Bond markets and failed theory

June 5, 2013

In theory, interest rates are one of the jewels of capitalist economies. The theory has been well tested over the past half-century, and it has failed. Interest rates have become a mark of shame. The recent increase in yields on government bonds in much of the world – by a quarter, from 1.65 percent to 2.1 percent since the beginning of May for 10-year U.S. government bonds – is only the latest chapter in a long and depressing story.

The theory starts well, with a plausible behavioural generalisation. A lower interest rate encourages less saving and more consumption today, while a higher rate encourages saving now and boosts consumption in the future. But the theoreticians are not content with that; they want mathematical precision. They get it by adding some extraordinarily unlikely assumptions about knowledge, uncertainty, defaults, growth, and inflation.

The result is almost magical: a single “natural” interest rate which serves as a sort of economic fulcrum. At this ideal rate, saving and consumption are supposed to be balanced correctly, and the financial system is perfectly aligned with the real economy of making and selling.

It turns out, though, that actual interest rates, those agreed between borrowers and lenders, are often quite different from the natural rate. No problem for the theory. This ideal-real gap can and should be closed by wise and powerful monetary authorities, otherwise known as central bankers.

Of course, these high priests of finance must first uncover this hidden natural interest rate. The theory provides a technique. The result is encapsulated in the dual mandate of the U.S. Federal Reserve. The natural rate has been reached when the levels of unemployment and inflation are both low – the first rises if the rate is too high, and the second if it is too low.

This theory is comfortable and all-encompassing, but history has exposed two glaring weaknesses.

First, central bankers have rarely been wise. Their chosen interest rates were definitely too low during the inflationary 1960s and 1970s, and probably too high during the subsequent two decades of falling inflation. Then the theory, which ignores debt levels, missed the dangers of the credit boom. And the extremely slow recovery from the credit bust – five years and counting – casts doubt on the post-crisis calculation of a sub-zero natural interest rate.

Second, the price of money has not actually been an economic fulcrum. Over the decades, incomes and consumption have increased significantly and fairly steadily. Monetary policy may have helped or hindered a bit, but has done far less than, among other things, technological developments, government initiatives and financial regulation.

My claim that interest rates make little difference in the real economy is controversial, but there can be no debate about the effect of central banks’ post-crisis monetary policy on the financial system. It has made a bad situation worse.

Savers and bond investors are suffering. Perhaps the recent upward move in government bond yields, with a corresponding fall in prices, is a sign of rebellion. But as yet they are like slaves demanding to be flayed with a smaller whip. Short- and long-term interest rates remain pathetically low, relative to inflation.

Other financial assets may offer investors a less terrible deal, but it’s hard to tell. Markets are distended by their addiction to central banks’ distorting policies. Share prices, for example, should generally rise along with economic prospects, but they fell after Fed Chairman Ben Bernanke gave a relatively rosy assessment of America’s growth prospects. Investors fear even slightly higher interest rates far more than they hope for a stronger economy.

Banks and other financial intermediaries are also addicts. Their business models are now built on the foundation of ultra-low interest rates. That’s understandable, since central banks have provided them through good and bad times for more than a decade.

The craziness of the situation shines out in the widespread fear of what will happen if savers and bond investors actually start to get fair returns again. Long-term interest rates of 4 or 5 percent will make mortgages and other loans so expensive that many more borrowers will default, even if the real economy is actually healthier. Far from supporting and balancing the real economy, interest rates have become an economic hazard.

The financial system’s dependence on central banks is unhealthy. As with any addiction, withdrawal will be painful. This is one reason that so little has been done to make the financial system less vulnerable to higher yields.

Central bankers’ pride is another reason. To move forward, they would have to admit that the theory upon which their existence is based is a dangerous chimera and that they are more puny than powerful.

It would be nice if the paradoxical market response to the prospect of a strengthening economy spurred a rethink of the theory. I’m not optimistic.



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What you apparently fail to understand is that, while controlling inflation is a difficult economic taks in itself, adding the POLITICAL goal of low unemployment makes the task impossible.

Add to that the Bernanke QE insanity, and we have an economy that is guaranteed to crash.


