DeLong, Project Syndicate, The Perils of Prophecy, here.
The third surprise, however, may be the most interesting. Back in March 2009, the Nobel laureate Robert Lucas confidently predicted that the US economy would be back to normal within three years. A normal US economy has a short-term nominal interest rate of 4%. Since the ten-year US Treasury bond rate tends to be one percentage point above the average of expected future short-term interest rates over the next decade, even the expectation of five years of deep depression and near-zero short-term interest rates should not push the 10-Year Treasury rate below 3%.
Indeed, the Treasury rate mostly fluctuated between 3% and 3.5% from late 2008 through mid-2011. But, in July 2011, the ten-year US Treasury bond rate crashed to 2%, and it was below 1.5% at the start of June. The normal rules of thumb would say that the market is now expecting 8.75 years of near-zero short-term interest rates before the economy returns to normal. And similar calculations for the 30-year Treasury bond show even longer and more anomalous expectations of continued depression.
The possible conclusions are stark. One possibility is that those investing in financial markets expect economic policy to be so dysfunctional that the global economy will remain more or less in its current depressed state for perhaps a decade, or more. The only other explanation is that even now, more than three years after the US financial crisis erupted, financial markets’ ability to price relative risks and returns sensibly has been broken at a deep level, leaving them incapable of doing their job: bearing and managing risk in order to channel savings to entrepreneurial ventures.
Neither alternative is something that I would have predicted – or even imagined.
Sober Look, LIBOR is becoming less relevant, even in the US, here.
The Barclays LIBOR scandal is expected to open doors wide open for private litigation. We know what that means for Barclays – the stock is down 11% for the day. But what does that mean for the LIBOR index?
It is possible that some banks will simply stop contributing to BBA in order to avoid running into similar problems in the future. Controlling flow of information across “the wall” (traders to contributors) in large institutions is difficult and expensive, and given that banks make no money by contributing, it may not be worth the risk.
As discussed before, this index is completely artificial in Europe. LIBOR/EURIBOR represents unsecured interbank lending which is not taking place among European banks, as they have almost entirely shifted to secured financing (repo) either with each other or increasingly with the ECB.
And even in the US where interbank unsecured lending still takes place, the market is becoming much less relevant. The chart below shows the total size of interbank loans for all US commercial banks going back to the 80s. The number is just over $100bn, which may seem like a large amount, but it’s a fraction of what it was at the peak.