Why treasury bond interest rates stay low when the budget deficit increases : Planet Money The government used to be afraid to borrow too much money. Today, it borrows hand over fist. And it's ... fine? | Subscribe to our weekly newsletter here.
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Bond Voyage

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Bond Voyage

Bond Voyage

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UNIDENTIFIED PERSON, BYLINE: This is PLANET MONEY from NPR.

MARY CHILDS, HOST:

In the next few weeks, it's likely that Congress will pass and President Biden will sign a bill to spend $1.9 trillion.

JACOB GOLDSTEIN, HOST:

Trillion. I still like to pause and step back when I hear trillion because, you know, like - OK, think of a billion. Billion is, like, already an unfathomably large number.

CHILDS: It's a lot.

GOLDSTEIN: And then a trillion, it's a thousand billions - a thousand. So this bill is a $1.9 thousand billion bill.

CHILDS: And that's on top of the $3 trillion that the federal government spent last year. And these trillions of dollars have done a lot of good. Like, the money paid for additional unemployment benefits for people who lost their jobs and for stimulus checks to most Americans and for hundreds of millions of vaccines.

GOLDSTEIN: And a key thing here is the government was able to spend all this money without having to raise taxes and without having to cut spending on other things because the government borrowed every dollar of the extra money it spent. And it's about to borrow trillions more.

CHILDS: And this is sort of amazing. It feels almost like a trick. Like, where did the money come from? How can the government just borrow $5 trillion in a single year?

GOLDSTEIN: And the answer to this question is that until pretty recently, it couldn't. It couldn't just borrow that much money in that short a time, or at least if it did so, it would have really messed up the economy. You know, for decades, for basically my entire life, the people who were running the government, people who were deciding how much money to borrow and spend - they knew this. And they were terrified that they might borrow too much money and break the economy.

CHILDS: But over the past decade or so, there has been this fundamental shift in the government's ability to borrow money. It's like the old rules just stopped working. The shift is pretty mysterious. People don't entirely understand why it's happened.

GOLDSTEIN: But it is profoundly important that it has happened. Every time I read some story about all the money the government is spending, I think about this shift. I think, this is the story behind the story. It is this shift, this change in how the world works that has made every stimulus check and every government-funded COVID shot possible.

Hello, and welcome to PLANET MONEY. I'm Jacob Goldstein.

CHILDS: And I'm Mary Childs. Today on the show, the story of how the government can borrow literally trillions of dollars...

GOLDSTEIN: Thousands of billions.

CHILDS: ...Without worrying too much about the deficit.

(SOUNDBITE OF MUSIC)

CHILDS: We're going to start in the early '90s, back before this shift, when the old rules about government borrowing still applied. Bill Clinton had just been elected president. He appointed an economist named Laura Tyson to be one of his top advisers. And she looked at the economy, and she saw this glaring problem. Year after year, both government deficits and interest rates were going up.

LAURA TYSON: And then he said, oh, my goodness, if we don't get ahold of this federal deficit, then that trend will continue. Those rates will continue upward. That was a very significant concern.

GOLDSTEIN: Higher interest rates were a concern for a couple of reasons. For one thing, obviously, they meant that the government had to pay more to borrow money. But also, when interest rates for the government went up, interest rates also went up for everybody else. And that set off this whole cascade of problems.

TYSON: So people won't buy as many houses, and there won't be as many houses constructed. And there won't be as much capital equipment invested in, and investment's an important part of the economic growth. And, yeah, all sorts of - every interest-sensitive part of the economy.

CHILDS: The way the government runs a deficit, the way it borrows money, is by selling bonds - Treasury bonds. The government says to really anybody, OK, lend us - whatever - a hundred dollars. And in, say, 10 years, we will pay you back with interest. We'll pay you back $120. The bond is basically the government's IOU that it will pay back that loan with interest.

GOLDSTEIN: And during the Clinton administration, because of that link between deficits and interest rates, everybody in the White House talked about Treasury bonds, about the bond market all the time. James Carville was a political adviser to President Clinton.

JAMES CARVILLE: It was just an obsession in the early days of Clinton administration. And everybody would say, well, what's the bond market - well, how's the bond market going to react? I didn't know what the hell the bond market was. Like, I don't know. It just became this sort of omnipresent part of every conversation.

GOLDSTEIN: James Carville was not an economics guy. But as he spent time at the White House, he realized that, sort of bizarrely, all these people who worked there making policy, the people who had what seemed like the most powerful jobs in the world, were, in fact, terrified of the bond market. So when a reporter from The Wall Street Journal called up Carville to talk about the bond market, he came up with this line that became sort of famous, or at least bond-market famous.