From “Central Banking at a Crossroad,” Paul Volcker, The Economic Club of New York, May 29, 2013

“In no doubt, the challenge of orderly withdrawal from today’s (vs. 1950s) broader regime of quantitative easing is far more complicated. The still growing size and composition of the Fed’s balance sheet implies the need for, at the least, an extended period of disengagement. Moreover, the extraordinary commitment of Federal Reserve resources alongside other instruments of government intervention is now totally dominating the largest sector of our capital markets – that for residential mortgages. Indeed, I do not believe it an exaggeration to note that the Federal Reserve with assets of $3.5 Trillion and still growing is, in effect, acting as the world’s largest financial intermediator, by acquiring long-term obligations and financing short-terms, of course aided and abetted by the unique privilege to create its own liabilities.

Beneficial effects of the actual and potential monetization of public and private debt – the essence of the various QE programs – appear limited and diminishing over time. The old “pushing on a string” analogy is relevant. And the risks of encouraging speculative distortions and the inflationary potential of the current approach plainly deserve attention. All of this has given rise, obviously, to debate within the Federal Reserve Board itself. In that debate, I trust sight is not lost of the merits – economically and politically – of an ultimate return to more orthodox central banking approaches.

I do not doubt the ability and the understanding of chairman Bernanke and his colleagues. They have a very considerable range of tools and instruments available to them to manage the transition. They include the novel approach of paying interest on excess reserves, potentially sterilizing their monetary impact. What is at issue – what is always at issue – are matters of good judgment, leadership and institutional backbone. The willingness to act with conviction in the face of predictable political opposition and substantive debate is, as always, a requisite part of a central bank’s DNA.

Those are not qualities that can be learned from textbooks. Abstract economic modeling and the endless regressions of econometricians will be of little help. The new approach of “behavioral” economics itself is recognition of the limitations of mathematical approaches, but that new “science” is in its infancy.

I think a reading of history may be more relevant. Here and elsewhere the temptation has been strong to wait and see before acting to remove stimulus and then moving toward restraint. Too often the result is to be too late, to fail to appreciate growing imbalances and inflationary pressures before they are well ingrained.

There is something else beyond the necessary mechanics and the timely action that is at stake: the credibility of the Federal Reserve, its commitment to maintain price stability and its ability to stand up against pressing and partisan political pressures is critical. Independence cannot be just a slogan. Nor does the language of the Federal Reserve Act itself assure protection, as was demonstrated in a period after World War II. Then, as now, the law and its protections seem clear, but then it was the Treasury for a long time that called the tune.

In the last analysis, independence rests on perceptions of high competence, of unquestioned integrity and the will to act. Clear lines of accountability to the Congress and to the public need to be honored. Moreover, maintenance of independence in a democratic society ultimately depends on something beyond those internal institutional qualities. The Federal Reserve – any central bank – should not be asked to do too much – to undertake responsibilities that it cannot responsibly meet with its appropriately limited powers.

I know it’s fashionable to talk about a dual mandate – that policy should somehow be directed to two objectives of price stability and full employment. Fashionable or not, I find that mandate both operationally confusing and ultimately illusionary. Operationally confusing and in breeding incessant debate in the Fed and the markets about which way policy should lead – month to month, quarter to quarter – with close inspection of every passing statistic. More important, illusionary implies a tradeoff between economic growth and price stability – a concept that I thought had been long refuted not just by Nobel prize winners but by experience.

The Federal Reserve, after all, has only one basic instrument so far as economic management is concerned – managing the supply of money and liquidity. Asked to do too much – for instance to accommodate misguided fiscal policies, to deal with structural imbalances, or to square continuously the hypothetical circles of stability, growth and full employment – then it will inevitably fall short. If in the process of trying it loses sight of its basic responsibility for price stability, a matter that is within the range of its influence, then those other goals will be beyond its reach.

Back in the 1950s, after the Federal Reserve finally regained its operational independence, it decided to confine its open market operations almost entirely to the short-term money markets – the so-called “bills only doctrine.” We can’t go back to that – we can’t go home again to the simpler days of the 1950s and 1960s. Markets and institutions are much larger, far more complex. They have also proved to be more fragile, potentially subject to large, destabilizing swings in behavior. The rise of shadow banking, the relative decline of regulated commercial banks, the rapid innovation of new instruments have all challenged both central banks and other regulatory authorities.

