The Interest Rate Enigma

The US government’s budget deficit was $1.4 trillion in 2009, $1.3 trillion in 2010 and $1.3 trillion in 2011. How was it possible for the government to borrow $4 trillion over the last three years without pushing interest rates to a much higher level? What ever happened to “Crowding Out”?

Economic theory teaches that when the government borrows a lot of money, it pushes up interest rates to prohibitive levels and thus crowds out individuals and businesses from borrowing in the money markets. During the current, government spending spree, however, interest rates have not jumped; they have fallen to record lows. The yield on 10-year government bonds, the rate the government pays to borrow (and the rate which indirectly determines all other interest rates), is down to 2%. How is that possible?

The cost of borrowing money is perhaps the single most important factor impacting economic activity and the direction of asset prices. It is crucial therefore that investors, economists and policymakers understand why interest rates have gone down rather than up since this crisis began. There are two parts to the explanation. The first involves post-bubble dynamics. The second involves the printing press. Let’s consider them in turn.

In 2008, the economic bubble in the United States popped. It had been decades in the making. When giant economic bubbles pop, they leave behind tremendous excess capacity across all industries and over-inflated (but rapidly falling) asset prices. Consequently, many investors believe there are very few viable investment opportunities in a post-bubble environment. However, there is a great deal of money available to be invested, the bubble profits made during the bubble years. The people who own that money come to understand very quickly that if they continue investing as they had done during the boom time (speculating in real estate, for instance), they will lose their money; whereas, if they put their money in government bonds, they can preserve their wealth. Therefore, a large pool of bubble profits quickly moves into government bonds. That pushes up the price of the bonds and pushes down their yields.

Similarly, corporations have a large stream of cash flow every year. After the bubble pops, there is excess capacity across most industries. So, if the corporations invest their cash flow in new factories and equipment, they will lose some or all of it; whereas, if they park their cash flow in government bonds every year, they can preserve their money and wait for a better day to come.

Meanwhile, falling asset prices undermine the creditworthiness of the general public. That means not only are there very few viable investment opportunities in a post-bubble environment, there are also too few creditworthy borrowers looking for loans. Investment and, therefore, the demand for loans collapse. Consequently, interest rates, i.e. the cost of borrowing money, move sharply lower. The government becomes the borrower of last resort. In other words, if the government did not borrow the money, no one would. Consider Japan. There, even though the ratio of government debt to GDP is 240% (vs. 100% in the United States), the Japanese government can still borrow money for 10 years at 1% interest or less – 22 years after Japan’s bubble popped. This is the first reason the US government has been able to borrow so much for so little.

Paper money creation by the Fed is the other explanation for our interest rate enigma. In the old days, when gold was money, if a government spent more than it took in as taxes, it was forced to borrow the difference; and, because there was only a limited amount of money, that borrowing drove up interest rates and crowded out the private sector.

That was in the old days, when gold was money. That is not the world we live in. In this new age of paper money, it is not just the demand to borrow money that determines interest rates. Now that governments are free to print as much money as they please, it is both the demand for and the supply of money that determines interest rates.

Since the crisis began, the US government has borrowed $4 trillion to finance its budget deficits. Over the same period, however, the Fed expanded its balance sheet by “printing” more than $2 trillion. It used that new money to buy government bonds and other debt instruments. That pushed bond prices up and bond yields (i.e. interest rates) down. Had it not done so, interest rates in the United States today would be very much higher (and home prices very much lower) than they are.

Paper money creation on such an enormous scale creates a radically different financial environment and policy framework than those described in the economic textbooks of old. Readers will not be surprised to learn, however, that printing money has negative consequences as well as benefits. We will look at both the benefits and the consequences next time.

Meanwhile, please find here a link to a speech I made before the CFA Institute in Hong Kong on March 7th. The topic is the outlook for Asia in light of the deepening global economic crisis. The speech contains a number of themes from my latest book, The New Depression: The Breakdown Of The Paper Money Economy, which, by the way, goes to print next week.

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