Negative real rates signify a broken financial system

Noah Smith reviews the debate over negative real rates, and Brad DeLong remarks on “how profoundly strange and unexpected” is the current environment. While Noah covers all the most common explanations for real rates, I think that he — and most of econo-blogosphere — are missing a key factor that is probably driving this data.

First, recall that the problem of negative real rates is very much focused on the “safe” side of the market. That is, it is Treasuries (and similar assets like Bunds) that bear negative real rates. The market rates available to non-public borrowers are much higher than the rate on “safe assets.” (The distinction between these two rates is the premise behind Caballero and Farhi’s work.)

In my view the missing element of the discourse on the low yields of safe assets is the remarkable change in the structure of the financial system that started very slowly in the 1990s, accelerated at the end of that decade, and was a full-fledged financial revolution by the end of the next decade. This change is the collateralization of inter-bank lending, that previously was unsecured and funded on the basis of reputation-type mechanism.

ISDA data shows that with the growth of swaps starting in the early 1990s, collateralization of bilateral derivatives contracts become fairly common, though far from ubiquitous. Subsequent to the 1998 LTCM crisis, collateralization of derivatives contracts became much more widespread. The 2000 Commodities Futures Modernization Act pre-empted long-standing common law and state law constraints on derivatives markets, which subsequently grew dramatically — along with the use of collateral. The 2005 bankruptcy reform act dramatically changed markets for collateral, and in particular made it possible for the repos of just about any asset to trade on a par with derivatives collateral.

In addition in the early naughties, the growth of structured financial assets that made possible synthetic assets in which “investors” sold protection on bonds (instead of investing in actual bonds) and held the collateral that was used to guarantee payment on the protection contracts in “safe assets.” Finally, financial market participants have sometimes commented that the Basel rules for banks promoted collateralized interbank lending over unsecured interbank lending (though I’ve never really investigated this point).

In short, the same data the Ben Bernanke explained in terms of a “savings glut” can also be explained by the financial industry’s massive increase in demand for safe assets that serve as high quality collateral over the same time period. The financial industry’s demand is a demand for safety and cannot be met by risky assets, so it is an excellent explanation for the 21st divergence between the behavior of “safe” interest rates and risky interest rates.

Furthermore, since the 2008 crisis the financial industry’s demand for collateral has only increased. In 2008 the unsecured interbank markets, including both the Federal Funds market and the Libor market, collapsed. They have not recovered. Interbank lending has shifted almost entirely to a collateralized basis. While it is true that the demand for collateral that was created by structured finance products has largely disappeared, this is most likely offset by regulatory changes that increase the demand for collateral.

In short, the best explanation for why private markets are forcing interest rates to zero is that the banking system is broken. The system which functioned for centuries on the basis of unsecured, reputation-based, inter bank lending no longer exists. ZIRP is just evidence that the financial industry is turning to government as a source of the liquidity that the financial industry is no longer capable of creating on its own.


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