Thursday, 20 September 2012

What explains low long-term interest rates: article for Liberal Democrat Voice

[This article was originally published in Liberal Democrat Voice here in response to a specific request to comment on the texts reproduced below. I have made many of the arguments below in previous blogposts, so regular readers may not find much new, but for others it may be a useful summary]. 

As the head of an independent economic research institute, it's not my job to attend the Liberal Democrat conference (or indeed that of any other party).  But, following up an FT article here, I was asked to comment on the text of a motion which argues that:

"Conference recognises that the difficult decisions taken by the Coalition Government have ensured the credibility of the UK government’s position in the financial markets allowing the UK to borrow at record low rates"

and on an amendment:

"Conference also notes that it would be a mistake to attribute record low public sector borrowing costs to accelerated fiscal consolidation rather than to a flight to relative safety."

The original text is economically ignorant nonsense. The amendment is partly correct, although it still gets the underlying explanation wrong at least in part.  The current level of long term interest rates does not reflect "market confidence"; quite the opposite.  Both economic theory and the empirical evidence suggest that the current level of long-term interest rates is primarily the result of economic weakness, not strength. 

First, some theory.  What determines the level of long term interest rates on government debt?  The standard neo-classical view  is that, as the Bank of England puts it in its handy beginners guide to monetary policy, "long-term interest rates are influenced by an average of current and expected future short-term rates".  

In other words, theory suggests that the low level of long-term interest rates in the UK reflects low expected future short-term rates. And what determines expected future short term rates?  Again, the Bank of England is quite clear on this - expected inflation.  And why does the Bank expect inflation to fall sharply in 2012 and perhaps beyond?  Because the economy is weak:  

"Against this background, and that of its most recent projections to be published in the February Inflation Report, the [Monetary Policy] Committee judged that the weak near-term outlook for growth and the  associated downward pressure from slack in the economy meant that, without further monetary stimulus, it was more likely than not that inflation would undershoot the 2% target in the medium term."

So record low public sector borrowing costs simply reflect the weakness of the economy.  Is my analysis widely shared? Let's look at the IMF's last report on the UK:

"Some further slowing of consolidation is unlikely to trigger major market turmoil

43. Further slowing consolidation would likely entail the government reneging on its net debt mandate. Would this trigger an adverse market reaction? Such hypotheticals are impossible to answer definitively, but there is little evidence that it would. In particular, fiscal indicators such as deficit and debt levels appear to be weakly related to government bond yields for advanced economies with monetary independence. Though such simple relationships are only suggestive, they indicate that a moderate increase in the UK’s debt-to-GDP ratio may have small effects on UK sovereign risk premia (though a slower pace of fiscal tightening may increase yields through expectations of higher near-term growth and tighter monetary policy).  This conclusion is further supported by the absence of a market response to the easing of the pace of structural adjustment in the 2011 Autumn Statement. Bond yields in the US and UK during the Great  Recession have also correlated positively with equity price movements, indicating that bond yields have been driven more by growth expectations than fears of a sovereign crisis."

For an IMF report, this is remarkably clear.  It is saying two things.  First, just as I argue above, the reason long-term gilt yields are low in the UK (and similarly in virtually every other "advanced economy with monetary independence") is weak growth, not "confidence" or "credibility".  "Bond yields are driven more by growth expectations."  That is, yields are low not because of economic confidence but because of its exact opposite. This is precisely what I and others 
(Simon Wren-Lewis here, and of course Paul Krugman in the US) have long been arguing.  Indeed, the specific evidence the IMF cites - that yields have fallen when stock markets have fallen - is precisely that, in the UK, I first pointed out here a year ago.  

Second, that there is no reason to believe that slowing fiscal consolidation would "trigger an adverse market reaction".  In other words, when the Chancellor said that "these risks [of slowing consolidation] are very real, not imaginary", he was indulging in evidence-free speculation, not serious analysis.  Indeed, the Fund accurately points out that the main reason yields might rise (slightly, not precipitiously) if fiscal policy were to be loosened would be because of "expectations of higher near-term growth". As I pointed out here, this would be good news.  So, the IMF agrees that the reason gilt yields are low is because of weak growth, not confidence; and that we could loosen policy with minimal risk and probable benefit.  

So what underlies the Treasury's contention that low interest rates reflect "market confidence"? It is, of course, true that reduced default risk should lead to lower interest rates on government debt, just as it should on any other debt. But, as I have pointed out before, there is not and has never been any significant default risk on UK government debt. Nor is there any obvious evidence that movements in interest rates have been related to changes in market perceptions of default risk. As I predicted at the time, Moody's recent decision to put the UK's rating on negative watch had precisely no impact on market interest rates.

Finally, it is worth noting that, if we believed the original motion, the main thing driving interest rates would be the deficit, and in particular market expectations of the deficit going forward. Conveniently, the Treasury publishes a summary of external forecasts of the economy. These forecasts change over time, and here is the average of external forecasts for the deficit in 2013-14, plotted against ten year gilt yields.

Higher deficits lead to higher interest rates?  Not exactly.  If anything, the opposite, certainly over the last year - because, of course, both higher deficits and lower interest rates are driven by economic weakness, precisely as theory predicts.

To conclude, we know, both as a matter of theory and evidence, why long-term interest rates are low.  It reflects the persistent weakness of the UK and international economies.  There is no mystery here.  The original motion simply ignores the facts. 


  1. Jonathan, as one of the authors of the amendment, I'd like to thank you for your carefully qualified support; although the English gets away from you a bit :-). Perhaps there is a good reason for that.