But one simple logic remains. It is, I think, reinforced by these developments. The basic responsibility of a central bank is to maintain reasonable price stability – and by extension that means it must take account of the stability of financial markets generally. In my judgment, those functions are complimentary and they should be doable.

With or without a numerical target, the broad responsibility for price stability over time does not in any way imply an inability to conduct ordinary counter-cyclical policies. Indeed, in my judgment confidence in the ability and commitment of the Federal Reserve or any central bank to maintain price stability over time is precisely what makes it possible to act aggressively in supplying liquidity in recession or when the economy is in a prolonged period of growth well below potential.

Credibility is an enormous asset. Once earned, it must not be frittered away by yielding to the notion that a “little inflation right now” is a good thing to release animal spirits and to pep up investment. The implicit assumption behind the siren call must be that the inflation rate can be manipulated to reach economic objectives – up today, maybe a little more tomorrow, and then pulled back on command. But all experience amply demonstrates that inflation, when fairly and deliberately started, is hard to control and reverse. Credibility is lost.

I have long argued that central bank concern for stability must range beyond prices for goods and services to the stability and strength of financial markets and institutions generally. I am afraid we collectively lost sight of the importance of banks and markets robustly able to maintain efficient and orderly functioning in time of stress. Nor has market discipline alone restrained episodes of unsustainable exuberance before the point of crisis. Too often, we were victims of theorizing that markets and institutions could and would take care of themselves.

My concerns in that respect and their relevance to central banking and the organization of regulatory authority, were more fully expressed in a speech to this Club several years ago. Congress was then beginning to consider reform legislation. It was recognized that regulatory agencies, perhaps most specifically the Federal Reserve, had exhibited a certain laxity and ineffectiveness in the period leading up to the financial breakdown, particularly with respect to the mortgage market…

The erosion of confidence and trust in the financial world, in the financial authorities that oversee it, and in government generally is palpable. That can’t be healthy for markets or for the regulatory community. It surely can’t be healthy for the world’s greatest democracy, now challenged in its role of political and economic leadership…”

Posted by EconCassandra | Report as abusive

You state that your “claim that interest rates make little difference in the real economy is controversial, but there can be no debate about the effect of central banks’ post-crisis monetary policy on the financial system. It has made a bad situation worse” is logically incorrect.

If, as you say, interest rates make little difference, then their impact on “post-crisis monetary policy on the financial system” would have little or no effect.

Interest rates are in fact the main tool of the central bankers to control inflation (i.e. maintain price stability) and there is a demonstrable connection between them and economic growth or decline.

Interest rates, or the lack thereof, are now the main driver of the supposed US/global recovery.

The net effect is that central bankers are failing in their primary duty of providing for price stability by deliberately introducing massive amounts of inflation into the economy.

Bernanke himself has stated there is no inflation — which is demonstrably wrong and the proof of his error lies in the fact of the rising stock markets and simultaneous stagnating real economies around the world, which he chooses to ignore — and that the QE should be continued until unemployment is reduced to some “magic” level of political acceptability.

By doing so, he is actually performing the job of Congress, which has the duty and legislative ability to provide jobs growth.

Both he and Congress are doing this nation a great disservice.

He is attempting to “cover” for a Congress that is not doing its job properly, thereby allowing them the luxury to remain inanely “deadlocked” over fiscal policy while he attempts to do their job for them.

In other words, the central bank does NOT have the “tools” that can deliver jobs growth.

Only Congress can do that.

The only reasonable solution, for the sake of this nation’s survival, is to replace and reform both Congress and the concept of an “independent” central bank.

NO central bank should be “independent”, as popular opinion would argue, since an independent central bank introduces an unstable element in the government processes, which are already inhereently unstable.

We don’t need an additional “loose cannon” rolling around on the deck during a financial storm.

The “logic” of an independent central bank defies “logic”.

What we NEED is both Congress and a central bank firmly under control of the democratic process.

Under the circumstances, there is little hope that will happen, and we will pay the consequences for that failure.

Posted by EconCassandra | Report as abusive

I used to agree with the author’s assertion that “savers and bond investors were suffering.” Then, I started to think about it … savers are different from investors. As longs as savers are provided a rate of return on their cash savings that offsets any existing price inflation, then they are neither being harmed nor benefiting from the current interest rate environment becuase they are not losing any of the principal value of their savings.

