Annals of the Great Recession XVI, Legacies.

In theory, the American economy is doing well.  Unemployment is at the lowest level in this century; corporations are investing, and there are signs of increasing consumer spending.  Fine.  However, there are also reasons to be concerned.  One is the “flattening of the yield curve.”[1]

The United States government borrows money by selling bonds (Treasury notes).  Basically, bonds are IOUs + Interest.  These Treasury notes run for different periods of time and pay different rates of interest.  Long-term bonds run for like 10 years, while short-term bonds run for like 2 years.  The long-term bonds pay higher interest (called “yield”) than do short-term bonds to account for inflation.  When the economy is growing strongly, prices will tend to rise.  The gap between the yield for long-term bonds and the yield for short-term bonds is called the “yield curve.”

If people think the economy will grow, then they will put their money in stocks and the Treasury will have to pay higher interest on its long-term bonds.  If a lot of people want the security of long-term bonds, rather than the risk of stocks and don’t fear inflation, then the Treasury won’t have to pay as much interest.

Then there are the banks.  They borrow money at low short-term rates and lend it at higher long-term rates.  That’s how they make a profit.  If short-term rate approach long-term rates, it pinches their profits.  If short-term rates exceed long-term rates, they actually lose money.  So, they stop borrowing and lending.

Here’s the thing.  The gap between long-term and short-term bonds has been closing.  This is called “the yield curve flattening.”  A year ago the gap was 1 percent; three months ago it was 0.5 percent; in early July it fell below 0.3 percent.  Interest rates for long-term bonds has not been rising much, while the rates for short-term bonds has continued to rise.  This suggests that bond-traders do not expect a lot of inflation, which suggests that they have doubts about future economic growth.  At some point, the yield for short-term bonds could rise above the yield for long-term bonds.  When this happens, the yield curve is said to be “inverted.”  Economists interpret an inverted yield curve as “a powerful signal of recession.”  Inversions have come before every recession and one near-recession since 1955.  However, the time lag between an inversion and a recession can stretch from six months to two years.  So, we aren’t there yet.

The huge number of bonds that central banks acquired to push down long-term rates during the period of “quantitative easing” are continuing to weigh on the long-term rates.  Now the Federal Reserve Bank is raising short-term rates to prevent excessive price rises in a strong economy.  There is mounting concern that policies being pursued by the Federal Reserve Bank could harm the economy by pinching off lending or by pushing banks to pursue riskier strategies.[2]    On the other hand, there is evidence that, in the wake of the “Great Recession,” the yield curve has lost some of its predictive power.  Moreover, a strong American economy coupled with a slowing world economy could push foreigners to buy long-term bonds.  The issue at hand is whether the Fed should continue to raise short-term interest rates as planned.  The stakes are high.

[1] Matt Philips, “A Recession Signal Is Flashing Yellow,” NYT, 27 June 2018.

[2] Nick Timiraos, “Fed Debates Signal From Yield Curve,” WSJ, 9 July 2018.

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GPA+.

Ten years ago, 32 percent of graduating seniors received some form of “Latin honors” from the University of Southern California.[1]  This year, 44 percent received “Latin honors.”  Way to go Southern Cal!  Recruiting all those extra smart kids!  I bet the Ivy League schools will be taking their meals standing up after that spanking.  Oh, wait.  Turns out Harvard granted “Latin Honors” to more than half its graduating seniors.[2]

Granting “Latin honors” isn’t based on the subjective direct judgement of individual merit by the faculty members.  It’s based on the more objective quantifiable judgement of Grade Point Average.  So, Southern Cal and all the many other schools granting “Latin honors” to a growing share of graduates is just an artifact of long-term grade inflation.  According on one expert, a 3.7 GPA (on a scale of 4.0) “is just a run-of-the-mill student.”[3]

It starts in the schools.  In 1998, 39 percent of high-school seniors graduated with an “A” average.  In 2016, 47 percent graduated with an “A” average.  Over the same span, the SAT Critical Reading scores fell from an average of 505 to an average of 494; the Math scores fell from an average of 512 to 508.[4]  Students expect to continue their high-school experience in college.  Elite schools claim that they haven’t studied the trend, and don’t know how to explain it.[5]  The situation probably differs at tuition-driven, not-selective schools.  Too many schools pursuing too few students has led the recruiting effort look like feeding time at the shark tank: “Throw in another goat.”  After the admissions office has done what it can, the faculty face a heavy emphasis by their employers on retaining the students who have been admitted.

Grade inflation is like monetary inflation.

