Conundrum revisited: Why are gov’t interest rates so low?

Back in 2005, Alan Greenspan complained of a ‘conundrum’: The fact that long-term interest rates were refusing to rise, despite a sharp increase in short-term rates.  At the time, there were all sorts of explanations given. In retrospect, this puzzling behavior of the financial market was a sign of deep problems.

Right now, we are facing the conundrum, part II.  The  news is  dominated by the massive gov’t budget deficits, which stretch as far as the eye can see.  But despite the incredibly large  borrowing needs, Washington is actually raising money at lower rates than it did in 1999 and 2000, when the federal government was running a surplus.  Here are the two relevant charts. First, the interest rate on 10-year Treasury bonds.

And here’s the change in the federal budget balance, as a 12-month sum.  We can see how small surpluses turned into stunning deficits.

These are the sort of charts which are frustrating to deficit hawks and professors who have to teach macroeconomics. There seems to be no easy and straightforward link between budget deficits and interest rates

So let’s go looking for other reasons. First, inflation is about at the same level as it was in 1999 (the consumer inflation rate in the year ended December 1999 was 2.7%, compared to 2.8% in the year ending December 2009).  Second,  net exports as a share of GDP are roughly about the same level as they were in 1999 and 2000, suggesting that the U.S. has about the same need to borrow from overseas.

Is it possible that the federal government is getting such a good rate because the rest of the economy is not borrowing?  Here’s a chart of borrowing by all nonfinancial sectors–consumers, nonfinancial business, state and local governments, and the fed. Measured as a share of GDP,  borrowing is still roughly where it was back in 1999 and 2000. (I’ve given both the quarterly and the smoothed charts).  

So what the heck is going on here? It could be that the U.S. government still counts as the only safe investment out there, even with the big budget deficits.  Possible, but that depends on highly myopic investors.  It could be that the demand for funds globally is low. Or it could be that the bond market is trying to tell us that long-term expectations for growth are low.

It’s a conundrum.


  1. I think you hit on the reasons at the end. Budget deficits are only one factor and as you can see in the first two charts, 10-year rates did rise 100 basis points or so with the ballooning govt deficits. I think what it can be likened to is a bank run, where people’s preference for holding cash goes up in anxious times. Today, the preferred “cash” is Treasuries and some people still use gold also, as you can see with the recent spike in the price of gold. Certainly the run on Treasuries in late 2008, reflected in the drop in rates at that time, was for just such a reason. You don’t elucidate why that’s necessarily myopic, though I would agree that those aren’t good long-term investments. I’m also unsure why you consider these “signs of deep problems.”

  2. I would humbly reject the notion that rates are low. It could be argued that real rates at the long end of the curve are actually at the high end of what we might expect.

    As for gov’t deficits and debt, the last several decades experience in Japan and the US (to name two countries) have shown that there is no correlation between deficits/debt and the nominal level of interest rates. Maybe some day it will correlate, but it hasn’t yet.

    You could also argue that Treasuries are “under-owned” by both the American banks and American citizens. The % of assets devoted to Treasuries by domestic buyers can only go in one direction … up. There will be plenty of buyers for all the government debt coming down the pike.

    Finally, I would say that gov’t paper is the most hated asset class on the planet. That alone is almost enough to convince me that its pretty much a slam dunk that Treasuries will be one of the top performing asset classes this year.

  3. A related question is why are long-term rates in Japan even lower considering that they have nearly a 200% debt/gdp ratio?

    I would argue that for an economy, long-term rates are determined by the expected underlying growth rate of the economy plus inflation plus risk premia. The main risk premia being country risk/default risk and interest rate risk (where interest rates could change because of growth suddenly kicks in or inflation suddenly kicks in). Or equivalently, REAL long-term rates are approximated by the expected growth rate plus risk premia.

    This idea makes sense if you consider the market segmentation theory behind the structure of the yield curve. Using this theory, long-term rates are determined by the supply and demand for long-term instruments in the economy. If an economy is expected to grow at a given real rate, then unless real long-term rates are at least equal to this growth rate, lenders will prefer to invest in the economy to lending out money (as the profit is higher). This will drive up the long-term rates till they exceed the expected growth rate. Conversely, if the long-term rates are above the expected growth rate, then investors will not borrow money because there is no where to invest that money and make a profit. This will drive down long-term rates until they approximate the expected growth rate.

