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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  

Greenspan Ignores the Elephant  
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