Why should savers expect to earn any kind of return (in excess of some kind of inflation rate) on their “savings” (which should not be confused with “investments”)? Savings, to me, implies the avoidance of risk associated with an investment (where there’s the potential for risk of loss), so savers shouldn’t expect to earn any kind of “investment” return on their savings.

Posted by VirtualThumb | Report as abusive

@ VirtualThumb —

You state Why should savers expect to earn any kind of return (in excess of some kind of inflation rate) on their “savings” (which should not be confused with “investments”)? Savings, to me, implies the avoidance of risk associated with an investment (where there’s the potential for risk of loss), so savers shouldn’t expect to earn any kind of “investment” return on their savings.”


You are assuming that the reasons behind saving and investing are the same when they are not.

Many people at various points in their lives choose to save rather than invest. For example, a person wanting to prepare for retirement, might choose savings in some form rather than investing. Offering avoidance of risk later in life is a major factor in many savings plans.

Another factor you are overlooking is that the bank or savings institution holding the savings essentially “pools the risk” that those savers offer it, thus the real rate of return on their investment is far higher than simply the inflation rate.

Most people do not understand this, which is in the banks’ favor when the bank pays literally no interest to savers, as they are doing now.

It is truly a policy of charging “all the market can bear”. Keep in mind that this is an abnormal situation due to an abnormal economy, mainly because the banks have the government in their pockets to the detriment of the consumer.

Posted by EconCassandra | Report as abusive

@EconCassandra, I do understand that the reasons behind “investing” and “saving” are different. That’s why I suggest that people who are truely “saving” cash should not reasonably expect a market rate of return on their saved cash in excess of some price inflation rate. And, since there is currently no (or nominal) price inflation at the moment, savers are not losing any of the value of their savings due to inflation. Said another way, the current low (no) interest rate environment is not hurting savers becuase the value of their savings is not decreasing due to inflation AND they should have no expectation of the value of their savings increasing (except to the extent they add additional funds to amounts currently saved).

The current interest rate environment IS detrimental to entities that are attempting to “invest” in financial securities or equivalents in an effort to extract an increase in the value of the cash investment. The risk / return spreads have been compressing across securities markets for some time, resulting in lower “investment” returns over time given the same amount of risk. I have no sympathy for this situation … investments in non-cash opportunities (construction of hard assets) is a reasonable investment alternative that benefits multiple facets of the economy.

Posted by VirtualThumb | Report as abusive

What Mr. Hadas is saying, in essence, is that “what we’re doing isn’t working”. He is correct in many, many ways.

Whereas once there was a “trade-off” made as we age where we abandoned the “risks of investment” logical at an age we could “make up” for any “mistakes” for the relative security of federally guaranteed bonds and “savings accounts” which paid them a lower, but safer, rate of return for the use of money for varying periods.

Today anyone who parks money in a bank has learned the hard way that that money is losing purchasing power. With most alternatives too complex for the average person to understand, they today ave little choice but to invest in rental properties, land, commodities, stocks, and other more risky investments.

“We’re not in Kansas anymore!”

Posted by OneOfTheSheep | Report as abusive

Well said. Another unwise theory that needs to come under scrutiny is fractional lending by banks.

Posted by BidnisMan | Report as abusive

All your criticisms of interest rate theory are relevant and substantial. But I dispute your endorsement of its basis:- “The theory starts well, with a plausible behavioural generalisation. A lower interest rate encourages less saving and more consumption today, while a higher rate encourages saving now and boosts consumption in the future.”

Anyone familiar with basic economics should be aware that price rises for a good can INCREASE demand for that good, when the good has negative income elasticity and the substitution effect outweighs the price effect.

Likewise with interest rates. Then they fall, and you are approaching (and saving for) retirement, in order o get a retirement pot of a certain size, you will need to save more, not less. In fact, people often save for a specific purpose, ranging from retirement, to college to a home to a new car. They have a certain absolute monetary target in mind. Reducing the interest rate increases the rate of saving necessary to reach that target within a given time.

Also, people generally increase saving at times of uncertainty, putting off larger purchases. I would estimate the effect of economic uncertainty / confidence (especially in the jobs market) to have a MUCH greater impact than central bank interest rates.

Therefore higher interest rates are quite likely largely irrelevant to savings levels. Whatever marginal effects there are could easily be positive or negative (almost certainly be dependant on other economic factors).