    This explanation fits Japan very well, the their real growth rate over the last decade approximating their real 10-year bond rate. This explanation also suggests that growth in the U.S. will be muted for quite some time.

  4. Don’t you think maybe it is the policies of Asian countries (particularly China) that changed after the Asian crisis in the late 90s? Their solution to ensure nothing like that ever happened again was to accumulate more reserves than they’d ever need (by keeping an exchange rate undervalued), although in China’s case it was probably more a result of wanting to industrialize as fast as humaly possible by encouraging exports…

    China has accumulated more reserves in nine short years at rates and to levels that are likely unprecedented, nothing that anyone would have predicted…

    But here’s the catch. In the US, we have no problem with China holding US dollars, so long as they only hold fixed income, particularly debt of our US govt… The second that they try to invest in an equity here, there are Congressional hearings…

    I regularly follow spreads between earnings yields on stocks and bond yields (both corporate and US Treasury), and the relationship that has held for over 30 years definitely changed in the middle of the last decade… I see much wider spreads than I ever have… The kinds of spreads that should encourage corporations to go to private…

    The only intuitive, logical explanation for this is China’s massive holdings of US fixed income at any interest rate that we’ll give ’em. In explaining this, they are the only elephant in the room as far as I can see…

  5. I suppose this might sound a little conspiratory, and a lot like fantasy, but it is the way I have to approach market signals as an outsider who doesn’t like getting burned. Greenspan’s conundrum inspired wariness in me that some parties with lots of money knew something that the rest of us didn’t; they were just off in their timing. Knowing who is buying would help clarify the message. Greenspan claimed that he could not know who the buyers were. It seems unlikely that Treasury would not know, or that this is a secret to guard from the Fed. Somehow it is no secret that the top holder is China, the amount is about $1trillion, and that story doesn’t change much. That’s only 20% of Bush administration new debt.

    I know that giant banks like JP Morgan do a heavy business in Treasuries for large buyers. Why these buyers wouldn’t do their own purchasing is beyond me, unless they prefer JP Morgan knowing and U.S. Treasury not knowing, if this does keep Treasury and the Fed in the dark. For sure, this gives JP Morgan a better sense of the story than I can get.

    We know that the Fed has been buying Treasuries and I assume that they are reporting it accurately. I don’t believe that the Greenspan Treasury ever did this. I neglected to keep track of the amounts — they seem substantial though not over the top. We are led to believe this is just another part of their monetary policy tool set, not a profit motivated scheme for the Fed. It is easy to imagine that their purchases are sufficient to artificially depress long term rates, so rather than the market signalling to us, we have the Fed signaling to the market that they will not allow interest on the debt to race out of control toward doom. Those other big players, then, can dump Treasuries at a stable price when they’re positioned for the next big thing (bubble), which JP Morgan will be well positioned to anticipate. China should be reassured, but also a little threatened that we don’t have to become ever more beholden to them if they continue to constrain their currency valuation. I, on the other hand, will be forced to take more risk if I want more income, but so will the big players.

    On the whole, I have a positive take on it with regard to economic recovery, except that the idea of the taxpayer being on the hook to pay back the Fed is a little mind-boggling, and I’m left wondering whether the Fed did it by creating dollars to compensate for the giant shrinkage of global liquidity, so they can just quietly cancel their part of the debt someday. Apologies for the wordiness.

    • Maybe I’m just talking to myself about this, but I just read in today’s Financial Times that China is no longer the largest holder of U.S. government debt — it’s Japan, at some $700-800 billion.

  6. Why do you call investors who view T-bonds as safe “myopic”? Maybe they are just “Keynsian.” In a demand-deficit recession, government deficits — replacing, as your chart suggests, private borrowing — aren’t inflationary. Rather than creating excess demand for a limited supply of goods, they move the economy closer to full employment. In turn, that increases the prospects of economic growth, which makes it highly likely that the government will be able to meet its obligations as they come due (since it issues only dollar denominated debt, it is hard to see why that would be in question anyway short of systemic collapse). In short, on a Keynsian view, US government deficits are a sign that the US government is not as broken as casual observation might suggest. Low interest rates are an entirely rational investor response to that reality.

