Law of Unintended Consequences Caused the Great Bond Rout
There is only one true law of history, and that is the law of unintended consequences. In the early 1920s, the University of Chicago economist Frank Knight famously drew a distinction between calculable risk and unknowable uncertainty. He overlooked a third domain: Unintendedness — where what happens is not what was supposed to happen. Those whose job it is to manage risk today tend to focus on the things to which probabilities can be attached and shrug their shoulders about everything else. They might do better if they simply assumed that most grand designs will go awry.
Take the sudden surge in nominal and real interest rates we are witnessing, which has seen the yield on a 10-year US Treasury rise from 0.66% in April 2020 to 4.88% this week. The last time the 10-year yield moved this much in the space of three years was 1979-82 — back when Fed Chairman Paul Volcker was slaying the 1970s inflation dragon — a period that saw not one but two recessions.
I am not the only one getting that nasty 1980s feeling. Last week my Bloomberg Opinion colleague John Authers was curdling investors’ blood by recollecting the way a comparable rise in bond yields was followed by the Black Monday stock market crash in October 1987 — “still the single most terrifying day in market history” (which is a little hard on the black days of October 1929).
Yet it is worth looking further back in history. In terms of total returns, this is the biggest bond market rout in 150 years. Last year was in fact US bond investors’ worst year since 1871, with a total return of minus 15.7%, even worse than the annus horribilis of 2009. For 2023, the year-to-date return has been almost minus 10%; annualized, that’s minus 17.3% — even worse than 2022. We are looking at bond investors’ two worst years in a century and a half.
The story is similar for investors in UK gilts. Returns in 2022 (minus 22%) were worse than in 1916, the nadir of Britain’s fortunes in World War I (minus 20%), though 2023 has not been so bad.
All this is terrible news for the banks holding large quantities of Treasury securities on their balance sheets. It is terrible news for the very large number of companies whose investment grade bonds — totaling more than $400 billion — mature next year. It is terrible news for anyone looking to refinance a mortgage. For all these different groups, borrowing costs will leap upwards.
But the biggest consequences will be for the biggest borrower — namely the US government. As Greg Ip put it in Thursday’s Wall Street Journal, “Rising Interest Rates Mean Deficits Finally Matter.” It is no coincidence, he argued, that “the recent rise in bond yields came as Fitch Ratings downgraded its US credit rating, Treasury upped the size of its bond auctions, analysts began revising upward this year’s federal deficit, and Congress nearly shut down parts of the government over a failure to pass spending bills.”
US fiscal policy has long been on an unsustainable trajectory — for more than 20 years, in fact. But under President Joe Biden it has jumped the shark. The federal deficit looks like it will exceed 7% of GDP in fiscal 2023, after the Congressional Budget Office adjusts for the vagaries of policy on student debt forgiveness. That is a truly shocking number for an economy that is running at close to full employment. And, as I pointed out here a month ago, there is no scenario the CBO can devise in which the total debt relative to GDP does not keep growing, with spending driven up partly by the rising burden of interest payments.
The key problem, as Brian Riedl of the Manhattan Institute has pointed out, is that the average maturity of the federal debt is just 76 months. So even if the CBO is right, and long-term interest rates average 4% over the next three decades, the result will still be budget deficits rising to 10% of GDP. And each additional percentage point on interest rates would add an additional $2.8 trillion of debt service costs over 10 years.
This disastrous outcome is a perfect illustration of the law of unintended consequences.
In the economics literature, Adam Smith’s “invisible hand” is a well-known example, whereby the individual, pursuing his narrow self-interest, is led “by an invisible hand to promote an end which was no part of his intention.” However, such benign unintended consequences seem to be the exception rather than the rule — especially when it comes to the intentions of public policymakers.
In “The Unanticipated Consequences of Purposive Social Action” (American Sociological Review, 1936), Robert K. Merton proposed five possible reasons why the best-laid schemes of politicians and planners so often go awry:
- Partial knowledge — “the paradox that, whereas past experience is the sole guide to our expectations on the assumption that certain past, present and future acts are sufficiently alike to be grouped in the same category, these experiences are in fact different.”
- Error — “the too-ready assumption that actions which have in the past led to the desired outcome will continue to do so.”
