by Matt O’Brien

Economists can tell us a lot about markets where there’s perfect competition, but what about the real world? You know, that place where there are only a few big companies fighting — or maybe not — against each other. What should the government do about those kind of businesses?

The answer, French economist Jean Tirole told us, is complicated. And his decades of work explaining how much so, which has become the textbook for regulators everywhere, has won him the 2014 Nobel Prize in Economics. It’s a story about what economists call asymmetric information, game theory, and contract theory.

Here’s what those all mean:

Asymmetric Information. A lot of markets are natural monopolies. That means it costs less for one company, rather than many, to make something, because you have to spend so much upfront to enter the market. Broadband is a classic example: once the first-mover has built all the infrastructure it needs, it’s not worth it for anyone else to even try to. If they do, the incumbent company can just temporarily lower prices until it’s not profitable enough for the other to continue.

But governments don’t like monopolies, natural or otherwise, so sometimes they break them up into highly-regulated oligopolies instead. That is, a few companies dominating the market instead of just one. There’s still a problem though. How exactly should the government regulate them? It wants to get rid of these companies’ excess profits without getting rid of their profit motive altogether. In other words, it doesn’t want big companies to gouge their customers, but it does want them to keep investing in a better customer experience. The easy answer is put caps on what they can charge — which makes them try to boost profits by cutting costs — but that doesn’t always stop them from making quasi-monopolistic profits.

And that gets at the real problem: the government doesn’t know how much it costs these companies to make things. Or, in econospeak, there is asymmetric information about the cost of production. If the government knew what the companies do, it could set the “right” price on any cap. But it doesn’t, and it can’t. That’s why Tirole just looked for a way around this issue—not a solution, but an answer.

Game theory. Now whatever regulatory system the government comes up with doesn’t just change how companies deal with it. That system changes how companies deal with each other, too. There isn’t, in other words, an invisible hand guiding everybody’s decisions, but rather rules of the game. And, depending on those rules, my decision might change based on what I think yours will be.

Here’s an example that doesn’t have to do with regulation per se. Suppose you want to dissuade other companies from coming into your quasi-monopolistic market. What should you do? Well, as Tirole showed, strategic concerns can trump economic ones. If new investments let you cut your marginal costs, then you should over-invest to make your margins so razor-thin that it wouldn’t be profitable enough for anyone to even bother trying. This same kind of logic—driven not by supply-and-demand, but by competition—applies to the government’s rules, too.

Contract theory. This is where things get tricky. The government usually can’t strike a long-term deal with companies, so they have to resort to a series of short-term ones instead. But if companies fear that the government will clamp down on big profits today with tougher contracts tomorrow, they might not work as hard as they could. So the second-best contract—which might be the best we can do—will let firms make more than they “should.” But Tirole showed that, sometimes, the government can do better if it offers companies a choice of contracts. This forces firms, at least indirectly, to reveal whether they have high or low costs, since different contracts will be better for them depending on that.

***

Tirole, of course, has done much, much more than just apply these ideas to regulation. He’s shown how firms that have a monopoly in one industry can also get one in a related industry by buying up a customer company. Or that “platform markets,” where a middleman connects two groups to sell access to one to the other, might be best off “undercharging” (or not at all) one of them. Think about bars that offer free “lady’s night” to bring more women and men together; social networks that let you sign up for free to bring more eyeballs to advertisers; or even newspaper that sell copies for less to do the same.

In short, Tirole’s well-deserved Nobel Prize is a triumph for the idea that economic theory can do better than telling us about perfect markets that don’t exist. It can tell us about the world as it really is. The answers aren’t as sweeping, but they’re much more important.

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Please visit the souce :: http://econbrowser.com/archives/2014/09/interpreting-the-yield-curve-some-pictures

Recently Jim highlighted the odd behavior of the various Treasury term premia. Here are some additional thoughts.
First, from “Debt market goes off script” in the WSJ:

Yields on short-term U.S. Treasury debt maturing in two to five years hit the highest level since 2011, reflecting an investor scramble to place bets on an expected Federal Reserve rate increase as soon as next spring. …

At the same time, yields on government debt maturing in 10 or more years have risen only modestly this week and remain well below their levels at the start of 2014, a year that many analysts forecast would include rising long-term interest rates and falling bond prices. …

The softness of longer-term yields highlights concerns shared by many analysts and policy makers about the uneven growth of the U.S. economy and falling expectations for inflation. Investors broadly expect the Fed to raise the fed funds rate next year for the first time since 2006. But many analysts say that even a small uptick in rates could slow the economy and send already-low inflation further below the Fed’s target.

A competing hypothesis was laid out in “US bonds are tracking ECB policy” in the Financial Times:

The link between US monetary policy and US bond yields has fallen apart this year, showing how fears of deflation in Europe are driving global financial markets.

According to analysis by the Financial Times, the correlation between five- and ten-year Treasury yields has fallen to its lowest level on record, with US bonds appearing to track European monetary policy instead.