    On a similar note, one might ask why you characterize the current deficits, mostly driven by the economic collapse resulting from the real estate bubble, as “big”. Given the shrinkage in private debt, a Keynsian analysis would suggest that they are “inadequate to maintain full employment.”

  7. Wow, Dan G, tragic to see someone dragging out those hoary old chestnuts. Such “Keynesian” analysis has been discredited for decades, after repeated attempts to make it work. Obama’s current advisors are being intellectually dishonest to support such spending when many of them wrote papers questioning such fiscal policy themselves. Your fundamental fallacy is in assuming that the govt knows better than private investors where to spend that borrowed money. Right now, the government is sucking money that could be invested in new technology or services out of the market to put it into the most bloated and inefficient markets of them all, health, education and of course, more govt. This is the equivalent of Roman emperors who used to butcher cows to propitiate the gods when crops failed, it satisfies a bunch of ignorant religious types, “Keynesians” today, but is really a waste of resources precisely when we should be husbanding them.

    As for your fantasy that the govt can simply inflate away its debt, that’s only if the banks let them. Right now, the Fed has pumped a trillion dollars into bank reserves and they simply choose not to lend this newly created money out, although the Fed thankfully doesn’t really want them to lend it either. Govt deficits are a sign that the govt isn’t broken?! Next you’ll say unemployment and lower growth is a sign that markets are doing great right now. 😉 I realize the political concerns over “full employment,” as a bunch of dissatisfied voters will often lash out politically, but the last thing we should be doing is making the market worse by throwing billions down the drain or trashing cars/”clunkers” because god forbid, they might be cheaper now.

  8. Ajay –

    First, it would be hard for the government NOT to do a better job investing than the private sector at this point. After a decade of entirely wasted private investment — in houses that no one wants and in speculative trading instruments designed to allow institutions to evade the law and their employees to evade their supervisors, or to shift risk from those set up to bear it to those who don’t understand it — the private sector has now shifted to refusing to invest at all.

    I’m not sure why you are opposed to health and education, but they are clearly far more productive investments than CDO squared, or Central Valley McMansions, or excess bank reserves, or CEO bonuses. Or, for that matter, the largest piece of Federal spending, which is past and present wars. Or the bulk of the actual Federal stimulus and bailout spending, most of which was gifts and subsidies to private sector finance in the — apparently vain — hope that the private sector might be able to do something useful with it. We’d all be better off today if the money that went to subsidize the CDO and ABS markets had, instead, gone to State governments to pay for real investment, such as desperately needed education and mass transit, or had gone to replace our failed market-based medical insurance system with an expanded version of Medicare.

    Second, since the private sector currently isn’t investing even government handouts — we have 10% unemployment — it doesn’t really matter whether education, health and safety are “better” investments than speculative houses. The alternative to government spending isn’t “new technology”. It’s more unemployment. Putting people and capital to work — even by wastefully subsidizing private investment banks — is nearly always better than just letting them rot, as the private sector is doing. That was Keynes’ basic point, and you ought to at least understand it before rejecting it.

    Third, you seem to miss the point about default. The US government has the ability to print dollars. Thus, it can’t default unless it decides to. To be sure, last week, the GOP senators voted to refuse to increase the debt ceiling, which seems very close to a decision to default, but the bond market seems to have dismissed this as mere grandstanding, not a sign of actual irresponsibility.

    Finally, you also miss the point about inflation. Mike’s “conundrum” is that bond market prices strongly suggest that bond investors are NOT worried about inflation any more than it is worried about the GOP causing a default. The simple explanation is that they’ve understood Keynes. It’s not inflationary to run deficits when the added government demand is simply replacing non-existent private demand. Instead, the deficits simply mean faster economic growth and lower unemployment than with lower deficits.

    In short, the simplest answer to Mike’s question — how to solve the conundrum that the bond market is pricing US government debt as if T-bonds are the safest investments out there and inflation is not likely — is that bond market investors believe that T-bonds are the safest investment out there and are not worried about inflation, because they accept the basic Keynsian explanation of why neither inflation nor default are likely results of policies that will, instead, partly ameliorate the market’s failure to invest rationally.

    The alternative explanation of the conundrum, of course, is that the bond market is once again grossly misdirecting investments.