CARVILLE: When I was a kid, I wanted to grow up to be a 400 hitter or the pope or the president. But now I just want to be the bond market so I can scare the hell out of everybody.

CHILDS: Wait; what did he say? A what?

GOLDSTEIN: A 400 hitter, like in baseball, or the pope or the president.

CHILDS: Baseball.

TYSON: I cannot tell you how many times he said that to me - every meeting, every meeting. A lot of my memories are about Carville sort of making jokes about, you know, he wishes he was a bond trader.

CHILDS: Bond traders - these are the people who work in finance all around the world who manage a bunch of money - generally other people's money - pension funds or college endowments, that kind of thing. And every day, they decide what bonds to buy and what bonds to sell, what companies and countries to lend to and what companies and countries to not lend to, to stop lending to.

GOLDSTEIN: And like with any lender, bond traders worry about lending more money to a borrower who is already borrowing a lot because all that borrowing makes it more risky. And so to compensate for that risk, bond traders demand a higher interest rate. They stop lending until rates go up.

CHILDS: And this - bond traders demanding higher interest rates when the government is borrowing more money - this is the scenario that everyone was so worried about. People were so afraid of this that there was even a special term for the bond traders who would do this - bond vigilantes.

GOLDSTEIN: Bill Clinton is convinced the bond vigilantes are scary. And in fact, he decides the U.S. needs to bring the deficit down. He decides to build a whole economic plan around getting rid of the deficit. One of the economists he brought in to make that happen was Jason Furman.

JASON FURMAN: And a central argument that we made was, if you do this, it will lower interest rates. And if interest rates are lower, we'll have more investment and more economic growth.

GOLDSTEIN: And sort of amazingly, all of this happened. They did raise taxes and cut spending and get the deficit down. In fact, by the end of the Clinton administration, the deficit fell all the way to zero.

CHILDS: And what came next was sort of a golden moment for the economy. In Silicon Valley, there was the dot-com boom, but really, the whole economy was doing great. Businesses of all kinds were doing well. Ordinary workers were getting raises. Lower deficits led to lower interest rates, which led to more investment. And that was good for basically everybody. The system was working.

GOLDSTEIN: The next big moment in the story comes right after the financial crisis of 2008. And this is the moment when everything is about to change, when this big shift in the way the world works is about to happen, but nobody quite knows it yet.

CHILDS: Barack Obama has just been elected president. And Obama brings in Clinton's guy, Jason Furman, as one of his economic advisers. And Furman goes into this meeting to discuss how big of a stimulus bill Obama should push for as he takes office.

FURMAN: We met with the president-elect December 16, 2008. And we were all crowded together in a conference room. I think it was in a law firm in Chicago. And he wanted it to be big. He wanted it to be bold.

GOLDSTEIN: But there was this worry the stimulus was going to be funded with deficit spending. The government was going to borrow the money. And some of Obama's own economic advisers worried that borrowing and spending too much money might actually harm the economy for that classic reason.

FURMAN: The idea is you don't want to be helping the economy with one hand by pumping more money into it and then hurting the economy with the other hand by raising interest rates. And you have to put some perspective on it. In late November of 2008, some of the leading progressive economists said that we should do something huge, enormous - $300 billion to $500 billion. Paul Krugman was advocating $600 billion.

CHILDS: Quaint. The administration decided to go even bigger. Working with Congress, they passed an $800 billion stimulus in 2009, which, at the time, seemed enormous.

GOLDSTEIN: Almost immediately after this - like, the next month - President Obama starts talking about getting the deficit back under control because that's the way the world worked back then. That's the way people thought. But the economy was still a mess. And so the deficit stayed big for years.

CHILDS: Now, remember those bond traders we just talked about a couple minutes ago? They see the government borrowing more money year after year. More borrowing means more risk. This is the classic moment for those bond traders to turn into bond vigilantes, to demand higher interest rates.

GOLDSTEIN: So were you a bond vigilante?

BILL GROSS: Well, I was a very powerful bond manager - vigilante at that level, yes. Yes, I'd have to say that.

GOLDSTEIN: This is Bill Gross. Mary, you know Bill Gross quite well. In fact, you wrote a book about him. It's called "The Bond King." It's coming out later this year.

CHILDS: That's right. Yes. For better or worse, I've spent the last six or seven years thinking about Bill Gross and the things that he's done. So at the time that all of this is going on, Bill Gross is running a gargantuan bond investment company called PIMCO.