- The “imperious immediacy of interest” — “instances where the actor’s paramount concern with the foreseen immediate consequences excludes the consideration of further or other consequences of the same act.”
- “Basic values” — “instances where there is no consideration of further consequences because of the felt necessity of certain action enjoined by certain fundamental values.” The example Merton gives is Max Weber’s Protestant ethic and the spirit of capitalism, where deferred gratification had the unintended consequence of accumulating capital and ultimately eroding Calvinist asceticism.
- Self-defeating prophecy — “Public predictions of future social developments are frequently not sustained precisely because the prediction has become a new element in the concrete situation … [so that] the ‘other-things-being-equal’ condition tacitly assumed in all forecasting is not fulfilled.”
Long before Merton, or even Smith, the English political philosopher John Locke provided an illustration that is highly relevant to our own predicament. In “Some consideration of the consequences of the lowering of interest and raising the value of money” — an updated essay that he sent in a letter to a member of Parliament, Sir John Somers, dated Nov. 7, 1691 — Locke brilliantly spelled out the unintended consequences of artificial caps on interest rates. He was writing three years before the establishment of the Bank of England, which was intended to put an end to the English crown’s shocking record of defaults (e.g., the 1672 Stop of the Exchequer, when Charles II suspended payments on his government’s debts). It was a time when English officials would dearly have loved to ease the pressure they were under by reducing the interest they paid to borrow.
Could “the price of the hire of money … be regulated by law?” Locke asked. His answer was stark:
It is manifest it cannot. … It will be impossible, by any contrivance of law, to hinder men, skilled in the power they have over their own goods, and the ways of conveying them to others, to purchase money to be lent them, at what rate soever their occasions shall make it necessary for them to have it; for it is to be remembered, that no man borrows money, or pays use, out of mere pleasure: it is the want of money drives men to that trouble and charge of borrowing; and proportionably to this want, so will every one have it, whatever price it cost him. Wherein the skilful, I say, will always so manage it, as to avoid the prohibition of your law, and keep out of its penalty, do what you can.
What, Locke asked, would be the unintended consequences of a law to force down interest rates?
- It will make the difficulty of borrowing and lending much greater, whereby trade (the foundation of riches) will be obstructed.
- It will be a prejudice to none, but those who most need assistance and help; I mean widows and orphans, and others uninstructed in the arts and management of more skilful men …
- It will mightily increase the advantage of bankers and scriveners, and other such expert brokers …
- I fear I may reckon it as one of the probable consequences of such a law, that it is likely to cause great perjury in the nation; a crime, than which nothing is more carefully to be prevented by law-makers …
Locke concluded that was “vain, therefore, to go about effectually to reduce the price of interest by a law; and you may as rationally hope to set a fixed rate upon the hire of houses, or ships, as of money.”
It is a pity that the economics currently taught at America’s leading universities, where the future Fed and Treasury economists are trained, now largely omits the history of economic thought. A little Locke might have warned the proponents of “quantitative easing” and “forward guidance” that their efforts to manipulate interest rates would sooner or later have unintended consequences, too.
There are, of course, more memorable, non-economic examples of unintendedness. (For some reason, they nearly all involve animals.) During episodes of bubonic plague, such as the Great Plague that struck London in 1665, stray dogs and cats were killed in large numbers. The unintended consequence was to reduce the number of predators on the rat population that carried the fleas that transmitted the disease.
In China during the ironically named Great Leap Forward, the Communist Party targeted “Four Pests” — rats, flies, mosquitoes and sparrows. But the “smash sparrows” campaign overlooked that sparrows eat bugs as well as grain. With the population of sparrows drastically reduced, the population of locusts soared, with catastrophic results — not a great leap, but a great famine.
The best recent example is the provision of free mosquito nets to impoverished African villagers by nonprofits. The unintended consequence in this case has been that people use the nets not protect themselves from mosquitos but to catch fish, leading to overfishing because the fine mesh catches even the smallest fry. Want to know more about unintended consequences? Ask any Australian about cane toads.
In some ways, our own unintended consequences began with an invasive species — the SARS-CoV-2 virus that caused the Covid-19 pandemic. As described in my book Doom, policymakers throughout the Western world were persuaded to attempt Chinese-style lockdowns. Minimal protection of the vulnerable was achieved at enormous costs, not only in the form of handouts to people forced out of work, but also in the form of huge disruption to the educational and social lives of the young. But (as Nate Silver recently reminded us) it was only the vaccines that really worked.
