It is an index of fear. Last week, interest rates on 10-year U.S. Treasury bonds fell to 1.4 percent. This was the lowest on record and less than present or expected inflation (generally 2 percent to 3 percent). On 30-year Treasuries, rates have tumbled to 2.5 percent. The investors piling into Treasuries and driving rates down aren’t buying risky stocks or using their cash to expand businesses. They’re protecting themselves against unknowns. The question is whether the resulting plunge of rates signals something more ominous: renewed recession, deflation or both.
Granted, there are always the standard unknowns of business cycles, new technologies, competitive pressures and shifting government policies. But today’s seem on a scale unprecedented since World War II. Does Europe — one-fifth the world economy — face stagnation or collapse because debt-ridden countries cannot defend the euro? What happens to the weak U.S. recovery if it drops off the “fiscal cliff”: the $500 billion of spending cuts and tax increases (as estimated by the Committee for a Responsible Federal Budget) scheduled for early 2013?
To these daunting uncertainties must be added at least one other that, though less recognized, is perhaps more powerful. It is an intellectual breakdown. There is a loss of faith in economic ideas — and government policies based on them — driven by most economists’ failure to anticipate the financial crisis and many subsequent events.
Take the Treasury bond interest rates. In 2007, the year before the crisis exploded, rates on 10-year Treasuries averaged 4.6 percent. It’s true that the Federal Reserve, in an effort to spur the economy, has tried to reduce long-term rates by buying nearly $3 trillion of Treasury bonds and other long-term securities. (The increased demand for the bonds raises their price and lowers their effective interest rate.) This may have cut rates by 1 percentage point, a Fed study suggests.
The remaining decline since 2007 mainly reflects two factors: a weak economy that diminishes credit demand; and precautionary buying of Treasuries as a hedge against calamity. Both have been underpredicted. If you had polled 1,000 economists five years ago, it’s doubtful that 10 would have foreseen today’s low Treasury rates.
By some signs, the economy should be improving. Treasury Secretary Tim Geithner reported last week that bank capital had increased 70 percent ($420 billion) from three years ago. Home prices have begun to inch up, suggesting a housing revival. Household debt service — monthly payments of interest and principal — as a share of disposable income has dropped to levels of the early 1990s, according to the Fed. But so far these favorable omens have been largely neutralized by widespread risk aversion and fearful psychology.
Just as “irrational exuberance” drove the economic boom, so the bust is sustained by an almost-pathological and self-fulfilling pessimism. The unspoken faith in economics — that governments could prevent another Great Depression and ensure that recessions, though unavoidable, are limited — has given way to profound skepticism.
In recent decades, “investors and economists did not discuss ‘disaster’ much,” writes Financial Times columnist Gillian Tett, citing a study by Fulcrum Asset Management. “Investors built their careers in a world without disaster risk.” Now this assumption is gone; behavior adapts by becoming more defensive. Despite the United States’s stalemated budget politics, U.S. Treasuries seem the safest investment.
A similar defensiveness grips consumers, corporate managers, bankers and small-business owners. Although they haven’t gone into economic hibernation, their instinct at the margin is to abstain. It is not to spend the next dollar, not to hire the next worker, not to make the next loan. Whatever the specific reasons, an underlying cause is anxiety that the modern means of economic control — central banks and government budgets -- have lost the capacity to generate recovery and avoid catastrophe.
It is not that economists lack ideas or proposals. There are many, often passionately advanced. But there is no consensus on what they should be or whether they will work. To take one example: The Federal Reserve’s policy committee meets this week amid much clamor that it “do something” (buy more bonds, buy mortgages, encourage inflation) to strengthen the recovery; but there is disagreement on how effective these measures might be and concern that some might backfire.
What good are lower interest rates if lenders impose such tight conditions that credit doesn’t flow or potential borrowers won’t assume added debt? Rates on 30-year mortgages are already 3.5 percent.
The real obstacles to a vigorous recovery are compounded by this shrunken confidence in the power of economics. The dangers — resumed recession or deflation (declining prices) — arise from their interaction. Low confidence will subvert recovery; an aborted recovery will subvert confidence. Whoever wins in November will face this cycle. His challenge will be to break it.