GROSS: PIMCO was a very large company at the time - $2 trillion in assets - bigger than Goldman, bigger than Bank of America, bigger than anybody. You know, 2 trillion - nobody had $2 trillion. And so...

GOLDSTEIN: I'm contractually obligated to repeat 2 trillion in a...

CHILDS: Yeah.

GOLDSTEIN: ...Stunned way, but I appreciate that you repeated it for me.

CHILDS: Here is this $2 trillion bond vigilante looking at all these years of massive deficits. And he does the thing that Bill Clinton and James Carville and the Obama people who are worried about interest rates are so afraid of, and he does it in a big way. He decides to sell all of his Treasury bonds.

(SOUNDBITE OF ARCHIVED RECORDING)

UNIDENTIFIED REPORTER: Good evening, everyone. The world's largest bond fund is no longer betting on U.S. bonds. PIMCO's Total Return Fund has sold off its government bond holdings to zero.

CHILDS: Bill Gross was not the only investor to say or do this. He was just the biggest, and he was very public about it. It was all very dramatic.

GOLDSTEIN: So the biggest bond investor in the world has just sold all of his Treasurys and told the whole world that he's doing it. We know what is supposed to happen next. Interest rates are supposed to go up. But this time, that doesn't happen. Instead, interest rates go down.

CHILDS: So that means that Bill Gross has bet wrong, which is obviously bad for his investors. After a few painful months of this, he realizes he's made a mistake, and he has to make it stop. He buys Treasurys again. And in late 2011, he writes a letter to his investors titled "Mea Culpa," basically apologizing for getting things so wrong. He tells them, quote, "I'm just having a bad year."

GOLDSTEIN: Bill Gross didn't really understand what was going on yet. Nobody really understood what was going on yet. But it was clear that something big had changed in the bond market.

GROSS: The world was beginning to not work the way it usually did.

GOLDSTEIN: The world was beginning to not work the way it usually did. The world is working in some new, frankly kind of mysterious way where it seems like no matter what happens, interest rates stay really, really low. And that is the world we are still living in today.

CHILDS: After the break, what even is going on?

(SOUNDBITE OF MUSIC)

GOLDSTEIN: So in the 10 years since Bill Gross's 2011 screw-up and mea culpa, interest rates have stayed low year after year, even as the deficit has stayed high. And as Laura Tyson told us when we talked to her about it, economists don't entirely understand why.

TYSON: We really - this is an area where economic science is not at its best yet (laughter) or where there's a lot of uncertainty. There is a lot of uncertainty.

CHILDS: But economists have spent the last decade trying to figure this out. Why are interest rates so low even when deficits are so high? And there are a few reasons they've come up with. Here are two big, important ones.

GOLDSTEIN: No. 1 basically comes down to supply and demand. You can think of interest rates as the price of borrowing money, borrowing dollars. And the higher the supply, the more money, the more dollars people want to lend, the lower the price, the lower the interest rate. And a thing that's happened over the past decade is the supply of dollars to lend has gone up. So the price to borrow those dollars, the interest rate, has gone down. The supply has gone up for a few reasons, but maybe most importantly, the Federal Reserve, America's central bank, has created trillions and trillions of new dollars.

CHILDS: Reason No. 2 for low interest rates - this one people are talking about a lot right now. This is the thing that people worry about. It's inflation.

GOLDSTEIN: Inflation.

CHILDS: It's inflation.

GOLDSTEIN: Inflation and interest rates are, like, very closely linked.

CHILDS: Very interlinked.

GOLDSTEIN: And here's why. If you lend somebody money today and there's a bunch of inflation between now and the time you get paid back, that is bad for you as the lender because the money you get paid back won't buy as much stuff as the money you loaned out 'cause of the inflation.

CHILDS: So as a result, when lenders, those bond vigilantes, expect inflation to be high, they demand higher interest rates to make up for it. And an essential fact of the last decade has been that inflation has stayed really low year after year. And this has been basically our Get Out of Jail Free card. There are a bunch of reasons for it. Maybe my favorite, because it's so weird, is inflation expectations.

GOLDSTEIN: Inflation expectations. Inflation has been so low for so long that people now expect that inflation will continue to stay low. And one of the kind of amazing things about inflation is that expectations can create reality. There's sort of a self-fulfilling prophecy. And you can think about why that is so like this. Like, there are lots of big multiyear contracts out in the world, right? Like, if somebody's going to build a skyscraper, they sign a multiyear contract, or if a union is negotiating a new deal, they sign a multiyear contract. And built into those contracts are annual pay increases based largely on what people expect inflation to be. So the higher they expect inflation to be, the higher the annual pay increases will be. And those pay increases ripple through the economy as inflation. And when people expect inflation to be low, those annual increases are very low, and that actually helps to cause inflation to stay low. And that is the world we're living in now - low expectations, low inflation.

