The history of interest rates shows that during the Great Depression when there was a 2% annual deflation and that real Treasury rates were about 4%. Real rates were about 2% before the GFC of 2008. Are rates too low, if one uses the 1930’s as a benchmark? Not necessarily.
In the 1930’s the Federal Reserve was only 20 years old and had its credibility damaged by the great crash. The political risk was that Roosevelt, with an attempt by him to have a 100% income tax rate on high incomes, was moving the country to socialism with the risk that private property would be seized. Investors and economists may have felt that the government’s finances were not as strong as a modern G7 country with a “print and pay currency” and instead they felt the government debt should be treated as risky as an obscure EM country or treated like household debt. The difference between household budgets versus a G7 sovereign budget is that when a government has deficit spending in a recession it may be possible to stimulate the economy and then the stimulation, by raising taxable income, enables the government to recover from issuing excess debt. In some cases, if a government has sufficient gravitas then people believe in its “print and pay currency” and will actually accept a low yield on government debt because it is safer and more liquid than other bonds. This is the “crowding-in” theory where investors fleeing a sinking ship crowd in to a lifeboat and are glad to pay a high price for a seat on the Treasury bond lifeboat. (High bond prices mean low yields).
In modern times global investors accept these theories, but in the dark days of 1933 they may have been reluctant to trust the government or to have sufficient faith in the government to respect the idea that the nature of government debt can morph into an almost magical “print and pay currency” type of debt which can help the economy in some counterintuitive ways.
This means that capital markets were justified in having very high real rates in the 1930’s and thus in modern times people should be careful not to leap to conclusions by saying that rates are now lower than the 1930’s so yields are not correct. Yields are low today because there is a flood of foreign flight capital, a huge risk of a global recession caused by too much debt and too many shaky, debt-fueled economic systems like the EU or China or Japan that lack demand.
In modern times people have recent memories of the high rate era of 1970’s and 1980’s that lasted until 1995. Thus people have a mental benchmark that rates “should” be in the high single digits. However, the average real rate for the ten year Treasury was 2.07% for the 20th century. If the 1930’s were to occur today since people have more faith in central banking and “print and pay currency”, etc. then instead of the high real rates of the 1930’s then real rates would be lower than today, probably closer to the German yield lows of 2016 where the ten year bund was close to zero.
The paradox is that business managers, who one might look to for a source of growth, will not expand their company simply because of the lure of low rates. Instead, they are more likely to respond to fiscal policy or to changes in macroeconomic conditions that are more business friendly. Thus rates are low because of crowding-in and not because of central banks. This is true even though central banks have a higher degree of gravitas now than in 1932 so the country enjoys the magic of “print and pay currency” and debt issuance.
My point about interest rates is that people need to recalibrate the meaning of low rates. Eras that are pre-industrial or pre-fractional reserve banking eras are very difficult to compare to modern times. In the first century or so of industrialization people didn’t believe in “print and pay currency” or central bank gravitas and thus viewed a G7 government as on the same footing as a household that is susceptible to having issued too much debt and thus the capital markets charged these nation states with a higher risk premium during a depression. By comparing today’s respect for modern central bank institutions versus the doubts of the 1930’s one can see that there should be a lower rate charged for sovereign debt today than in the 1930’s because the sovereigns have moved from being like a weak EM country to a modern Developed country with a reliable elastic currency that may be able to benefit from moderate increases of issuance of debt.
The “print and pay currency” concept and the idea that a government’s budget is not the same as a household are reasons why governments with gravitas can indulge in what the French called an “Exorbitant privilege” of using printed money to do things that are counterintuitive to the expectations of what household and corporate financial planning would do. However, this too has its limits. Surely at some point as debts grow faster than GDP then the “print and pay currency” system becomes unsustainable. To a certain extent what is happening is that the socialization of finance is like a diversified investment portfolio that in theory gets an extra boost to investment returns over what the sum of the individual components would provide. The great danger is that people may be tempted to overestimate the power of this counterintuitive phenomenon and rely on it too much until it collapses from overuse. The risk is that since people like to look at past results and try to project that to the future then people may be looking at the great growth of stocks and debt over 20 years and assume that it will grow problem free to infinity. (Remember that past results are no guarantee of future performance).
It is possible that the end point of the placebo’s usefulness is near. Assuming that central bank actions to stimulate the economy only worked during the easy to fix small recessions, and only worked when they were coming down 5% from a rate that was at 6% or higher then perhaps we are already on the edge of the limit of the placebo’s efficacy and won’t get a placebo effect during the next crisis.
Since the 1930’s each crisis has provoked the authorities to improve and heal the financial system. Much of the success came as a result of the placebo-like magic of “print and pay currency” and “crowding-in” (where the worse things get the more people crowd into Treasuries thus making rates go down). These things couldn’t work (and hadn’t been developed) during the EM-like period of extreme political distress of 1933. These tools reached their high point during the 2009-2014 era of Quantitative Easing.
I feel that since savers were hurt by the confiscatory, deflationary nature of QE then during the next huge crash that uses QE they may reject the hypnotic or placebo-like aspects of these modern financial tools. If enough people dislike and distrust the placebo then word will get out to avoid it and the placebo won’t work. This means that government debt will stop being different from household debt and suddenly it will be harmful to the economy. That will make G7 government debt on a somewhat equal footing to EM countries, in which case “print and pay currency” wouldn’t work and Treasury market crowding-in won’t happen.
In Hong Kong recently there were days when the Yuan had a very high overnight interest rate offered by China’s central bank, so as to stop short sellers and speculators. Imagine if this happened to the U.S. at the same time the Federal Reserve was trying to fix a deep crash then they would be stuck between a choice to support the dollar with a hard money, high rate policy, causing a recession, or do the opposite to stimulate the economy, causing devaluation.
In summary, real rates are not excessively low, however the modern era of central bank gravitas, “Print & Pay” G7 financing, and crowding-in are phenomena that could lose their efficacy, like an overused placebo, leading to failure of the placebo during the next crisis. This would include creating a return to the 1930’s-like conditions where a lesser degree of respect for issuers of G7 sovereign debt would justify a higher real yield (due to a higher risk premium) for sovereign bonds.
The possibility exists that asset prices of risk-on assets were inflated by these monetary phenomena and when the placebo loses its effectiveness (somewhat like in Japan where gigantic debts have not yet made stocks recover to the halfway point from their bubble top of 1990) then no amount of central bank stimulus or Print & Pay deficit spending fiscal stimulus will be able to reflate the risk-on asset markets in any country. Therefor investors should allocate significant assets to low duration investment grade bonds and wait for a crash in stocks. Investors need independent financial advice about the risks of being fooled by central bank sponsored bubbles.