  9. I wish Keynesians would take on the subject of how this works when a nation’s wealth is dribbling out, or flows in from outside, and the globe’s wealth goes to landfills and waste heat which are governed more by the laws of thermodynamics than economics. The Friedmanites don’t have to talk about it, although if they would stop ignoring Friedman’s safety nets, it seems to me that their theoretical end state might require a safety net for a great deal of humanity, and bond market signals would become moot.

  10. Dan G, Housing and new trading instruments were only a part of all the investment going on this decade, you act as though they were the entire deal. What precisely is desperately needed about education, where we already spend more than anywhere else to pay off useless education unions with horrible and ever worsening results? As for mass transit, don’t make me laugh, if it were so necessary, Americans wouldn’t be behind even Turkey in using what we do have. The best form of “mass transit” is actually bus, which requires no govt intervention whatsoever, yet somehow train and subway transit, that will throw off a bunch of construction and union jobs that can be paid off to vote for more govt control every election, are magically the forms of transit that keep being brought up. As for replacing market-based medical insurance with Medicare, yes, by all means, let’s replace a somewhat working system with a completely broken system that’s estimated to have a 10% fraud rate. 😉 Complaining about the miniscule amounts of CEO bonuses in the face of $90 billion of Medicare/Medicaid fraud every year is just silly, particularly with the vast beneficial investments made in new technology and services by the private market.

    Did you ever stop to consider that the reason the private sector isn’t investing as much is because the govt is sucking up all that lending with its deficits and that the private markets are not sure where to invest right now? Not only does it matter whether education and health (safety? really?) are better investments than housing, the truth is that they’re worse investments, two sectors that are already horrifically bloated because of all the past govt involvement. There’s a reason why those two quasi-public sectors grow ever more bloated and suck up a higher share of GDP every year while every other sector gets more efficient, it’s because they’re shielded from market competition by govt regulation and funding. Well, those two cows have been fattened up and they’re about to get butchered. 🙂 Just as the internet has been killing off the fattened up and shielded newspaper and magazine businesses, it’s about to kill off education and medicine too in the coming decade. What you don’t realize is that public funding and protection only make those sectors lazy and inefficient, making them particularly susceptible to being killed off in one fell swoop as new technology comes along.

    I don’t know where you get the delusion that there’s something hard to understand about Keynes’s simplistic point that govt spending will reduce unemployment. I already answered that by pointing out that that assumes that govt knows better than the private sector where those people should be employed, which is obviously not the case. It is not enough to merely “employ” people, they have to be doing something useful. Roosevelt even hired people to dig ditches and then fill them up, the canonical example of such wrong-headed thinking about employment. Unemployment in a free market merely shifts resources from bloated industries like construction or finance to new and better services that people actually want. Redirecting those people to useless and already bloated industries like health and education instead is the worst thing one can do, yet you advocate exactly that.

    What point did I miss about default? You repeat your fallacy and then flatly assert that the point was missed. As I said, the govt “prints” dollars by putting them in bank reserves, which banks can choose not to lend out. In fact, the Fed would have to be fantastically stupid to take the inflationary route out of debt that you suggest, as that would devalue all contracts in this country and would be sure political suicide. Inflating your way out of debt is a relatively rare phenomenon, usually only attempted by failed states and not something the US is going to do. Why keeping the debt ceiling where it is moves us closer to default I have no idea, you continue to make ever loonier statements then ignore that when pointed out.

    The simple and accurate explanation about inflation is not the one you suggest but the one I already made, that there is a great demand for safety right now, hence gold and Treasuries. As I already noted, those rates rose again in response to ballooning govt deficits. You flatly assert that govt-stimulated demand has replaced private demand when it is well-known that much of the “stimulus” money hasn’t even been spent yet. The real answer to why Treasuries continue to sell is because investors know that no matter how many fantastically horrible “Keynesian” decisions the govt continues to make with the money it’s lent, it can always raise taxes in the future to force taxpayers to pay off those stupid debts compiled by idiot politicians and cheerled by people like you. The market is acting rationally to stanch investment in housing and finance and move it to new markets, the problem is that the govt is stepping in and redirecting that flow to its useless constituencies of quasi-public health and education.

  11. Hmm, that first link about education spending should be this one, not sure how it got changed to the CBS one.

  12. Jim Caserta says:

    You should include net stock offerings in addition to corporate borrowings – whether a company is raising funds through equity or debt, they are still raising funds. In 99/00 you had massive stock issuances, while now you may have net buybacks, further depressing current corporate borrowings. Borrowing was probably higher than your measure in 2000, and lower today…still only a partial explanation.

