainty was not enough to dissuade that investment boom (or, maybe one could claim that the investment boom would have been much greater).
It is further difficult to apply regime uncertainty to mid-1937 to early-1938, because there was a productivity shock in the form of that recession.
Would the claim be that investment was lower than it otherwise would have been?
Jonathan M. F. Catalán | Aug 24, 2010 | Reply
Right on Dr. Higgs, I can see regime uncertainty too. State action in itself creates gross distortions in the market, which periodically causes financial panic. It should come as no surprise that upon the State becoming more active and suppressant that investors respond in the stock market, just like people respond in their daily life by screaming at town hall debates, joining the military out of patriotic fervor, or me writing this comment.
Ken Camp | Aug 24, 2010 | Reply
I had a thought while reading this excellent article that I can’t resolve myself. In the 30′s commercial paper was hugely domestic, today it is “world based”. So if the Chinese or Saudis, worried about the future of the dollar, start to dump bonds (as they appear to be doing to some degree), this will increase the commercial paper interest rate, thus distorting the data on what Americans businesses are actually doing/feeling. Any ideas, or am I full of whatever for even asking?
Al Sledge | Aug 25, 2010 | Reply
Jonathan,
You may wish to review my original 1997 article on regime uncertainty or, better, the first five chapters of my book Depression, War, and Cold War. In those sources and others, I have always made clear that regime uncertainty is not intended to be a complete macroeconomic model; therefore it does not seek to explain each move the economy makes in the course of its fluctuations.
I advanced the idea first to help us understand the long duration of the Great Depression and, more recently and to a lesser extent, the continuing doldrums of the current U.S. economy. Any particular year’s or short period’s movement of national output cannot refute the idea, because the idea does not claim that such short-term movements cannot occur, and they clearly do occur, as during the revival of the period 1934-37.
However, the recession of 1937-38 actually does have several important connections with the regime uncertainty that developed from 1935 onward. Indeed, 1937 probably brought that uncertainty to a peak. Early in the year, the president announced his court-packing plan, confirming fear’s that he was trying to make himself a dictator. Then U.S. Supreme Court upheld the Wagner Act, the Social Security Act, state minimum-wage laws, and other New Deal measures, effectively ending the court’s obstruction of the government’s growing intervention in the economy. Labor unions went wild, and wage rates began to rise rapidly in newly unionized industries. Social security taxes began to be collected. These events and others of similar thrust led many investors to flee or to remain on the sidelines. The stock market plunged. Gross investment fell by 45 percent between 1937 and 1938; net investment became negative again, as it had been in 1931-35. Roosevelt responded to the recession by blaming the capitalists for a “strike of capital” and by launching a new antitrust campaign against big business.
The regime uncertainty idea is, to my knowledge, essential to our understanding the entire period 1935-47 within a coherent analytical framework. (Neither Keynesianism nor monetarism nor any other macro framework I know of can do so.) When combined with a defensible understanding of the war-command economy, this idea, I believe, proves indispensable in understanding why the Great Depression lasted so long and why genuine prosperity returned after the war for the first time since 1929.
Remember, too, that even though investment grew somewhat during the 1934-37 recovery, that investment was greatly distorted (by comparison with the 1920s) toward short-term and inventory investment, rather than long-term investment of the kind required if an economy is to enjoy sustained growth in the long run. And even with the recovery that did occur after 1934, the economy in 1937 remained far below its high-employment level of output and employment.
Robert Higgs | Aug 25, 2010 | Reply
Al,
My short answer to your question is that I don’t think it makes any difference — for my purposes of analysis here — whether the people who are buying and selling the corporate bonds, and thereby determining their prices and hence their effective yields — live in the United States or some other place.
Robert Higgs | Aug 25, 2010 | Reply
Does this analysis only look at the change in the difference between yields for private bonds less the yields for federal bonds? I would imagine that, if the yield curves for both private and federal bods moved similarly, that would mainly tell us about inflationary expectations, not regime uncertainty. (Well, inflation is a kind of regime uncertainty, but you know what I mean.)