    I am afraid that an amendment, tabled at a party conference, cannot compete with a 1000 word plus blog entry. But at least LDV didn't insist that your contribution on the subject should be somewhere between 500 and 300 words and refuse to publish it, if it was longer, unless it was delivered in two separate parts.

    My piece, for LDV, which is somewhat more political, found a home at the Social Liberal Forum website - as a guest blog: .

    I'd be fascinated to hear what you think and want to express my appreciation for your closing and very interesting observation that: "The original motion simply ignores the facts".

    I guess the real political test, from my point of view, will come when Liberal Democrat representatives vote on the relative merits of the motion and the amendment. As we both clearly agree...however they vote won't change the economic facts.

    Your own awkward phrasing, about our amendment, "The amendment is partly correct, although it still gets the underlying explanation wrong at least in part" makes it clear that you agree with the points that myself and Linda Jack will be making next Monday to our party conference. An intelligent party - concerned with the future of the UK economy - will concentrate its energy on formulating and implementing policies that remedy persistent weaknesses in the UK economy and which contribute, so far as possible, to counteracting weaknesses elsewhere.

    Great to see that we are on the same page.

    Ed Randall

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  3. Ed Randall's amendment includes: "Conference also notes that it would be a mistake to attribute record low public sector borrowing costs to accelerated fiscal consolidation rather than to a flight to relative safety."

    Jonathan Portes, in this blog post, says: “The amendment is partly correct, although it still gets the underlying explanation wrong at least in part."

    Randall refers, in his comment to Portes' post, to: “Your own awkward phrasing, about our amendment...”

    I think Randall is wrong about Portes's phrasing being awkward.

    Randall's amendment is partly correct because it is true that it would be a mistake to attribute record low public sector borrowing costs to accelerated fiscal consolidation.

    But the underlying explanation is wrong at least in part because the amendment attributes low interest rates to a “flight to relative safety” while ignoring the reality that the current level of long-term interest rates is primarily the result of the UK's economic weakness, not strength.

    It's perfectly feasible that the UK's economy is both weak (it is), and also safe for gilt investors (it is -- because a government that borrows in it's own currency can always service the debt and the interest).

    Randall's thoughtful article for the Social Liberal Forum:


    “The Liberal Democrats have an opportunity, at their annual conference, to make their dissatisfaction with George Osborne’s self-defeating austerity plain, regain some of their Party’s political integrity, give real momentum to a more intelligent economic strategy and help to restore a modicum of intellectual coherence to the Party’s approach to economic policy-making. I hope that we won’t fail to take it.”

    Hmmm.. “restore a modicum of intellectual coherence to the Party’s approach to economic policy-making.” Isn't this aiming a bit low – why just a “modicum”? Why not complete intellectual coherence?

    The problem the Lib Dems have is that Nick Clegg and Danny Alexander swallowed completely George Osborne's politically motivated, deliberate mis-diagnosis of the state of the economy in early 2010 - ie, that the "economic mess" was all Labour's (Gordon Brown's, Ed Balls', Alistair Darling's...) fault. Anyone who believes this has no chance of coming up with policies that demonstrate intellectual coherence on economic policy making.

    Alexander told the Treasury select committee in November 2010 that the low bond yield in the UK were because, "we have re-established a degree of economic credibility."

    Economically ignorant nonsense, indeed.

    There is a credibility issue evident here -- Alexander and Clegg, by the nature of their public statements on the economy, have no credibility. They have both often echoed Osborne's “the UK was on the brink of bankruptcy" line. This is not only wrong it is ludicrously, dishonestly wrong.

    Simon Reynolds

  4. The Liberals as is implied by their name are not hamstrung by rigid ideology, and are supposed to approach every problem in a pragmatic evidence based way. I sincerely hope the conference debate goes along these lines.

    They entered the coalition, and reversed their economic analysis through 180 degrees, because at the time they were persuaded that we faced economic catastrophe unless we were all forced to swallow the austerity medicine, and that by some mysterious process involving confidence, our economy would then reemerge like a phoenix from the ashes. At some point they must decide whether continuing to support this demonstrably wrong prescription, and by implication the coalition government, is still in the national interest. If they want to preserve any reputation they once had for honesty and integrity, there is only one decision they can come to.

  5. The resolution makes sense to me as an investor. When the economy is dead in the water with little prospect for growth, there are two sensible investments.

    First, there is lending money to the government. The government will always pay you back, and it isn't going out of business anytime soon. When the US had its credit rating lowered, it scared people so much that they scrambled to buy more US debt and rates actually went down.

    Second, there is the stock market. When there is no sign of economic growth and no return on real investment, it pays to put some money into the stock market on the theory that if enough people are desperate for some RoI, you can all make money. This worked for my father in the 30s and for me in the early 90s.

    Both of these strategies will work whether the economy stays in the crapper or actually wipes up and walks out of the stall.

  6. I agree with this assessment by in large. The theory of interest rate determination is something I learnt in the 1st or 2nd year of my undergrad economics course.

    However I feel that you may only looking at one of the aspects that determines long term rates. Risk premiums are a real world phenomena.

    You can imagine a situation where investors expect short term rates to be low for the foreseeable future due to low inflation driven by consistent low growth (i.e. as you describe) but who also feel that there is a significant risk of default on government debt.

    Under these circumstances we might expect high rates on government paper due to the extra risk investors will be taking on. This isn't the case, we have both a high probability of low growth for the foreseeable future and a low probability of government default.

    So I feel the question is, how likely is it that engaging in fiscal expansion will increase the risk premium on government debt to an extent we we fall into uncontrollable debt dynamics.

    I think this is highly unlikely, by in large because of our monetary independence. So while I agree with the assessment we still need to answer the question of risk premiums arising from fears of default, which seems to be what DC refers to when arguing against fiscal expansion.