[kbxcoop]

I want to clarify the question I made during the Q&A today. The first question I asked (why recessions occur when the yield curve flattens/inverts) makes sense. As short term rates get closer to long term rates, the rates of return on short term projects becomes greater than long term projects relative to the period of a steeper positive yield curve. Also, time preferences would cause the saving/consumption patterns to be “reset” to what the time preferences of the population are. If you can explain this part a little more, I’d love to hear it.

The way I asked the second question was mucked. The Fed has a lot of long term bonds in its balance sheet (If I remember). As they bought these bonds, it forced the interest rate down on these bonds (relative to inflation expectations like you were talking about). If the Fed does start to sell of its long term bonds, pushing bond prices down and the long term interest rate up, the yield curve would be steeper. Even if this is not the case (or the premise of the question is wrong, I’d like to hear your thoughts on that too), in an environment where the yield curve is steeping due to long term rates going up, what does it mean when it comes to the capital structure, and could it cause a recession?

[bob.murphy.ancap]

Sorry for the delay, I didn’t realize you had asked this. (Unfortunately I have to manually check; the system doesn’t alert me when a new topic starts.)

I’m not trying to dodge your questions, but I think I spelled out the whole idea in Part IV of this paper, and it would probably be simpler for you to read that. If you still have questions, I can follow up.

[kbxcoop]

So I was reading Part IV about your critique of Rothbard’s explanation of the yield curve in the ERE. It makes sense that, all else equals, people prefer to have their money tied up for shorter lengths of time than longer lengths of time. Most people may prefer to have a 1 year 5% bond rather than a 5 year 5%, so there may be a premium (or differential) in the interest rate to entice people to hold longer term bonds. My question would be, can’t these bonds be bought and sold though? Even in an ERE, wouldn’t an investor buy a 5 year 7% bond and sell it when he needs the money? This would seem to be a tendency to keep the yield curve horizontal in the ERE.

[bob.murphy.ancap]

Let me paraphrase what you’re asking, to make sure I understood. (Obviously if my paraphrase is wrong, then correct me.) I think you’re saying something like this:

Q: “I understand that someone might be willing to buy a one-year CD that yields only 2%, rather than a 5-year CD yielding an annualized return of 4%, because his money is only tied up for a year in the former asset. But OK, why wouldn’t someone buy the latter asset, hold it just for a year, and then sell it in order to reap the 4% return?”

A: I guess that’s right in the ERE (and if you think that means I said something wrong in my paper, please let me know), but it’s not right in a broader no-arbitrage concept of intertemporal equilibrium. The reason is that short-term interest rates might change in the future.

In particular, suppose you buy your 5-year CD, but that 6 months later interest rates across the yield curve all shift up by 50 percentage points. That means the market value of your CD drops; it is worth a lot less than you paid for it upfront. It’s true that if you hold it to maturity you still earn the contractual 4% annualized on your original investment, but you can’t even “get your money back out” of the thing until close to the maturity date.

So, given this possibility, if you really want to lock in a short-term return, you will keep rolling your money over in short-term CDs.

Does this make sense?

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