The Downward Spiral

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:

fredgraph (18)

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.

67 thoughts on “The Downward Spiral

  1. Actually, looking at your original graph, it looks like big spikes in govt. spending are not associated with big spikes in interest rates.

    Also, your rates are nominal. Try real rates.

    • Actually, looking at your original graph, it looks like big spikes in govt. spending are not associated with big spikes in interest rates.

      That’s true… Forget my original graph, and look at World War 2, in which rates fell to a trough in 1946 even as public debt soared to an all-time GDP-adjusted high. With the Fed as a partner, the Treasury department very successfully managed the costs of borrowing. Which has been what has happened since 2008 (arguably even since the dotcom bubble burst), and what has happened in Japan since the 1990s. Empirically, it’s very clear that more government borrowing does not necessarily lead to higher borrowing costs. The interesting part is trying to disentangle the differences between when it does and when it doesn’t.

      Also, your rates are nominal. Try real rates

      Yeah, I mean I am less keen to adjust for inflation on this particular metric simply because CPI-U or PCE is not particularly relevant to the interests of, say, the PBOC etc who have a totally different basket of costs than an average urban consumer. But let’s do it anyway:

      What you get is a tighter relationship that exists to this day. While correlation is not causation, that suggests that real rates on Treasuries could significantly rise with more government borrowing (say if we returned to 2010 levels of debt growth). What this data,of course, reveals, is that Obama and Congress are cutting the deficit in very much the way Clinton did. Given the obvious demand for Federal debt from the market (and given other variables, like unemployment), I find this rather surprising…

      • Gosh, John! Please share whatever you are drinking that makes you see “Obama and Congress are cutting the deficit in very much the way Clinton* did”!

        * Clinton finally agreed to compromise with Speaker Gingrich, and, thanks to press bias as now, got all the credit.

        • I said John was a little premature with his praise for Obama. Most of the reductions are spread over ten years… I guess John is ten years ahead of himself… I think John must of been thinking of the Clinton now Obama tax increases….

        • Gosh, John! Please share whatever you are drinking that makes you see “Obama and Congress are cutting the deficit in very much the way Clinton* did”!

          The deficit is reducing, both in absolute terms and as a percentage of GDP:

          That may be as much an artefact of GDP rising as it is one of Congress no longer increasing spending. Please don’t take this as praise for Obama or Congress. It’s just a factual observation.

      • This is excellent analysis… Politically the comparison to the Clinton years is a little premature… Clinton and Congress passed 8 budgets. Obama and Congress have passed 0 budgets. The US Government is being funded by “Joint Continuing Resolutions” that by design tend to slow the growth in government spending largely due to baseline budgeting and that the resolutions are short term spurring several spending debates each year. During periods of crisis and/or slow or no economic growth the extra oversight this process entails may work better. Political downside in process is both sides have more opportunity to vilify each other that I believe creates negative consumer/business confidence. Obama has been masterful at managing his political standing by telling his supporters that Congress does nothing and is gridlocked and then he quietly takes credit for spending reductions.

    • I = V*(1-u) interest = velocity times debt

      Therefore, dI/d(debt) = V. When velocity is low, as now, interest is relatively lest responsive to debt increase.

  2. It’s worth noting that both the ‘growth-engine’ concepts you have introduced – tech being the equivalent of 3D printing, and energy being the equivalent of solar power – are driving forces for high-level complex systems ‘decentralization’. Any concept that drives decentralization in today’s complex society will drive net-positive change throughout the system and resulting in higher productive capabilities. As a society we must spend less, and produce more….it’s pretty simple.

    I believe the decentralization dark-horse that not many people are thinking about will be Bitcoin.

    • “As a society we must spend less, and produce more….it’s pretty simple.”

      Those who control “society” have convinced people that economics is a macro- situation, where the reality for the individual [99.999999….%] is that this is not the case at all.

      Just as time is the wildcard that trips-up everybody’s thinking when it comes to the three dimensional world, converting economics from its natural relationship between one producer and one consumer allows all kinds of variables to distort/change the meaning of value, its manifestation being that those who garner the highest reimbursements for their efforts produce little to no wealth.

