Nancy Sagar -‐ Management 468, Professor Ed Leamer Final Paper -‐ June 12, 2010
The Elephant at the Party: Federal Debt BACKGROUND In his February 15, 2005 Senate testimony, Alan Greenspan shares his optimism about the U.S. economy. GDP grew 3.57% in the previous quarter, and consumer spending is up in conjunction with escalating household net worth and home prices. Yet businesses are cautious. Capital investment isn’t keeping pace with rising profits. Firms are stockpiling inventory and seem reluctant to hire new workers. And Greenspan is puzzled about long-‐term US interest rates, which aren’t rising in step with short term rates, the typical trend. He points to many possibilities: market hesitancy about long-‐term growth thanks to rising oil prices. Global demand in world bond markets. Record low mortgage rates and rapid turnover creating increased demand that force rates downward. But then he ends with “it’s a conundrum.” Oddly, Greenspan fails to highlight two critical facts. First, there is a specific factor exerting powerful influence on 10-‐year rates, and he doesn’t mention it in this context. Second, this trend is dangerous because if it continues, the economy will likely slip into recession. Greenspan has ignored the elephant at the party: rising federal debt.
THE STORY First, let’s consider the consequences of this interest rate trend. In a healthy economy, 3-‐month Treasury rates are lower than 10-‐year rates. After all, Treasuries have a short time horizon with little risk that inflation will reduce the real value of an investment. That risk grows with time, so 10-‐year rates must increase to reward long-‐term investors for facing that risk. In addition, banks earn profits by borrowing short-‐term funds at low rates (buying low) and loaning those funds at higher rates over longer terms (selling high). In contrast, if rates “invert,” banks would have to “buy high” and “sell low,” a money-‐losing proposition. Thus, lending stops and businesses can’t get loans to fund future growth, choking the economy. This phenomenon, shown in the yellow bars below, has directly preceded every U.S. recession.
Before every recession (gray bars), 3-‐month Treasury rates have exceeded 10-‐year interest rates (yellow bars) 16% 14%
Interest rates
12%
10 year i nterest rate
10% 8% 6% 4%
We are here
2% 0%
1950
3 month Treasury rate 1960
1970
1980
1990
2000
2010
Had Greenspan looked at the quarterly percentage growth of each interest rate in a graph like that shown below, he would have been reminded that, indeed, 10-‐year rates aren’t keeping up with 3-‐month rates, which could lead to the “inversion” we saw on page one.
0.40
The 3-‐month Treasury rate is rising
0.30 0.20
-‐0.20
2004Q4
2004Q3
2004Q2
2004Q1
2003Q4
2003Q3
2003Q2
2003Q1
2002Q4
-‐0.10
2002Q3
0.00
2002Q2
0.10
2002Q1
Quarterly % growth of interest rates
3-‐month rates are rising faster than 10-‐year rates
And 10-‐year rates are not keeping up
So what causes the sluggish growth in the 10-‐year rate? One major factor: Rising federal debt, which is becoming a larger percentage of real GDP and is marching steadily upward as the consumer savings rate plummets and government deficits increase. Consumers just spend, spend, spend as long-‐term investors worry about swelling interest payments that reduce available funds for research, innovation, education, healthcare, and national defense. Not to mention this frightening scenario: with crushing debt, the US will be unable to pay the looming expense of Social Security and Medicare for Baby Boomers.
The upward march of debt pulls down 10-‐year interest rates
US Federal Debt as a % of Real GDP
0.7 0.6 0.5 0.4 0.3 0.2 0.1 0
With such an uncertain future, it’s easy to see how investors would begin to shy away from long-‐term investments. That pullback causes a drop in demand for long-‐term loans and thus a drop in long-‐term rates. A regression analysis (appendix) shows the impact quite convincingly: federal debt (as a % of real GDP) has the most significant, measurable impact on 10-‐year interest rates. Swelling debt drags 10-‐year rates down. In a period of climbing short-‐term rates, this rising debt sets up a potential interest rate inversion and recession, and Greenspan missed this important relationship in his testimony.
APPENDIX: REGRESSION ANALYSIS Dependent Variable: RATE_10YR
Method: Least Squares Date: 06/09/10 Time: 22:59 Sample: 1980Q1 2004Q4 (a historical period in which interest rates have generally fallen) Included observations: 100 Variable Coefficient Std. Error t-‐Statistic Prob. C 2.584598 0.810789 3.187758 0.0020 RATE_10YR(-‐1) D(RATE_10YR(-‐1)) RATE_3MONTH(-‐1) U(-‐2) G_CAPITAL_ACCOUNT(-‐1) FED_DEBT_RGDP(-‐1) R-‐squared Adjusted R-‐squared S.E. of regression Sum squared resid Log likelihood F-‐statistic Prob(F-‐statistic)
0.628144 0.368587 0.153198 0.116156 -‐1.60E-‐06 -‐3.237755 0.969671 0.967714 0.507285 23.93249 -‐70.39718 495.5559 0.000000
0.075227 8.350005 0.086985 4.237386 0.054732 2.799027 0.061737 1.881475 3.53E-‐07 -‐4.535225 0.954504 -‐3.392080 Mean dependent var S.D. dependent var Akaike info criterion Schwarz criterion Hannan-‐Quinn criter. Durbin-‐Watson stat
0.0000 0.0001 0.0062 0.0630 0.0000 0.0010 7.861600 2.823220 1.547944 1.730306 1.621749 2.071327