There was once a rough and logical correlation between the level of government borrowing, and the rate of interest on government debt. If the government borrowed more money, the cost of borrowing rose and the private market’s appetite for government debt fell. But that correlation totally broke down around the year 2000:
During the George W. Bush Presidency we saw interest rates remain low, even while borrowing spiked. And during the post-Bush recession we saw borrowing spike to a 30-year high while interest rates crawled lower. During the Obama Presidency, borrowing has inched downward but only to Bush-era levels, and rates have slunk ever lower.
This is weird, counter-intuitive stuff. My logical intuition is that all things being equal, a higher government demand for credit would tend to result in higher borrowing costs. Certainly, there are all manner of other factors like growth, stock prices, growth expectations and the private appetite for debt that might influence interest rates. But given that the intuitive relationship held roughly up ’til the year 2000, it is rather peculiar that it would suddenly break down.
We can explain the lowness of Treasury rates during the Bush years. Treasury rates are strongly correlated with the Federal funds rate:
Greenspan kept the Federal Funds rate low even while large debt-fuelled asset price gains were being recorded in stocks and housing:
Greenspan hiked rates, eventually, but it was too little too late. And a huge debt bubble (defined here in terms of total debt as a percentage of GDP) had formed by the time Bernanke became the Fed Chairman:
Of course, in addition to keeping interest rates at zero, the Fed has expanded its balance sheet by over two trillion, removing Treasuries and various securitised debt from the market, with the intention of further depressing aggregate interest rates. (Although some say that quantitative easing raises interest rates through the expectations channel, the empirical record is clear that every single nation that has engaged in quantitative easing has ended up with lower interest rates following the implementation of that policy).
So the story that prevails is that total debt climbed to an unsustainable level supported by the Federal Reserve’s low-interest policy regime. The divergence of government borrowing levels from government borrowing costs around 2000 was an early warning sign that the markets were filled with distortions. And the 30-year trend of falling interest rates and rising debt was another early warning sign.
In 2008 we hit the Minsky moment, and today we are in the deleveraging phase. The market distortions remain huge — interest rates remain at zero, even while housing and stock prices begin to reflate. The spread between government borrowing costs and government borrowing levels remains huge. And the long, slow grind back to a sustainable debt-to-GDP ratio is slow and depressionary. Japan hit their Minsky moment in the 1990s, and today still remain trapped in the deleveraging phase. While private debt levels have fallen, government debt levels have grown to be the highest in the developed world, and the private sector — encumbered by demographic problems such as a shrinking, ageing population — seems to have little appetite to take on new debt. The Japanese economy remains weak and growthless.
The question that remains unknown is how the distortions will resolve. Will they resolve gradually over a matter of years or decades, or will they resolve quickly and brutally? Well, the speed of private deleveraging tends to suggest that we will not meet another Minsky moment in the immediate future:
While America is nowhere near a sustainable level at well over 240%, at least the trend is downward toward the more-sustainable 1990s, 1980s and 1970s levels. So while the Fed is resorting to more extreme forms of the same policies that fuelled the 00s debt bubble, it is seeming less and less likely that the result — a blowout top in private debt levels, followed by a crushing deflation — will be the same.
Instead, we should probably look to Japan where the economy has remained depressed and weak for the past twenty years, and where government debt has through cycles of stimulus and austerity replaced the private deleveraging. Perhaps Japan is an extreme example, and perhaps its demographic woes have prolonged its malaise. Perhaps that means that once the United States private debt level shrinks to a more sustainable level, the United States will enjoy solid new growth, rather than continued depression. Perhaps a new technological or energy revolution will result in falling energy and transport costs, providing America with a new growth engine for the next twenty years. Perhaps we can look at the low interest rate environment as an opportunity to invest in transport infrastructure, energy infrastructure and basic research and create a backbone for the post-depressionary economy. On the other hand, perhaps a new crisis — and one that won’t go away just by throwing money at it, like a natural disaster, or a war — will suck America into an even deeper depression.
I am more optimistic than I was five years ago, or even one year ago. I can see a light at the end of the tunnel, but is still possible that this crisis may end in war or total systemic failure.
In the long run, the data is clear. The Greenspan-Bernanke era Federal Reserve wilfully built up bubbles and distortions, which grew out of control, and sucked the economy into a black hole. At the very best, this has led to a Japanese-style depression.