For years, allegedly serious people have been issuing dire warnings about the consequences of large budget deficits — deficits that are overwhelmingly the result of our ongoing economic crisis. In May 2009, Niall Ferguson of Harvard University declared that the “tidal wave of debt issuance” would cause US interest rates to soar. In March last year, Erskine Bowles, the co-chairman of US President Barack Obama’s ill-fated deficit commission, warned that unless action was taken on the deficit soon, “the markets will devastate us,” probably within two years. And so on.
Well, I guess Bowles has a few months left. However, a funny thing happened on the way to the predicted fiscal crisis: Instead of soaring, US borrowing costs have fallen to their lowest level in the nation’s history. And it is not just the US. At this point, every advanced country that borrows in its own currency is able to borrow very cheaply.
The failure of deficits to produce the predicted rise in interest rates is telling us something important about the nature of our economic troubles (and the wisdom, or lack thereof, of the self-appointed guardians of our fiscal virtue). However, before I get there let us talk about those low, low borrowing costs — so low that, in some cases, investors are actually paying governments to hold their money.
For the most part, this is happening with “inflation-protected securities” — bonds whose future repayments are linked to consumer prices so that investors need not fear that their investment will be eroded by inflation. Even with this protection, investors used to demand substantial additional payment. Before the crisis, US 10-year inflation-protected bonds generally paid around 2 percent. Recently the rate on those bonds has been minus 0.6 percent. Investors are willing to pay more to buy these bonds than the amount, adjusted for inflation, that the government will eventually pay in interest and principal.
So investors are, in a sense, offering governments free money for the next 10 years; in fact, they’re willing to pay governments a modest fee for keeping their wealth safe.
Now, those with a vested interest in the fiscal crisis story have made various attempts to explain away the failure of that crisis to materialize. One favorite is the claim that the US Federal Reserve is keeping interest rates artificially low by buying government bonds. That theory was put to the test last summer when the Fed temporarily suspended bond purchases. Many people — including Bill Gross of the giant bond fund Pimco — predicted a rate spike. Nothing happened.
Oh, and pay no attention to the warnings that any day now we will turn into Greece. Countries like Greece, and for that matter Spain, are suffering from their ill-advised decision to give up their own currencies for the euro, which has left them vulnerable in a way that the US just is not.
So what is going on? The main answer is that this is what happens when you have a “deleveraging shock,” in which everyone is trying to pay down debt at the same time. Household borrowing has plunged; businesses are sitting on cash because there is no reason to expand capacity when the sales are not there; and the result is that investors are all dressed up with nowhere to go, or rather no place to put their money. So they are buying government debt, even at very low returns, for lack of alternatives. Moreover, by making money available so cheaply, they are in effect begging governments to issue more debt.