Mises Daily Articles
The Demise of the Interest Rate
Eugen von Böhm-Bawerk (1851–1914) expressed concern that the interest rate might not get rid of its "moral shade" ("moralischer Schatten").1 Indeed, people have actually been looking upon the interest rate phenomenon with animosity for centuries. Back in the middle ages those who dealt with money lending tended to be exposed to heavy discrimination by their fellow people.
In the more recent past, totalitarian systems did all they could to do away with the interest rate. Communism, for instance, abolished loans and payment of interest altogether; and the German Nazi's programmatic objective, from the 1920s to the early 1930s, was the breaking of interest rate slavery ("Brechung der Zinsknechtschaft").2
Even today, in the so-called "free western world," the interest rate's moral shade has not been fully vanished. The interest rate is usually seen as an obstacle to growth. Ludwig von Mises wrote: "It is a fact that today measures aimed at lowering the rate of interest are generally considered highly desirable and that credit expansion is viewed as the efficacious means for the attainment of this end."3 Indeed, "low" interest rates are widely perceived as being conducive for creating output and employment gains.
Central banks—the suppliers of government's monopoly paper money—are regularly called upon to force, e.g. keep, short-term interest rates to the lowest levels possible.4
So it was widely hailed when central banks around the world lowered interest rates to record lows following the collapse of the "New Economy"-hype in 2000. From the point of view of the Austrian School of economics, though, this appears to be a doubtful policy reaction to policy mistakes committed in the past: "The boom can last only as long as the credit expansion progresses at an ever-accelerated pace. The boom comes to an end as soon as additional quantities of fiduciary media are no longer thrown upon the loan market. But it could not last forever even if inflation and credit expansion were to go on endlessly. It would then encounter the barriers which prevent the boundless expansion of circulation credit. It would lead to the crack-up boom and the breakdown of the whole monetary system."5
With this in mind it is particularly interesting to take a look at price action in international bond markets. Figure 1 (a) shows the government long-bond nominal yields of the US, Japan and Germany from the early 1960s to June 2005. The yield for 10-year US Treasuries is currently 3.95%, for German government bonds (Bunds) 3.1%, and for Japanese 10-year government bonds the return is just 1.21%. What is more, bond yields in real terms (that is 10-year nominal yields minus current consumer price inflation) have declined to their lowest levels in decades since the middle of the 1990s (see Figure 1 (b)).
The low level of long-term rates in major markets has taken many market participants by surprise, especially so as economic data for the last two years showed fairly strong growth on a global scale. The surprise is even stronger as the world's leading central bank, the US Federal Reserve (Fed), has begun tightening interest rates back in June 2004—a policy action which, at least in the past, has tended to exert upward pressure on international long-term interest rates.6
To shed some more light on the information contained in bond yields, it seems appropriate to start with the Irving Fisher (1867–1947) decomposition of nominal interest rates.7 Fisher's approach suggests that the nominal market yield consists of (i) a real interest rate, (ii) a compensation for (expected) inflation and (iii) a risk premium (for a more formal explanation, see the comment below Figure 2).
It is important to note that bonds, like any other tradable financial asset, are priced according to market agents' expectations held at a certain point in time. Not current data but expected future data play a crucial role for the pricing of bond yields. When making buying and selling decisions, investors tend to form a view about growth, inflation and other factors (risk, liquidity, etc.) over the maturity of the respective bond.
Usually, markets' expectations cannot be measured directly, so that the information content of asset prices is hard to extract. However, "inflation protected securities," or "inflation indexed bonds," which are traded in financial markets, provide valuable insights. These instruments allow investors to track a bond's real yield and, when comparing these bonds with "traditional" nominal coupon bearing bonds, markets' inflation expectations (as approximated by the so-called "Break-Even" inflation).
Figure 2 (a) and (b) show that bond markets' inflation expectations (as far as consumer price index changes are concerned) have remained relatively tame in recent years. In fact, they have remained fairly close to levels which the US Fed and the European Central Bank (ECB) would consider as price stability, respectively. To put it differently: investors find the price stability promise given by central banks credible—otherwise inflation expectation would be trading at different levels.
