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.