Deficit Spending and Long-Term Interest Rates

December 22, 2008

Warnings have begun that U.S. long-term interest rates will turn higher by the second half of 2009, possibly significantly, under the weight of massive government deficit spending.

This of course did not happen in Japan, so a brief review of that economy’s experience seems  timely. Japan’s housing bubble burst in the early 1990’s. There was a plunge in stock prices. Non-performing bank assets soared, disabling banks’ ability to lend. Economic activity limped along for more than ten years, entering and leaving several recessions. The initial policy response came from the fiscal side. Eight stimulus packages during the final eight years of last decade summed to 118 trillion yen, equal to $1.3 trillion at the current dollar/yen rate and $1.0 trillion at prevailing exchange rates back then. By far, Japanese public finances were the worst among G-7 countries, and fears were expressed at the time, like now, that all that deficit spending (about 25% of GDP) could send long-term interest rates soaring. Japan’s ten-year JGB yield averaged only 2.68% in the eight years to 2000 and dropped to an even lower 1.43% average during the past eight years since and including 2001. The rate today touched a low today of 1.20% despite planned government spending of around $1.0 trillion next year resulting in a deficit that will likely exceed 6.5% of GDP in fiscal 2009. The progression of annual average yields is shown below.

Year 10-Year JGB, %, Annual Mean
1991 6.41%
1992 5.13%
1993 4.05%
1994 4.23%
1995 3.29%
1996 3.02%
1997 2.14%
1998 1.29%
1999 1.73%
2000 1.76%
2001 1.35%
2002 1.27%
2003 1.00%
2004 1.50%
2005 1.38%
2006 1.74%
2007 1.68%
2008 1.50%

 

The lesson from Japan’s earlier experience for U.S. and Japanese bond yields in 2009 is not that they will categorically remain low but rather that nobody really knows what is going to happen. Heavy deficit spending per se does not translate into high and rising bond yields. Context is key. World economies are so out of kilter that many normal economic cause-and-effect relationships have broken down. To the extent that recessions do not end by next summer, credit conditions are still abnormal, and inflation is below target, rising long-term rates will probably remain a concern but not become a reality.

In Japan last decade, deficit spending provided only temporary and generally ineffective relief. Officials should have first recapitalized the banking system and used other incentives to encourage banks to unload bad loans. For the United States, the full extent of bad assets will not be known until housing prices stop falling, and a housing market bottom is not yet in sight.

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