Chris Lemens | Aug 25, 2010 | Reply
I’m not sure that 1935 and 1936 could really be considered “boom” years, though there was, indeed, an increase in GDP. But does that really challenge the author’s hypothesis that long-term investments were considered risky?
I don’t see much use in asserting that investment might have been greater absent FDR’s anti-business sentiment — sounds too much like jobs “created or saved”.
Craig | Aug 25, 2010 | Reply
I’m confused by the jump in the yields of shorter-term corporate debt (2 and 5 years) relative to their longer-term counterparts. In some cases, the yields on these instruments even jumped above the yield on longer-term instruments. I understand the inverse relationship between price and yield; I don’t understand why investors would be more spooked about tying up their capital for 2/5 years than keeping it tied up for even longer time periods. What was the rationale there? Why would short-term yields ever rise above long-term yields?
saltmanSPIFF | Aug 25, 2010 | Reply
I think the answer is clear (and I don’t know why Robert doesn’t emphasize it):
The Supreme Court KILLED the NRA in May 1935 by a vote of 9-0. It then did the same with the farm program. Headlines in the business press: “NRA is Dead! Long Live Industry!” So, of course, business thought the court would bring the much needed rule of law. That didn’t last because of the New Deal Court revolution later in the 1930s, along with other factors.
In short, the investment boom of 1935-36 is entirely consistent with the uncertainty hypothesis.
Jonathan Bean | Aug 26, 2010 | Reply
Jon,
The upswing of 1934-37 involved much more than industry, so at best your suggestion must be weighted by the relative importance of industrial output in the national total output. I agree that the overthrow of NIRA in 1935 had a definite effect in causing industrial output to rise.
When NIRA was originally being shaped in Congress and during the first few months after its enactment on June 16, 1935, industrialists raced to produce output before the new law went into effect, because it was sure to increase labor costs in most industries. So, between March 1933 and July 1933, the index of industrial production increased from 3.77 to 5.94. However, as the Codes began to be written and put into effect in one industry after another, this surge petered out and reversed itself. By December 1933, the index was only 4.81.
Throughout 1934, with NIRA pretty widely in effect via specific Codes or the blanket Code the president imposed in many cases, industrial output more or less stagnated; the index fluctuated in the range 4.76-5.59 — that is, in a range below the level achieved in July 1933.
In May 1935, the month in which the Supreme Court invalidated the NIRA, the industrial production index stood at 5.75 — still below its 1933 peak. After the Court’s decision, however, industrial production began to increase rapidly. By December 1935, the index had reached 6.61, and a year later, it stood at 8.02, having risen by almost 40 percent in only a year and a half. In the first seven months of 1937 the index ranged from 8.00 to 8.32.
Between August 1937 and May 1938, however, industrial production, as measured by this index, fell to 5.62, a reduction of more than 30 percent in only twelve months — one of the greatest busts in U.S. economic history.
When NIRA’s invalidation in May 1935 set off a boom in industrial production, however, other forces were beginning to produce increased regime uncertainty. Interest groups, Congress, and the administration immediately began to work toward the restoration of parts of the NIRA, especially its labor provisions. In this effort, they more than succeeded when the National Labor Relations Act became law on July 5, 1935. For the next two years, entrepreneurs throughout the economy, whether in industry or elsewhere, endured heightened uncertainty as to whether the Supreme Court would uphold the act, which gave unions greater power than ever before or since and, along with a highly partisan NLRB, set in motion a gigantic wave of union organization. When the Court did uphold the law in 1937, it only made matters worse, by knocking down all hope of reining in the unions, which were at that time running wild with sit-in strikes, violent picketing, and other violations of law, and getting away with their crimes.
In the same period, 1935-37, the president put both his rhetoric and his politicking much more in the service of attacking investors and businessmen, blaming them for the depression, and seeking to punish them with a variety of output-reducing tax changes and new regulations. Regime uncertainty probably reached its apex during these years, but it had by no means disappeared in the period 1938-40, as the data I cite in my 1997 article show.