The legends show the real coupon of the respective bonds, followed by the data of maturity. The nominal yield of a bond, , can be decomposed as follows: , whereas = real rate component, = inflation expectation and = risk premium. The so-called "Break-even"-inflation, which can be interpreted as being associated with market agents' inflation expectations, can be calculated according to the following formula: .
Figure 2 (c) and (d) show the "real return component" of inflation indexed bond yields in the US and the euro area. In both currency areas real yields have nosedived since around the beginning of 2000 and the middle of 2001, respectively. In the US, 10-year real yields are currently trading only slightly above 1.0%, and in the euro area real yields are trading even a notch below US-American levels.
The findings above suggest that the decline in long-bond yields in the last years has actually been brought about by a decline in the real yield component rather than a downward "level shift" in market agents' inflation expectations. This is quite a challenging finding, as it leads straightaway to the question about the origin and the determinants of the real market yield.
When it comes to bond markets, the long-term (real) yield can be thought of being a geometric average of the expected future path of (real) short-term interest rates. For instance, a 10-year bond investment can be duplicated by ten successive 1-year investments. In an arbitrage free market, both investment strategies should yield the same outcome.
Short-term interest rates, in turn, are set by monetary policy. It has become common practice that central banks tend to lower (raise) interest rates whenever economic growth and employment are below (above) levels seen desirable from the point of view of monetary policy. So a finding that long-term inflation expectations are relatively benign and, at the same time, long-term real yields are fairly low would suggest that investors don't expect an increase in official interest rates back toward levels seen in the past.
It remains striking, however, that current real long-term yields are so much lower than what could be seen as being a "normal" level by historical standards. So the crucial question is: What factors can be held responsible for the demise of the real yield?
Various explanations (or "special factors") have been put forward lately. For instance, the demand from pension funds for long-term assets is seen as increasing bond prices, compressing market yields. Such price increases in bonds would, sooner or later, be reversed and yields would return to their average levels seen in the past. Whereas that might be true, it cannot be excluded that other, and more powerful, factors are at work.
To start with, one might think that central banks' low rate policy has translated into ample credit and money creation in global markets.8 The rather generous growth of credit and money supply in the last years may not have been confined to stimulating demand for current consumption and/or real investment but keeps driving up the demand for already existing stocks of wealth such as, real estate, housing, stocks and bonds (a development which is usually termed as "asset price inflation").
Such an interpretation would lead directly to the work of Ludwig von Mises. From Knut Wicksell (1851–1926), whose Interest and Prices was published in 1898,9 Mises took on the idea that the market rate of interest might diverge from the "natural rate of interest." The latter, which is free of all monetary influences, was interpreted to be the interest rate consistent with consumers' time preferences, whereas the former is manipulated by monetary policy. Holding the bank rate below the natural rate requires a continuous expansion of bank credit and thereby money supply.
To Wicksell, divergence of the two rates of interest was of concern primarily because of its effect on the general level of prices. Mises, however, extended the analysis, concerning himself also with allocation effects of credit expansion in the context of time-consuming, capital-using production processes. Tracing the effects of policy on production activity furthered the integration of monetary and value theory and identified the ultimate consequences of a cheap-credit policy.
Since the natural rate is the rate of interest that reconciles intertemporal production activities with the time preferences of consumers, credit expansion, by keeping the market rate below the natural rate, induces a fundamental inconsistency. A cheap-credit policy distorts business calculations causing the production of consumer goods to be reduced and production processes in general to be excessively roundabout. Mises used the term "forced savings" to describe the policy-induced reduction in consumption and the term "malinvestment" to describe the intertemporal misallocation of resources induced by artificially cheap credit.
So if bond market price action reflects monetary policy pushing and keeping the market rate below the neutral rate, bond yields could be said to be (heavily) distorted, thereby leading to a costly misallocation of scarce capital, likely to be followed by an inevitable business cycle crisis. But, of course, the explanation of prevailing record low market yields may not necessarily be ascribed to "bad monetary policy."
Alternatively, the fall in bond yields might reflect investors losing confidence in the economies' capacities for generating growth in the years to come. For instance, the effects of forthcoming demographic changes in virtually all western industrialized countries—that is ageing populations and an increase in life expectancy—could reduce the economies' growth potentials, and lower the expected return of real investment.