  13. I just read an article that sort of gets at what perhaps seems amiss to me in Keynesian concepts in our global environment — Triffin’s Dilemma — and brings into it a perspective about a global Fed that I did not have before — curiously another of Mr. Mandel’s recent topics. I am not familiar with the writer nor am I in a position to defend or attack, but it is very interesting:

  14. I just read that web of debt link and it’s mostly nonsense. For example, it claims that the US has to keep running debts in order to keep dollars, ie Federal Reserve notes, pumping out as reserve currency, which is just bunkum. The annual growth in federal debt is $500 billion to $1.5 trillion while there are only $50 billion or so in Fed notes issued every year. You could start running govt surpluses and you would still have plenty of ability to monetize the trillions of existing Treasury debt as new Fed notes, if you wanted to. Also, the notion that the dollar is collapsing because gold is skyrocketing is idiotic: most people don’t buy gold, they buy everyday goods, where prices are actually falling, implying a strengthening dollar if anything. The real howler is the claim that contingent liabilities of $60 trillion will be paid off by devaluing the dollar by half. You cannot successfully pay off such future liabilities with a devalued dollar as prices will simply rise to adjust. You can only devalue already existing contracts through inflation, particularly if such contracts don’t take inflation into account by being pegged to some moving index, like CPI or LIBOR. The second half of that article I don’t know as much about because I’m not too familiar with the IMF and their activities with various govts but the part about propping up banks through inflation is also largely nonsense. The problem is that this monetary stuff is complex and even most economists have problems grappling with it, leading to know-nothings like this Brown woman confusing people further with such misleading nonsense.

  15. Hi Everyone,
    Great debate as usual, and as usual I take the view that the fundamental problem is too much money and a consequent overvaluation of assets. The sources of this are Wall Street Money creation through financial innovation, linked in with the China’s development strategy and the boomer bust.

    In the equities market I would expect the only people making any sort of money are now traders. My reading is that P/E ratios are way above historical levels so “dividend” investors are getting very little and any assumption of capital gain looks fanciful.

    In the debt market people would logically be looking at borrowing to purchase assets. If the vast majority of assets are overvalued, then there isn’t going to be a lot of borrowing. Logically then, if borrowing does happen it will be by the government. Governments are not constrained by any need to make a return on their borrowings, they can borrow just to pay wages and “create jobs”. Governments are also able to both print money and extract money from tax payers by force.
    Governments then are the major source of money demand at the moment, and are probably the only ones who can realistically guarantee any sort of return in this overvalued asset market.
    So, government borrowing to “stimulate” and make up for tax revenue shortfalls, is balancing delevereging in the economy, very uneasy place in my view. The real interesting question is what happens next.
    Possible scenarios include:
    Waves of defaults by governments who are constrained in their ability to print and tax leading on to major disruption.
    Governments successfully holding the line (with the support of the international community) until inflation catches up with asset values
    Too early exits by governments leading to a fresh wave of financial sector crashes and a repeat of the current cycle with governments in an even worse fiscal starting position
    Civil unrest brough on by the need of governments to balance budgets through reductions in services and increases in taxes (successful tax collection strikes me as a very delicate balancing act)
    The establishment of governments that are willing to withdraw from the global economic system with its obligations to pay – perhaps even the creation of a complete alternative world economic system (led by China?)
    And, of course (for AJ) the establishment of a complete new world financial order (based on micropayments) where governments are cut out of the game and their gentle collapse is of little interest or importance.

    Of course there must be lots more scenarios (and of course lots of different explanations of where we are, and why).

    All that being said, I think a perfectly valid first step should be to look at the derivatives market as a source of major imbalance and disruption and limit the possibility of the imaginery assets created in that market getting liquidated and the liquidity flowing into more physical markets.

  16. Maybe the rates are low because “animal spirits” are low and almost all other asset classes are expensive or just too risky. You prefer a poor return and an inflation risk to a riskier investment. Remember that all investment decisions are made by humans, and after the crash in 2008 most people are just a bit scared and risk averse.

    I think the long bull market in bonds is over but it might take a few years before rates really start to rise.


  1. […] are government bond yields so low?  (Mandel on Innovation and Growth also Trader’s […]

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