      The smartest people on this planet are engaged in finding ever more inventive ways of turning “a” into “b,” i.e., convincing people that their best interests are served by supporting [knowingly or not] the few at the top [e.g., suggesting the Earth will implode if the TBTF banks fail, etc.].

      Spending and producing on an individual level is something so elementary, that every five-year-old learns the first time they take their shiny quarter to the candy store and find out that it will only but x amount of candy.

      When economics is raised above this level [of the individual], then the transmutations begin until you are left with a society of adults who go into the candy store with their shiny quarter and walk out with the deed to the building [and debt for life].

    • Decentralisation is compelling. But transport costs have to reduce.

      You can not run off the grid, when you factor in air conditioning or heating. Base load has to be supplied to decentralised communities.

      Unless you mandate super efficient housing it won’t work. How do you cater to the housing that is heritage listed?

      I think a major start is the recycling of vehicles. Many cars are scrapped when they can be repainted and refurbished and restored by many unskilled workers (A form of manufacturing). This would have to be the biggest waste of resources in the world. You never hear of tearing down houses and rebuilding after 5 years. Restoration is the solution to a lot of our problems.

      This will result in rationalisation of the vehicle industry (Natural decay and replacement), but it needs to happen.

      • De-centralization, or, perhaps better termed, re-individualization, is an interesting process. Re-reacquiring the [economic] self, in an material or intellectual sense, needs to take place in close relationship to the giving up of the ego-self.

        It is our ego’s that have abandoned us in latching on to that which exists completely outside of ourselves, to the point where our ego has been manipulated into doing that which is completely outside of our acknowledged interests.

        Rectifying this situation involves giving up the ‘something for nothing’ chimera that so many have sunk their very essence into, an illusion that its contemporary creators are attempting to to sustain [the debt-driven, counterfeit laced, non-market based economy].

        As is always the case, it is with the realization that this illusion is [like all things] impermanent, that the healing begins, and people move on in order to re-capture a more functional sense of [economic] self, beginning the process of repairing [de-centralizing] their economic relationships, hopefully getting as close as they can to the ideal [one to one].

        • It could be that the drivers of the system planned the crisis so they can further consolidate and centralize power. One world government might be the goal.

  3. Since the 1880’s interest rates have run in approximately 30-40 year cycles. From the mdi 1960’s/1970 to 2005-2007 interest rates were above 5%. From the mid 1920’s to the mid 1960s interest rates were below 5%. The last time debt was built up was the 1930s to end of the 1940s, coinciding with low rates. Rates did not rise after the debt.

    I expect interest rates to stay below 5% until the 2030s. No matter what fundamentals state.

    • I expect interest rates to stay below 5% until the 2030s. No matter what fundamentals state.

      I tend to agree with this assertion… Obviously a black swan could change everything, but that’s the trend.

  4. “I am more optimistic than I was five years ago, or even one year ago”
    “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.”

    Define “optimistic”.

    • A year ago, I didn’t think that solar costs may soon be cheaper than fossil fuels. Today, I think it’s a good shot. Today, I think that the new decentralised model — internet for decentralised information, 3D printing as decentralised manufacturing, solar, wind for decentralised energy — is really a light at the end of the tunnel.

      • Decentralization of information, energy and things: I must remain a skeptic on energy and goods (raw material/fertilizer/etc., equipment, components, semi-finished materials, products, etc.), even if you hypothecate a very long time. The magical (to me) manipulation of electrons and photons involves little energy or mass; mining ores and making finished metals, for example, is quite different!

      • I recently saw basically a home wind power kit that was about $1200 including the inverter. 5 years ago the inverter alone would have set you back $3K! We have come a LONG way.

        • You can make one for virtually free. Google smart drive motor wind generator or go on youtube.

          You buy a $50 controller that stops the battery over charging, then run everything possible on 12 volt, using an inverter for short term high load divices (Toaster, Microwave, Hair dryer etc)

  5. We know that the US government is borrowing huge amounts of money. We also know it will not stop, yields are falling…but people are still investing and loaning to the US. It just takes a panic to start for people to realize they will never get paid, the dollar is worthless and they could start dumping US debt. It can happen and it becomes more likely as time goes on.

