Today the yield on US Treasury 1-year bonds fell to 2.50%. Three months ago, it was above 3.25%. In April, it had actually peaked at 4%. A falling interest rate means that investors are worried about the long-term economic outlook of the United States. Many people have been arguing for months that we must begin reducing the deficit to improve investor confidence; it has gotten to the point where this is conventional wisdom. Except, that’s not why investors are saying they’re worried.

On August 1st, the Wall Street Journal ran this story about why investors were becoming worried. In short, a stalling economic recovery and fears about deflation. In other words, another Great Depression. The investors interviewed in this article were clear that they were only preparing for the worst and that it might not happen. However, today Bloomberg reported that capital spending declined in July. In addition, within the past month the Presidents of the St. Louis and Boston Federal Reserve Banks have both made it clear that they’re worried about deflation; the current inflation rate is only about 1%.

So how do you deal with a stalled economic recovery and potential deflation? Paul Krugman provides an explanation:

In normal times, we believe that more saving, private or public, leads to more investment, because it frees up funds. But for that story to work, you have to have some channel through which higher savings increase the incentive to invest. And the way it works in practice, in good times, is that higher savings allow the Fed to cut interest rates, making capital cheaper, and hence on to investment.
But right now we’re up against the zero lower bound — yes, I’ll get the usual complaints about how long-term rates aren’t zero, but the Fed doesn’t have direct control over those rates — so this normal channel doesn’t work.

And what that means is that if people — or the government — try to save more, they only end up depressing the economy. And the weaker economy leads to lower, not higher investment. And this in turn means that attempts to save more don’t help our future prospects. On the contrary, they reduce the economy’s future growth.

The last paragraph is the key to this debate, at least for Krugman’s argument. Increasing the deficit further could very well be dangerous, which is why short-term deficit spending is needed.

Of course, right now the bond rate is about expectations: investors expect low or stagnated growth and low inflation or deflation. The situation could be much worse; if the bond rate skyrockets, it means the US Treasury cannot find investors to buy bonds. In other words, the government can no longer borrow money. This is, incidentally, what has happened to Ireland since it implemented its severe austerity program. Krugman’s argument is based on what is actually happening: austerity now in Ireland means higher long-term deficits.

I personally think that we should at least be paying attention to what investors are saying.

2 Responses to 2.50%

  1. JoeS says:

    “Increasing the deficit further could very well be dangerous, which is why short-term deficit spending is needed.”

    I expect you have some reversed in this statement, you may want to clarify.

    One of the problems that occured earlier in this decade was the combination of greatly expanding “free trade” agreements and the lack of savings by the citizens. This combination led to annual trade deficits that exceeded $700B for three years running. For over $2B of wealth we got a lot of low-priced items from these countries, but we sacrificed our jobs and future wealth in the process.

    Spending to get more low-priced goods from China and elsewhere will do us no good and may further increase the federal deficit or erode our savings. Federal spending on infrastructure, green jobs and alternative energy may on the other hand help restore the middle class.

  2. Andrew says:

    I was just reiterating what Krugman had written, but here’s my understanding in more detail. But first I should correct a typo. That should read: “Increasing the debt further…” Right now, the economy is depressed, which is greatly depressing tax revenues. The federal government can only cut so much before they are forced to cut programs citizens will not allow to be cut, whether it be social security, Medicare, or defense. Though actually right now the big cost is unemployment benefits.

    If this situation does not change, the government will continue to run deficits. And, as I think everyone realizes, the economy isn’t even close to a recovery. Now, the government could cut off unemployment benefits, which would help with the current deficit. But this seems both cruel and indefensible when you consider that there are 5 unemployed individuals for every available job, and that the unemployment numbers don’t include the underemployed. It’s not the fault of these individuals that they lost their jobs.

    The federal government should have passed a larger, and much better designed, stimulus package back in 2009, but it didn’t. If it wants the economy to recover anytime soon, it must pass another. The amount this would add to the debt would be negligible compared to the cumulative deficits of the next decade due to an economy that has not recovered. Not only would it generate tax revenues, but it would reduce the amount of unemployment benefits that the government would have to pay. You can think of it as an investment in the future economic health of the country.

    To add to what you wrote after your request, there was an additional problem. The only way that consumption kept up with production was that everyone turned their houses into banks. Our consumption rate would have been below the actual rate of production if so many Americans had not mortgaged their houses.

    This speaks to the massive upward transfer of wealth over the past 30 years, where average worker wages have stagnated (and in some demographics decreased when adjusted for inflation), while average CEO salaries have increased by an order of magnitude. This should have led to reduced demand, but as I said above, people kept their standards of living high by mortgaging their houses.

    That’s one of the ironies of the 2008 campaign. Senator McCain and Governor Palin criticized then-Senator Obama for “wanting to spread the wealth around.” Except what they weren’t saying is that the Republicans, and the Democrats under Clinton, had presided over a massive transfer of wealth upward that led to a very tenuous situation with regards to our ability to grow our economy. Obama simply wanted to restore the earlier balance that had allowed for significant growth by ensuring that demand kept up with production rates.