Why are interest rates so low? Why are state governments going broke? Rates don’t reflect the current risk.

Alexander Hamilton created the US Treasury bond market in 1790. If the yields of US Treasuries are artifically depressed, so are private bonds (WSJ 9-30-11 Ronald McKinnon). The more bonds are manipulated downward, the less useful they become in reflecting current risk and the more the government insists on allocating public capital in place of private capital.

Because all bonds prices are artifically cheap, low interest rates will decapitalize private and public pension funds. The funds generally assume much higher yields to determine current annuity payouts. Without a sharp decrease in payouts the funds will fail.

The other alternative, is to let interest rates increase, saving state governments and anyone with a fixed income. Increasing interest rates would increase the cost of business to borrow and increase prices.

Keynesians believe government can create demand, while Friedrich Hayek and others believed that any artifical intervention disrupts the market prices; one of Hayek’s premises was that changing prices communicates information about the market. Without accurate prices how can the market predict risk?

At best our recent stimulus programs seem to be a very inefficient engine. There is no such thing as a 100% efficient engine. To think we can create demand by flooding the market with cash is silly. The money is all safely sitting in big banks, because they can’t accurately assess future risk and think it’s safer to buy Treasury bonds with near 0% yield. At least they aren’t losing money! What happened to creating demand?

Historically, this is solved by increasing supply and decreasing prices, not by trying to create demand. However, until the solution is found, look out for a wild ride. We are teetering on massive inflation, held in check partially by European inflation equal or greater than our own.  The net result is someday the government will change it’s position in the bond market and eventually interest rates must rise.  Then, bond yields will reflect risk.