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Unanswered question

17 June 2014 By Edward Hadas

The world of finance is ensnared in a triple mystery: falling bond yields, falling inflation and rising debt. The ignorance is dangerous.

Low inflation and lower yields have puzzled investors in recent months, but the mystery dates back several decades. The yield story started in 1981, when 10-year U.S. Treasury bonds offered 15.6 percent. Though yields have both fallen and risen since, each peak and trough has been lower than the last one. The pattern has been similar for all bonds from all developed countries. The falls in 2014 – yields on German 10-year paper have dropped from 2 percent to 1.4 percent – fit right in.

The decline in the pace of consumer price increases has been less regular, but equally persistent. American inflation was in the low double digits around 1980, then fell to between 3 and 6 percent over the next two decades, and has been heading towards zero in the post-crisis years. The pattern in most European countries has been similar. Japan reached effective price stability in the mid-1990s.

Bond investors were slow to catch on. For most of the last three decades they consistently priced in too-high inflation rates. The result has been splendidly high returns. Anyone who bought 10-year U.S. Treasury bonds in 1981 and held them until they matured enjoyed a 10 percent annual return after inflation. For equivalent bonds bought as recently as 1997, the real return was still an attractive 4 percent.

Today, however, yields are so low that bonds will only prove good investments if inflation is replaced by steady deflation. That, though, brings up another puzzle: increasing debt. Deflation is bad for borrowers at almost any interest rate, but there are few signs of an end to the significant, steady and widespread increase in leverage in the financial system that started at around the time that inflation started to fall.

In the United States, total debt increased from 148 percent of GDP in 1980 to 267 percent in 2013, according to Federal Reserve figures. A recent paper by three academics for the San Francisco Fed shows a similar pattern for 17 advanced economies. This is a secular trend, which the last cyclical downturn has not interrupted. A sharp increase in government debt since the crisis has more than made up for a modest decline in private and financial leverage.

The puzzles are related. Bond yields fall along with inflation, and people are more willing to borrow when nominal interest rates are lower. However, the reason or reasons for the changing shape of the financial system remain mysterious.

Some purported explanations raise more questions than they answer. For example, central bankers often give themselves credit for controlling inflation. However, despite their recent efforts to stimulate economic activity, inflation rates have continued to fall. The psychological explanation, that inflation falls because people think it will, leaves out the source of the belief.

There are other, more imaginative theories about disinflation. The most popular right now is probably secular stagnation, promoted by Harvard economist Larry Summers, which traces the trend back to slower GDP growth. Others look to ageing populations or the expansion of cheap imports from Asia.

These stories are all incomplete. The existence of secular stagnation is disputed, and it is not clear why any such disinflationary trend would consistently prove more powerful than inflationary forces like higher property and commodity prices.

It is easier to explain the immediate causes of the debt expansion. Deregulation encouraged banks to be more aggressive; trade deficits generated cash which the financial system turned into loans; and politically weak governments resorted to ever more borrowing. Still, those factors look like effects as much as causes. An increased willingness to lend and borrow propelled deregulation and eased the financing of trade and fiscal deficits. Something deeper must have changed the dominant attitude towards leverage in the financial system.

Economists are not in a good position to unravel these mysteries. The standard macroeconomic models basically exclude finance. The profession’s intellectual twilight is unfortunate, as the triple mystery holds many risks.

If the disinflationary trend leads to deflation, policymakers will be left flailing. They also have no idea what level or sorts of debt are destabilising, so they cannot respond helpfully to changes in national balance sheets. Politicians also have a problem, because they cannot know if large fiscal deficits are helpful or ultimately harmful.

Investors and lenders are equally at a loss. They might want to prepare for deflation. But it is always possible that they should be preparing for a new mystery: the long-delayed return of inflation.



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