Bond markets and failed theory
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.