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  7. Who are having the most of the money/capitals in the world? The riche people. So isn’t low to zero interest rate affect them the most? And where are the money coming from to pay interest?

    Poor people may be affected most by inflation but the rich people are affected by both low interest rate and inflation on their bank accounts. So the richest people must invest their money into the economy help to create jobs and growth. No, actually the people who are somewhere in the middle and lower middle get hit the most. They are going to be reduced to poor from well to do level because zero interest rate and inflation. So middle class will be wipe out.

    It’s all about the balance act. It needs people who has the right vision and the ability to see the big picture and know how to organize the all the moving parts according to the priorities.

    • These people with the ability to manage the economy do not exist, but only in their own mind.

      Google “hubris”.

  8. “…once the United States private debt level shrinks to a more sustainable level, the United States will enjoy solid new growth…”

    Considering how banks operate (loans creating deposits, money created out of thin air, etc.), this statement is highly optimistic. For every dollar of private loan principal reduction, there is one dollar removed from the economy. That’s not theory; it’s fundamental reality.

    As Steve Keen has claimed, and mathematically proven:
    (Aggregate Demand) = Income + (Change in Debt)

    Taking the first derivative one can see that, assuming stagnate national income, an increasing aggregate demand requires an accelerating level of debt. So, any net reduction in debt reduces aggregate demand!

    • Aggregate demand is just another ill defined load of Keynes.

      The Treasury could, today, do the following:

      1. Issue demurrage currency sufficient to pay the entire federal budget;
      2. Pay down the public debt with the revenue stream from the demurrage, thereby lowering the price level;
      3. Issue zero interest bonds to pay down the public debt; these bonds would appreciate in value. Investors would buy them because all the appreciating non-demurrage currency would vanish into mattresses by Gresham’s Law; the proceeds from these bond sales could further pay down the public debt.
      4. The demurrage currency would circulate with a high velocity and furnish plenty sufficient aggregate demand to give everyone a decent job.

      I wonder what Keynes would say about “credit acceleration”. Keynes himself said of inflation –

      By a continuing process of inflation, government can confiscate, secretly and unobserved, an important part of the wealth of their citizens.
      John Maynard Keynes

      • The national debt and deficit strike me as being total and complete non-problems. That is government and central bank could easily print money and pay off substantial chunks of debt and reduce it to nothing in a few years. The inflationary effect of that would need to be countered with a bit of tax increase, but not all that much.

        So I think I agree with some of what you are saying. However: can you clarify? In particular, what do you mean by “demurrage currency”? If you mean money that cannot be immediately spent, that’s no different to government debt, is it?

        • Demurrage currency is stamp money. To keep it current, the holder must affix a stamp to it every month or so. A stamp costs 1% or so of the face value. It is a pay as you go way of borrowing from the future. The government doesn’t go into debt in order to issue it.

          The “value” of ordinary non-demurrage currency is secured by a debt which no one believes anymore will ever be paid.

    • If someone maxes out their credit card in New York and goes bankrupt, does a waitress in Hong Kong, buy a new apartment?

  9. “This crisis may end up in war or systemic failure”: Is anyone making book/setting odds on which is more likely? Depending on how it’s defined, “systemic” failure is inevitable. How big a conflict qualifies as “war”? Which nation capable of starting a real war would have reason to do it? US, Russia, China? Even if you include Israel, Iran, North Korea?

  10. There is no reason why deleveraging need be deflationary.

    Obviously if all and sundry decide to delever, then all else equal the effect is deflationary. But there’s nothing to stop government printing new money and spending it into the economy to compensate. (And if anyone doesn’t like the phrase “print money”, they can replace it with “fiscal stimulus followed by QE”. Comes to the same thing.)

    Re distortions, while I don’t approve of governments or central banks manipulating interest rates, the total amount of distortion brought about by rates being say 2% lower than free market rates is not all that much. Reason is that there are a huge number of costs involved in any capital expenditure (associated labour costs, energy costs, depreciation, etc). Thus the net effect of the above 2% is small, I think.