CHILDS: So bond traders saw all of this - this huge increase in supply of dollars to be lent, the incredible stability of inflation expectations - and they just kept buying Treasury bonds, kept lending money to the government at really low interest rates.

GOLDSTEIN: And then, as we can't stop saying in stories like this, the pandemic hit.

CHILDS: Let's go one more time to Obama's guy, formerly Clinton's guy, Jason Furman.

GOLDSTEIN: And were you involved in any policy conversations with, say, people in Congress, you know, last spring? Were you inside any of these virtual rooms?

FURMAN: Yeah. I was in one of the last actual rooms. At the beginning of March, I addressed the full House caucus, told them that we might have something that was worse than the financial crisis and that very large fiscal action was needed urgently.

GOLDSTEIN: And what? March of last year, April of last year - what's the story?

FURMAN: Congress, for the first time I've ever seen, acted correctly, in my view, as if there was no budget constraint. They asked, how much could we possibly spend on this problem? And they spent more than we've ever spent outside of World War II.

GOLDSTEIN: And was this surprising to you?

FURMAN: I was pleasantly surprised.

CHILDS: He was surprised because of how different it was from the last time he was talking to Congress about spending a lot of money to fight a crisis a decade ago. Now, Furman and a lot of other economists say Congress should have spent a lot more in 2009, should've done a lot more to help people get back to work and make that long, painful recovery a little less long and painful. They just understand the world of deficits and interest rates really differently than they used to.

FURMAN: Many of the economists who were warning about the debt and deficit a decade ago this time around said if you need to spend 5 trillion, you need to spend 10 trillion, you should do it.

GOLDSTEIN: And that's just so different.

FURMAN: And that's so different. And I think, in part, it's because people made a mistake 10 years ago and learned...

GOLDSTEIN: Yeah.

FURMAN: ...From the mistake. But in part, objectively, there was much less reason to be concerned about interest rate risk this time than there was a decade ago.

CHILDS: So here we are today. The government has borrowed trillions of dollars to fight the pandemic and its effects. In the next few weeks, Congress will probably pass a bill to spend another roughly $2 trillion more in borrowed money. And so far, interest rates and inflation are still - you guessed it - super low.

GOLDSTEIN: But there is now more resistance than there was last spring to borrowing and spending trillions of dollars. And, yes, some of this is Republicans who want to undermine the Biden administration, but it's not just that. Several economists who worked in the Obama and Clinton administrations have, themselves, argued that it might be better to spend less now. They say that borrowing and spending so much money could drive up inflation and drive up inflation expectations. And remember; low inflation and low inflation expectations - they have been the key to this whole low interest rate world that's made all the borrowing possible.

CHILDS: These economists say, yes, we got it wrong in the financial crisis because we didn't spend enough, but that was in part because we didn't really understand how deficits and inflation and interest rates all fit together. And we still don't really understand, and we could get it wrong this time by spending too much.

GOLDSTEIN: But a handy thing about the bond market is you don't just have to listen to what people say. You can go and look at what bond traders are betting on. They're not always right. Remember when Bill Gross sold all his Treasurys back in 2011? But their job is to bet money and make a profit, not to go on CNBC or to advance some political agenda. And what bond traders are betting on now is that for years to come, inflation and interest rates will stay low. They're betting that this is just the way the world works now.

(SOUNDBITE OF ADRIAN QUESADA, ERIC BURTON AND SKINNY WILLIAMS SONG, "THE SOUL OF SHAOLIN")

CHILDS: You can find us on all the social media platforms. We are at @planetmoney pretty much across the board.

GOLDSTEIN: Also, we have a free weekly email newsletter. Latest one is all about student loan forgiveness. Subscribe at npr.org/planetmoneynewsletter, all one word, except it's, you know, three words or whatever - npr.org/planetmoneynewsletter.

CHILDS: Today's show was produced by Dave Blanchard, edited by Molly Messick and mastered by Gilly Moon.

GOLDSTEIN: Our supervising producer is Alex Goldmark. Special thanks to our intern, Dan Girma. I'm Jacob Goldstein.

CHILDS: And I'm Mary Childs. This is NPR. Thanks for listening.

(SOUNDBITE OF ADRIAN QUESADA, ERIC BURTON AND SKINNY WILLIAMS SONG, "THE SOUL OF SHAOLIN")

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