My point here is mainly to emphasize that although the invalidation of NIRA in 1935 certainly helps us to understand the industrial boom of May 1935 to May 1937, we must not give industry more weight than it deserves in the national total, and we must keep in mind the general tendency of the New Deal’s actions and its rhetoric at the same time that industry was booming. Not until early 1937 did the momentum begin to swing slightly against the president, as he badly miscalculated by introducing his courtpacking scheme. In the wake of the elections of 1938, the New Deal’s retreat was inevitable, though the administration remained a powerful threat to the national economy on many fronts.
Robert Higgs | Aug 28, 2010 | Reply
Robert,
I didn’t mean to imply by my one headline quote that ONLY manufacturing revived. In fact, I’d be interested (but don’t have here at home) in the national recovery in the wake of NIRA. I believe more general indexes showed a broader recovery after Schecter (I realize the problems with all indexes — BTW, what “industrial production” index are you using?)
You wrote:
“My point here is mainly to emphasize that although the invalidation of NIRA in 1935 certainly helps us to understand the industrial boom of May 1935 to May 1937, .... we must keep in mind the general tendency of the New Deal’s actions and its rhetoric at the same time that industry was booming. Not until early 1937 did the momentum begin to swing slightly against the president, as he badly miscalculated by introducing his courtpacking scheme.”
I’m not so sure of your appraisal in this regard. I’ve read widely in the business press–they felt *confident* (until the 1937) that the Supreme Court would strike down New Deal programs, even Wagner. Wagner drove business crazy but it was not until April 1937 that the Court ruled it constitutional. The reaction was one of shock (not just the press but corporate records I researched back in the day). In a word, the 9-0 nature of the Schechter (anti-NRA) decision buoyed business until the Court turned and the Constitution died (circa 1937 onward). Ditto with the January 1936 decision (6-3) striking down AAA.
The April 1937 decision upholding Wagner was a bombshell — little wonder that the “boom” ended the following month!
Jonathan Bean | Sep 16, 2010 | Reply
saltmanSpiff wrote:
“I’m confused by the jump in the yields of shorter-term corporate debt (2 and 5 years) relative to their longer-term counterparts. In some cases, the yields on these instruments even jumped above the yield on longer-term instruments. I understand the inverse relationship between price and yield; I don’t understand why investors would be more spooked about tying up their capital for 2/5 years than keeping it tied up for even longer time periods. What was the rationale there? Why would short-term yields ever rise above long-term yields?”
Remember that bond yields are determined by their prices, and bond prices often move inversely to stock or asset prices. If investors were more fearful of long-term bonds, but they were also fearful of asset prices, they may park their money in short-term bonds. Yet they probably had no intention to keep them there. So why not park them in longer-term bonds? Well, such bonds may have greater risk of default. Some unexpected events may cause the yield spread to narrow or invert; other events may cause it to widen dramatically. It seems investors felt safer in short-term bonds for their yields.
Anyway, the point is, let’s say you’re holding some 2-year bonds and you see an opportunity in the stock market. And you’re not alone. Everyone starts selling bonds, lowering the price and driving up yields. Do you refuse to sell your bonds simply because the selling price creates an inverted yield curve? Do you buy more 2-year bonds because the yield curve is inverted? No – you want to sell the bonds, even at a loss, to buy into what you feel is a more lucrative opportunity.
Similarly, for those who are holding 5 year bonds, do they decide to immediately sell their 5-year bonds and buy 2-year bonds when the curve inverts? Not necessarily. For one there are transaction costs involved. And with long-term vs. short-term tax rates, such a move may actually yield less profit.
Of course, the inverted yield curve will not persist without serious gov’t intervention. It defies the logic of time preference.
However, short-term inversions can be explained by business forecasting errors and gov’t intervention, and often these forces work in tandem. This does not mean businesses behaved irrationally, only they took a risk and lost. They may have lost more if they had parked their money in long-term bonds, then an unexpected event happened, and the yield curve widened dramatically. Then we’d be saying, why didn’t short-term bonds see similar yield movements?
To some extent bond markets are not great measurements of time preference because they are liquid markets and people speculate on them, anticipating to hold the bonds for durations less than maturity.
meambobbo | Oct 12, 2011 | Reply