The lockdowns had multiple unintended consequences. President Donald Trump failed to secure re-election partly because he seemed incapable of managing the emergency, but also because lockdowns implicitly conceded the legitimacy of big government. Joe Biden defeated him only narrowly, his party gaining slim majorities in Congress, but his advisers believed he should emulate Franklin Roosevelt and Lyndon Johnson with extravagant spending bills. Given that the vaccines, plus the 2020 stimulus checks, had already stoked the US economy for recovery, this was predictably inflationary, as former Treasury Secretary Larry Summers rightly pointed out. A further unintended consequence is that voters now give Biden no credit for the reduction in inflation we have seen this year.
Triumphing over his fellow Republican ex-Speaker of the House Kevin McCarthy last week, Representative Matt Gaetz declared: “I don’t think voting against Kevin McCarthy is chaos. I think $33 trillion in debt is chaos. I think that facing a $2.2 trillion annual deficit is chaos.” Not every voter will see this pose of fiscal rectitude for the grotesque hypocrisy that it is.
The surge in borrowing costs is the unintended consequence of many good intentions. The Federal Reserve’s decision to ignore the inflation warning lights and to sit idly by through 2021 and into 2022 was no doubt well meant. The governors wanted Americans to get back to work, and fast, after the pandemic.
But then Chairman Jay Powell belatedly realized his mistake and began jacking up short-term rates and shrinking the Fed’s balance sheet in a desperate bid to regain credibility and emulate Paul Volcker. At the Jackson Hole economic symposium in August, Powell described his task as “navigating by the stars under cloudy skies.” But the challenge is much greater if you knowingly set sail for Cape Horn.
In the same way, Trump and Biden were not wrong to think that China was posing a growing economic as well as strategic threat to the US. But the measures Washington has taken since 2017 — first tariffs, then technological sanctions aimed at containing China’s growth — have unintentionally added to the upward pressure on interest rates, effectively cutting the US off from Chinese capital.
Likewise, Western efforts to reduce greenhouse gas emissions are spurred by the best of intentions. We were not wrong to think that we should collectively switch from burning hydrocarbons and embrace renewable energy sources in order to slow or halt global warming. But the unintended consequence has been that China has flooded Western markets with solar cells and electric vehicles, all manufactured with increasing amounts of coal-generated electricity.
We cannot foresee how long the upward trend in bond yields will continue. Perhaps there will a 1987-style crash that will force the Fed to change course and cut rates. Or perhaps my brilliant former student Paul Schmelzing will turn out to be right. In Bloomberg last week, he was quoted predicting a quite rapid return to low and even negative real interest rates. Schmelzing’s forthcoming book-length history of interest rates points to a sustained declining trend for real rates dating back to the 14th century, albeit with bouts of volatility above and below the trendline.
“There’s a mean reversion going on around that centuries-long trendline,” he said. “But within a certain time frame, that global cost of capital always comes back to that trendline. And that … line is downward trending.” True, wars and pandemics can seem to derail the downward trend. But, according to Schmelzing, such shocks soon fade. If it “typically … takes about four years for half of shock [such as Covid] to reverse … [then] by 2024 we should be halfway back to that trendline.” And by 2050, real rates should be back in “deeply negative territory.”
Paul, I hope you’re right. My worry is that you are underestimating the tendency for one unintended consequence to lead to another in a veritable cascade of unintendedness. Schmelzing emphasizes the relative “absence of conflict” in the recent past, which was certainly a factor in the great disinflation that followed the end of the Cold War. But the interwar period is over. A new Cold War has begun. A hot war raging in Ukraine shows no sign of ending soon. With the Hamas onslaught on Israel, a new war has erupted in the Middle East. And storm clouds continue to gather over Taiwan.
I am quite sure Biden doesn’t intend to get embroiled in World War III. But then he didn’t intend to preside over the worst bond market in a century and a half. The law of unintended consequences is like that. It’s not an iron law. It’s an ironic law.
Ferguson is also the founder of Greenmantle, an advisory firm, FourWinds Research, Hunting Tower, a venture capital partnership, and the filmmaker Chimerica Media.