Nominal and Real Spreads Are Still Positive, Despite Having Narrowed

Should we worry about imminent recession? There’s been some discussion of the age of the recovery and hence the anxiety. [0] [1] While spreads — both nominal and real — have indeed narrowed, they are still generally positive. As Chinn and Kucko note (blogpost), while spreads do not have extremely high explanatory power for recessions and growth, they do contain some information.

Figure 1: Ten year-three month spreads (blue), ten year-two year spreads (red), and ten year-five year spreads (green). Observations for September are for 9/19. NBER defined recession dates shaded gray. Source: FRED, and author’s calculations.

Figure 2: Ten year TIPS-two year Treasury minus 2 year expected inflation spreads (red), and ten year-five year TIPS spreads (green). Observations for September are for 9/19. NBER defined recession dates shaded gray. Dashed line at 2008M09. Source: FRED, Cleveland Fed and author’s calculations.

Has the Comovement between Ten and Five Year Yields Decreased?

The FT article documents the drastic drop in the 180 day daily correlation between 10 year and 5 year yields. On the other hand, the relatively large 10 year-5 year term premia shown in Figure 1 suggests the decline in yield comovement needs to be placed in context. Figure 3 shows that the one-year-window correlation does indeed drop drastically.

Figure 3: Correlation coefficient (blue), and regression coefficient, ten year on five year (red), one year window, monthly data. NBER defined recession dates shaded gray. Each observation pertains to the sample period encompassing the twelve month period ending in the observation. Source: FRED, NBER, and author’s calculations.

Jim made the same observation regarding correlations in his post. On the other hand, the regression coefficient (∂i^10yr/∂i^5yr) indicates that this period of low comovement follows a period of extremely high comovement. This casts in a slightly different light the assertion that the behavior of the five year has been abnormal in the past year. In fact, the behavior has been abnormal over the past four years. In that sense, looking back to Figure 1, the five year ten year gap has “normalized”.

Five Year Five Year Forwards

As Jim noted, one can use the information on ten year and five year Treasury yields to infer the five year yield expected five years from now. The calculation is simple if the pure expectations hypothesis of the term structure (EHTS) holds.

(1a)     i_t^10y = (i_t + E_ti_t+1 + … + E_ti_t+9)/10

(1b)     i_t^5y = (i_t + E_ti_t+1 + … + E_ti_t+4)/5

(1c)     E_ti_t+5^5y = (E_ti_t+5 + E_ti_t+6 + … + E_ti_t+9)/5

Which implies:

(2)     E_ti_t+5^5y = i_t^10y×2 – (i_t^5y)

Since the pure EHTS does not hold, one needs to adjust by the term premia; I use the same adjustment that Jim uses. This yields Figure 4.

Figure 4: Nominal five year five year forward, calculated as 2 × i^10yr– i^5yr (light gray), Nominal five year five year forward adjusted for premia (dark blue), and TIPS five year five year forward (red). September observations are for 9/19. NBER defined recession dates shaded gray. Source: FRED, NBER, and author’s calculations.

This interpretation (which presumes the EHTS with constant term-specific liquidity/risk premia is correct) suggests low real borrowing rates for the US government for the period 2019-2024.

The International Thesis

The FT article suggests that ECB monetary policy — or anticipation thereof — is driving the decline in the long dated US Treasurys. The movements in the ten year yields are shown in Figure 5.

Figure 5: Nominal ten year constant maturity government bond yield for US (blue), ten year on the run government bond yields for Italy (red), France (green) and Germany (black). NBER dated recessions shaded gray, CEPR dated recessions shaded light blue. Source: FRED, ECB, NBER, and CEPR.

The downturn in US ten year Treasury yields could reasonably be ascribed to the downward movement in Euro area government bond yields; to me, there are two problems with this view. The first is that in the econometric work I have conducted in the past, US rates are typically weakly exogenous for foreign (European) rates (or have unidirectional explanatory power).[2] The second is that the evolution of the US-Germany ten year gap is virtually indistinguishable from the US-Germany five year gap.

Figure 6: Nominal ten year US-Germany government bond yield differential (blue), and five year differential (red). NBER dated recessions shaded gray, CEPR dated recessions shaded light blue. Source: FRED, ECB, NBER, and CEPR.

Given these observations, I am more inclined toward the interpretation that the markets are pricing in a period of lower rates in the period five years hence — both in the US and the euro area — than in ECB policies driving US rates.

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The Spanish government Monday launched its long-awaited 50-year bond, stretching the maturity of the country’s debt into new territory, the finance ministry said. The country raised 1 billion euros ($1.31 billion) through a so-called private placement, meaning the bonds were sold directly to specific investors.

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Commerce knits the modern world together in a way that nothing else quite does. Almost anything you own these days is the result of a complicated web of global interactions. And there’s no better way to depict those interactions and the social and political circumstances that give rise to them than with a map or two. Or in our case, 38. These maps are our favorite way to illustrate the major economic themes facing the world today. Some of them focus on the big picture while others illustrate finer details. The overall portrait that emerges is of a world that’s more closely linked than ever before, but still riven by enormous geography-driven differences.

http://www.vox.com/2014/8/26/6063749/38-maps-that-explain-the-global-economy

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