    • If you add money into a static system [leveraging, therefore increasing asset prices], then by definition, you have inflation. It would then make sense that the same principle would apply to de-lerveraging. De-leveraging is simply dispensing with debt [money] within an static asset class [deflation].

      We have had 100 years of inflation that has completely screwed up the economic relationships that one refers to as the economy. Until you ring a good deal of this out of the system, nothing will work [properly].

      And, RM, how did you come up with 2% as an amount that interest rates are skewed from what a market might set them? I would suggest that interest rates should be in the 15% range considering what’s going on.

      • “If you add money into a static system [leveraging, therefore increasing asset prices], then by definition, you have inflation.” Nope. Not if there are enough unutilised or unemployed resources: e.g. large numbers of people willing to produce stuff in exchange for the extra money.

        In contrast, if the economy is at capacity, that’s a different matter. The result WILL BE inflation (i.e. rapid price increases).

        “We have had 100 years of inflation that has completely screwed up the economic relationships…”. Real living standards have improved dramatically over the last hundred years. In fact they’ve improved faster than at any time since humans appeared on planet Earth. I don’t see the problem.

        Re the 2% and 15% point, my 2% was just a guess. I can’t think of a way of proving what the exact figure is.

        • RM, to your first retort, there is tremendous unused capacity in the economy today, yet asset inflation exists. How do you explain this?

          Inflation is an increase in money and credit relative to assets. No?

          Secondly, yes, real living standards have increased over the past 100 years due to tremendous increases in productivity. Since the 60’s, real incomes have gone down for the vast majority, so whereas you might regal in your gadgetry, real living standards have decreased [cost of necessities increased in real terms].

          As far as interest rates are concerned, in an inflationary period such as the one we are now immersed, interest rates are more or less a measure of such. Only in a command [or manipulated] economy can you have this kind of money printing AND ZIRP.

          In other words, let’s say that the Fed kept up its money printing [bond buying], but only for government securities and left other markets to fend for themselves. Would you have private mortgage markets at 2.75% fixed 30yr loans? Who would be stupid enough to invest money in such a thing? Nobody, but at 5%? 10%? !5%? Perhaps.

  11. Much is reported in American press regarding US debt owned by China and the FED. Seldom mentioned is debt held by US government purchased with Social Security fund, Federal retirement money, Savings bonds and Freddie Mac/Fanny Mae. (attached pie chart) Additionally US has State, Local and Teacher retirement liabilities. With dim prospects for real economic growth, slow growth in employment/wadges (FICA taxes) is this the most likely “Black Swan”

    On Thu, Feb 28, 2013 at 10:28 AM, azizonomics

    • Sovereign debt is much like your wife/girlfriend telling you this, but meaning THAT. Nobody in government has ever worried about paying back debt because they have two other options, one being default, which happens so often that nobody takes money very seriously anymore, and secondly, if you happen to be lucky [or unlucky] enough to have the reserve currency, then you can simply print to your hearts content [or at least until you defer to option 1].

      Government is unlike any other institution in that it pretty much does whatever it wants, depending on who is pulling the strings. Beyond the string pullers [in this current (and most) cases, the bankers], changing governments, especially in the established Western democracies is not such a easy task, not technically, but instead, psychologically.

      Once the population gets on board with the idea that personal debt should be approached much like sovereign debt, that is, paid if and only if it makes sense, then the bankers lose much of their power.

      The money “borrowed” from all of the trust funds was not borrowed, but stolen. It is gone, out-of-there, good-bye…forever. It was transferred to all the interests that just can’t get enough of other people’s money, that is, pretty much everybody.

      Once you move away from the relationship of one individual producing and one consuming, it ALWAYS goes bad, the variable simply being time.

      • Many Americans noticed this when real estate was leverage to buy new cars and pay for vacations only to have the debtor drive away from the debt. We don’t have a budget gap, we have a responsibility gap and government shows us the way….