I am well aware of the assumption that higher interest rates encourage saving. What empirical evidence is there?

Posted by Urban_Guerilla | Report as abusive

@ VirtualThumb —

Granted “savers” should not receive a market rate of return — which right now, taking the DOW, for example, is 15.69% ytd — but my point was that banks are indeed gouging savers since the real rate of inflation is not zero. Thus, their current interest rate policies DO in fact suffer a loss of principal.

This contrast with your assertion that “As longs as savers are provided a rate of return on their cash savings that offsets any existing price inflation, then they are neither being harmed nor benefiting from the current interest rate environment becuase they are not losing any of the principal value of their savings.”

The only question remaining is do you accept the government version that there is no inflation or the main street version where prices are indeed rising.

The problem lies in how the government chooses to measure inflation, as well as which type of inflation you want to choose for yourself.

You state “the current low (no) interest rate environment is not hurting savers becuase the value of their savings is not decreasing due to inflation AND they should have no expectation of the value of their savings increasing (except to the extent they add additional funds to amounts currently saved)”, but that is the really the current fed rate, and is not the same as other rates of interest.

For example: tion_Rate/CurrentInflation.asp

This website shows the “real” rate of inflation for Jan-Apr 2013 has averaged 1.525%. Unless the banks pay at least the current real rate of inflation, which to my knowledge they are not, they are gouging their customers whose principal is indeed eroding, although most people do not understand because they think there is no inflation.

There is also the issue of monetary versus price inflation:

(1) “Monetary inflation is a sustained increase in the money supply of a country. It usually results in price inflation, which is a rise in the general level of prices of goods and services. Originally the term “inflation” was used to refer only to monetary inflation, whereas in present usage it usually refers to price inflation.[1]”

Since the Bernanke QE program is steadily and substantially increasing the money supply (i.e. liquidity) in the US the long-term DEflation of a savings account for savers is staggering, since this will drive up prices generally. The only reason it is not doing so at the moment is because the fed is choosing to offset its inflationary policies by holding the equivalent amount of inflation (i.e. the amount the stock markets have risen over GDP over the past 4 years or so QE has been in effect), but when the fed reverses its QE policies that “accrued inflation” on their balance sheet (right now somewhere between 3-4 TRILLION dollars) MUST be released back into the economy. As a result the markets will suffer, at the very least, a significant decline in value, which will result in deflation.

(2) Price inflation: “In economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time.[1] When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation reflects a reduction in the purchasing power per unit of money – a loss of real value in the medium of exchange and unit of account within the economy.[2][3] A chief measure of price inflation is the inflation rate, the annualized percentage change in a general price index (normally the consumer price index) over time.[4]

Inflation’s effects on an economy are various and can be simultaneously positive and negative. Negative effects of inflation include an increase in the opportunity cost of holding money …

(3) Related to price inflation is the concept of “opportunity cost of holding money”.

In microeconomic theory, the opportunity cost of a choice is the value of the best alternative forgone, in a situation in which a choice needs to be made between several mutually exclusive alternatives given limited resources. Assuming the best choice is made, it is the “cost” incurred by not enjoying the benefit that would be had by taking the second best choice available.[1] The New Oxford American Dictionary defines it as “the loss of potential gain from other alternatives when one alternative is chosen”. Opportunity cost is a key concept in economics, and has been described as expressing “the basic relationship between scarcity and choice”.[2] The notion of opportunity cost plays a crucial part in ensuring that scarce resources are used efficiently.[3] Thus, opportunity costs are not restricted to monetary or financial costs: the real cost of output forgone, lost time, pleasure or any other benefit that provides utility should also be considered opportunity costs.”

If you include the opportunity cost of holding money in a savings account when the real rate of inflation is rising at around 9.6% per year (my calculation of the rate at which the DOW is rising year over year for the past 4 years) “savers” are actually losing nearly 10% per year on their savings.

But, as you say, that is their choice by choosing not to invest, but in a supposedly safer method.


What I am trying to say is that the issue of saving versus investing is quite a bit more comlicated than it appears to be.

The bottom line, however, is that you are incorrect to say that savers are not being hurt by bank interest rate policies, the only question is by how much.


Posted by EconCassandra | Report as abusive