Loose money, high rates: interest rate spreads in historical perspective

Abstract:

Over the past fifty years interest rate spreads have widened substantially, both between longer and shorter maturity loans and between loans to riskier and less risky borrowers. In much of economic theory, the determination of interest rate spreads is analytically distinct from the determination of the overall level of interest rates. But from a Keynesian perspective that regards interest as fundamentally the price of liquidity, there is no conceptual basis for picking out the difference in yield between money and a short-term government bond as “the” interest rate; there are many other pairs of asset yields the difference between which is determined on the same principles, and may have equivalent economic significance. In this article, we argue that this Keynesian perspective is particularly useful in explaining the secular rise in interest rate spreads since the 1980s, and that both conventional expectations and stronger liquidity preference appear to have played a role. The rise in the term and credit premiums is important for policy, because they mean that the low policy rates in recent periods of expansionary policy have not been reliably translated into low rates for private borrowers.

Key words::

• interest rates
• liquidity preference
• monetary transmission

JEL classifications::

• B22
• E12
• E43

ACKNOWLEDGMENT

The authors would like to thank Mike Beggs, Jim Crotty, Jerry Epstein, Bob Pollin, and participants at workshops at the University of Massachusetts at Amherst and the Eastern Economics Association for helpful comments.

Notes

¹It is no coincidence that Woodford’s title echoes Wicksell (2007). Woodford describes his approach as “neo-Wicksellian” and opens his book with a quote from Wicksell.

²“We can draw the line between ‘money’ and ‘debts’ at whatever point is most convenient for handling a particular problem. For example, we can treat as money any command over general purchasing power which the owner has not parted with for a period in excess of three months, and as debt what cannot be recovered for a longer period than this; or we can substitute for three months one month or three days or three hours or any other period” (Keynes, 1936, p. 174).

³As noted above, the existence of a unique interest rate in this framework requires either working in terms of a single representative good or assuming no changes in relative prices between periods.

⁴See a full discussion in Rezende (forthcoming).

⁵These numbers are derived from Moody’s Investor Service, “Annual Default Study: Corporate Default and Recovery Rates,” various years.

⁶For instance, Deutsche Bank’s 2012 report, “Five Years of Financial Crisis: The Default Bark Is Far Worse Than the Bite.” See also Moody’s Analytics June 2011 report, “If the Default Rate Is So Low, Why Are Credit Spreads So Wide?” The report notes that “credit spreads are too wide from the perspective of a comparatively low … default rate,” and attributes the excessive spreads to a “perceived reduction in the ability of sovereign governments and central banks to prevent or remedy economic downturns” and to “much greater financial systemic risk.”

Additional information

Notes on contributors

Arjun Jayadev

Aryun Jayadev is an associate professor in the Economics Department at University of Massachusetts, Boston, and Asim Premji University, Bengaluru, India.

J. W. Mason

J. W. Mason is an assistant professor in the Department of Economics at John Jay College of Criminal Justice, City University of New York.