Economists are flummoxed

When Alan Greenspan can’t explain the bond market, I start to get very, very nervous.

Among the biggest surprises of the past year has been the pronounced decline in long-term interest rates on U.S. Treasury securities despite a 2-percentage-point increase in the federal funds rate. This is clearly without recent precedent. The yield on ten-year Treasury notes, currently at about 4 percent, is 80 basis points less than its level of a year ago. Moreover, even after the recent backup in credit risk spreads, yields for both investment-grade and less-than-investment-grade corporate bonds have declined even more than Treasuries over the same period. The unusual behavior of long-term interest rates first became apparent almost a year ago. In May and June of last year, market participants were behaving as expected. With a firming of monetary policy by the Federal Reserve widely expected, they built large short positions in long-term debt instruments in anticipation of the increase in bond yields that has been historically associated with a rising federal funds rate. But by summer, pressures emerged in the marketplace that drove long-term rates back down. In March of this year, market participants once again bid up long-term rates, but as occurred last year, forces came into play to make those increases short lived. There remains considerable conjecture among analysts as to the nature of those market forces.

Of course, what Greenspan is sure about doesn’t make me feel any better:

Our household saving rate remains negligible. Moreover, modest, if any, progress is evident in addressing the challenges associated with the pending shift of the baby-boom generation into retirement that will begin in a very few years. And although prices of imports have accelerated, we are, at best, in only the earliest stages of a stabilization of our current account deficit–a deficit that now exceeds 6 percent of U.S. gross domestic product (GDP).

Now part of the reason savings is at a historic low is that asset prices have been rising so dramatically over the past ten years — equities in the late nineties and housing now. So it’s tough to say that the American consumer is behaving irrationally — why save income when your assets are appreciating at a healthy clip? Tyler Cowen speculates on whether this is true and is just as flummoxed as Greenspan is about the bond market:

So what is the problem? Does liquifying real assets somehow bring excess leverage to the economy? I don’t see why. Or does borrowing against real assets lead to a later switch toward consumption, thereby necessitating transformation costs? Each individual thinks he has a more liquid savings position than is the case; borrowing is cheap but society as a whole must incur reallocation costs to convert the real capital into consumption. But how big a factor can this be? All seems fine. Yet in my neo-Austrian gut I cannot bring myself to think as capital gains as analytically equivalent to abstinence out of income. I file this one under the category of “macroeconomic problems I’ve been thinking about for twenty years but haven’t made much progress on.”

Now is normally the point in the post when I give you my take on things. Not this time — I’m just as stumped as Cowen and Greenspan on these questions.