The market yield is an equilibrium price, signalling where peoples' savings and investment intentions are brought in line with each other. Whereas the former reflects consumers' time preference, the latter is driven by investor expectation regarding the marginal return of investment. That said, an expected decline in an economy's return generating capacity, other things being equal, should actually be accompanied by declining real yields.
That might also explain why rising government debt and deficits are accompanied by declining long-term real yields. As scarce resources are increasingly being wasted, investors might expect an undermining of the system of a free market economy, making it less efficient, thereby lowering market agents' real return expectations and, as a reflex, real bond yields.
Also, potential fears of protectionist measures, to which governments might take recourse to "shield" their electorate from the competitive pressures of "globalization," could contribute to less favorable return expectations as such measures would almost certainly reduce the economies' growth potentials. Such a scenario would go hand in hand with an outlook that central banks would find it hard to bring interest rates back towards more "normal levels."
The finding of record low bond (real) yields in most western industrialized countries does not seem to have become a major cause of concern in the public at large; it is merely seen as a surprise or puzzle. This might be largely due to the prevailing economic mainstream view that the lower an economy's interest rates are, the better it would be for growth and employment.
When taking on board the viewpoint of the Austrian School of economics, however, a much less relaxed stance would be required: it suggests that record low bond yields—or a de factodemise of market interest rates—might contain a rather gloomy message as far as future output and employment growth are concerned.
Interest rates could stay at current record levels, or could even decline further, for some time to come. But the current low rate environment is more likely to represent a transition rather than an equilibrium period. Mises wrote: "What generates the evils is the expansionist policy. Its termination only makes the evils visible." . . . "If one does not terminate the expansionist policy in time by a return to balanced budgets, by abstaining from government borrowing from the commercial banks and by letting the market determine the height of interest rates, one chooses the German way of 1923."10
So Mises does not only provide an explanation for the demise of the interest rate, he also offers a recipe against disaster: the return to market oriented principles and a monetary policy designed to deliver stable money.
- 1. Taking reference to Issing, O. (1993), Der Zins und sein moralischer Schatten, in: F.A.Z, 20 November.
- 2. See Mises, L. v. (2002), The Trade Cycle and Credit Expansion: The Economic Consequences of Cheap Money (1946), Ludwig von Mises Institute, pp. 220.
- 3. Mises, L. v. (1996), Human Action, 4th edition (1966), Fox & Wilkes, San Francisco, p. 795.
- 4. For instance, the president of the European Central Bank (ECB), Jean-Claude Trichet, said: "The exceptionally low level of interest rates across the entire maturity spectrum continues to provide considerable support to economic growth in the euro area, which currently shows only moderate dynamics." Introductory statement to the ECB press conference, Frankfurt am Main, 2 June 2005.
- 5. Mises, L. v. (1996), Human Action, 4th Edition (1966), Fox & Wilkes, San Francisco, p. 555.
- 6. "For the moment, the broadly unanticipated behavior of world bond markets remains a conundrum. Bond price movements may be a short-term aberration, but it will be some time before we are able to better judge the forces underlying recent experience." Testimony of Chairman Alan Greenspan, Federal Reserve Board's semiannual Monetary Policy Report to the Congress Before the Committee on Banking, Housing, and Urban Affairs, U.S. Senate, February 16, 2005.
- 7. Such an approach has become quite familiar among financial market analysts. See, for instance, Bank for International Settlements (2005), Quarterly Review, March, pp. 2.
- 8. See in this context also Fed Governor Ben S. Bernanke's "The Global Savings Glut and the U.S. Current Account Deficit", Remarks made at the Sandridge Lecture, Virginia Association of Economics, Richmond, Virginia, 14 April 2005. He wrote: "Because the dollar is the leading international reserve currency, and because some emerging-market countries use the dollar as a reference point when managing the values of their own currencies, the saving flowing out of the developing world has been directed relatively more into dollar-denominated assets, such as U.S. Treasury securities." However, the question remains why the effects were not confined to the US but why real yields in virtually all countries tended to grind towards record lows.
- 9. Wicksell, K. (1898), Interest and Prices, translated by R. F. Kahn, London: McMillan, 1936 [originally published in 1898].
- 10. Mises, L. v. (2002), The Trade Cycle and Credit Expansion: The Economic Consequences of Cheap Money (1946), Ludwig von Mises Institute, pp. 231.