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  13. I am more optimistic about the US than I am about Europe(no chance over there). I think one key factor was running deficits during the boom that really screwed over the US. If you were running a 5% surplus with no government debt in 2007, you’d have a lot more room for fiscal stimulus to prop up demand while the private sector was deleveraging. I think the key thing about deleveragings is to hold everything together until the debts can be reset, which the US seems to be doing. Japan never actually delevered; their total debt/GDP ratio is higher now than it was in 1990. The US, on the other hand, has a falling total debt/income ratio. The key thing for the US now is to make sure that you don’t end up turning a private debt crisis into a sovereign debt crisis.

    • Governments should only borrow to spend on nation building projects because they have a lower cost of capital (Risk free rate). Everybody should have a living payment to prevent hunger and homelessness, and everybody should do civic service in return for that safety net payment.

      Everything else spent on by Government should be done to take the heat out of over investment/rampant speculation, and to maintain surpluses where possible, building a national treasury for national disasters.

      Keynesian economics only worked in Third Reich Germany. Because as Keynes astutely observed, it works better in a Dictatorship. Can you imagine a family household shopping budget being dictated by the children? No Father or Mother decides.

      • “Everybody should have a living payment to prevent hunger and homelessness, and everybody should do civic service in return for that safety net payment.”

        This is the democratic socialist’s mantra, or more aptly put, their intellectual penance for participating in a system that creates tremendous disparities in wealth.

        Without the state-sponsored mechanisms in place that allow for such gargantuan transfers in labor-value earned, poverty would not be seen as mis[sed]-fortune, but instead as a common problem to be dealt with through individual efforts, but NEVER through the “haves” transferring part of their haul back to those from whom it was taken in the first place.

        • In a truly free market economy with limited labour laws, turnover of the labour force would be high, but as a result anxiety among the populace would increase. With a living wage, and I mean basic living (You have to work to afford cigarettes booze and gambling, unlike the EBT card today) the anxiety of job loss is not so great. Hobos and the homeless would at least sweep the street, sweep the parks of leaves, remove grafitti etc.

      • Keynesian economics works everywhere. It was actually first used in the Western world during World War II to control inflation, not to get the world out of a depression. The compulsory savings that took place in World War II allowed the private sector balance sheets to be repaired while all of the spending and price controls created pent-up demand. Once the war controls were removed, all that pent-up demand was unleashed while the private sector balance sheets were repaired creating a massive boom. Keynesian economics was used to control inflation before it was used to treat depressions.

        Keynesian economics was never actually used or followed over the past 40 years. Since when is running deficits in the largest debt bubble in world history Keynesian? Since when do you just let a massive investment boom take place while you simultaneously have the development of a massive financial sector where the average person is getting screwed. Keynes hated debt and he hated people that lived purely off of other people’s debts. He calls it the “euthanasia of the rentier”. Keynes actually understood the destabilizing role of debt and talked about investment booms that “carry within them the seeds of their own destruction. Keynes actually wrote a whole book about how debts across the world should be written down and reset after World War I, but no modern “Keynesians” ever talk about restructuring debts–they just talk about how every problem can be solved by deficits(which is not possible, of course).

  14. The economy is an ecosystem, inputs, outputs internal and external feedback loops etc. Human interacting and behaving. Yes individuals should be sovereign and as long as they do not harm anyone or encroach on them or their property and they do everything they have agreed to do, they are free from government interference (Governments should just protect individuals from encroaching on one another), but a moral philosophy would also teach the individuals to voluntarily help their friends, neighbors and communities, or those who might have fallen on hard times. As long as there is no force or coercion.

    It is crazy that we supposedly allow our governments to take out debts that will be paid by future generations. This is not how contracts work in a free society…you cannot get others to pay your debts without their consent. There is no logic to this practice.

    • Socialists don’t believe in morals with a divine base or reference book, so they need the State to manage society. Why do you think the hardest criminals came out of the ex Soviet Union? Because the moral fibre was decimated, when the Socialists destroyed Churches. Could you imagine the Islamo Fascists destroying Synagogues in Israel?

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