It is fueled by a weak authority in charge of controlling the volume of the unit of exchange.   In the case of the schools this could be parental pressure applied through the influence of a school’s reputation on housing prices.  In the case of colleges and universities, it is the desire to attract student dollars.  A strong authority might tell students that they aren’t particularly distinguished, or well-prepared, or hard-working.

It distorts incentives.  Thus, if you can get the same or more money for less work, then you’ll do less work.  If you can’t trust the money to have real value, then you’ll pursue other stores of value.  One form of this could be a flight to non-public schools with a reputation for greater rigor, or to home-schooling.

It favors people, better positioned to exploit the nominal value of a unit of exchange/measure and disfavors people poorly positioned to do so.  Employers, for example, lack any reliable means to evaluate the educational attainment of potential employees.  High GPAs fog over individual differences in both ability and work ethic.

The historical record shows that breaking an inflation is very painful and politically difficult.  People are willing to try this only after conditions have become intolerable.  We aren’t there yet.

[1] That is “cum laude,” magna cum laude,” and “summa cum laude.”

[2] Down from 91 percent in 2001.

[3] Melissa Korn, “You Graduated Cum Laude?  So Did Everyone Else,” WSJ, 3 July 2018.

[4] See: https://blog.prepscholar.com/average-sat-scores-over-time

[5] See “Captain Henri” in “Casablanca.”

Indonesian Islam.

Back in the day, Seymour Martin Lipset wrote The First New Nation: The United States in Historical and Comparative Perspective (1963).  Like most of Lipset’s work, it was about several things at once.  For one thing, it was about the United States as the first colonial territory to gain its independence from a colonial overlord.  Therefore, American could serve as a model for all the Asian and African countries recently or about-to-be liberated from European empires.  For another thing, it was about the related issue of how to create a stable democracy.  (That’s what most of the leaders of new nations said that they wanted, although the historical record now suggests other ambitions.[1])  According to Lipset democracy is intimately connected with economic growth: “[t]he more well-to-do a nation, the greater the chances that it will sustain democracy.”  This idea lay behind both the Marshall Plan to aid Western European economic recovery after the Second World War and the First Gulf War (1990-1991).[2]

Time hasn’t fully born out Lipset’s ideas–so far.  China, for example, is an increasingly prosperous autocracy.  In many Muslim countries, oligarchies have gobbled up national wealth, while the vast majority of people have little opportunity.  More importantly, religious belief can outweigh political theory.  It isn’t clear that the beliefs of Islam are compatible with Western conceptions of democracy.  Traditional Islam rejects any separation of church and state, it rejects law derived from legislatures rather than the Word of Allah, and it rejects the very idea of nation-states in favor of the “umma” of all Believers.[3]  Moreover, Islam is socially conservative in ways that Western liberals find repugnant.  Women’s rights and gay rights antagonize social conservatives.

Indonesia provides an interesting case.  It is the most populous Muslim country in the world.[4]  Piled on top of religious conservatism are hostilities related to ethnic or religious minorities.[5]  The very small share of people with Chinese ancestry play an out-sized role in the economy and have long been the target of Muslim hostility.  Women’s rights and gay rights have a salience in Muslim concerns because of Indonesia’s popularity with Western tourists.

Like Turkey, Indonesia has a democratic system.  Can democratic politics can be used to impose an Islamist agenda?  In 2002, Jemaah Islamiya—an Islamist group linked to Al Qaeda—killed 200 people in bomb attacks on the Indonesian island of Bali.  Repression followed.  Recently, however, there have been both a mass mobilization of Muslims against the Christian governor of Jakarta and renewed terrorist attacks.  There is also legislation pending to criminalize public display of affection by gay people.

Will Southeast Asia become the next front in the war against radical Islamism?

[1] A friend insists that there is a scene from one of Ionesco’s plays in which a character says “We will drink wine under the willow trees.  AND YOU WILL BE MY SLAVES!”  I haven’t been able to run it down.

[2] It was a war for oil prices and oil markets, not a war for oil companies.  The historically-minded men and women behind the war were aware that the 1970s “oil shocks” had pitched the world close to the edge of depression and that the Great Depression of the Thirties had been the principal cause of the Second World War.  They didn’t want that to happen again.

[3] We’ll probably hear complaints that the University of Michigan Museum of Art is a sign of creeping Islamization.

[4] Indonesia’s population is 270 million.   87.2 percent Muslim, 9.9 percent Christian, 1.7 percent Hindu, and 0.7 percent Buddhist and 0.2 percent Confucian.

[5] Yaroslav Trofimov, “Islamist Shift Unsettles Indonesia’s Democracy,” WSJ, 29 June 2018.