A Theory on Interest Rates and The Yield Curve

Abstract

In this book I argue that the slope of the yield curve measures the rate of an economy’s capital accumulation or consumption, and specifically, that a negative yield curve (AKA a downward sloping yield curve; an inverted yield curve) is a market signal that capital is being accumulated, and that a positive yield curve is a market signal that capital is being consumed. Such a thesis is completely different from the contemporary academic argument that the negative yield curve is detrimental to the health of the economy and that a positive yield curve is a sign of economic growth. Therefore, I begin this book with the piece of evidence which caused me to radically reassess the theories which prevail today - the simple observation that the yield curve was almost always negative (more than 90% of the time) prior to 1914. The 19th century in the United States was a time of the most astounding economic growth the world has ever seen. Barren land was plowed and irrigated, cities, roads, factories and shipyards were constructed, a positive balance of trade was maintained with the rest of the world - and all this was accomplished while the yield curve was inverted.My first critics (to whom I am grateful) did not believe me when I pointed out to them that the yield curve was negative during the 19th century, so the first chapter of this book is a discussion of the interest rate data which we have from the 19th century, its reliability, what it says, and how it can be compared to modern interest rate data. Once I have shown that the yield curve was in fact negative during the 19th century, I discuss theoretical anomalies that support my case that the existing theory deserves to be re-evaluated. According to modern theory on the yield curve, the astounding economic growth of the 19th century should never have happened. But it did happen, and we as economists ought to know why. Also, modern theory on the yield curve argues that a positive sloping yield curve is conducive to economic growth, yet we see that in times of severe economic depression (the 1930’s Great Depression, 1990’s Japan, and the 2007 crisis), that the yield curve becomes extremely positive. As of this writing, the 20yr-3mo yield curve is 3.5% and our economic policy makers are still concerned that the financial and economic system is in a state of extreme risk. Never in the history of the 19th century (when the yield curve was negative, mind you) was anybody fearful that the entire economy could be demolished via a financial chain reaction. We, as economists, must have an explanation. That is the purpose of this book.