One of the enduring economic mysteries of the past few years is that even during a period when budget deficits soared to record levels, interest rates have remained low. After all, conventional wisdom has long held that the government, by soaking up massive amounts of capital, would compete with the private sector for a finite pool of capital, and thus push interest rates up. That's why maintaining fiscal discipline has been considered the key to keeping interest rates low. The theory has been dubbed Rubinomics by its critics (mostly former deficit hawks who have been complicit in the creation of the gigantic Bush-Frist-Hastert deficits) in honor of Robert Rubin, the former head of Goldman Sachs who served as Clinton's treasury secretary. But the theory is really more Economics 101 than the gospel according to Bob. As Berkeley economist/blogger J. Bradford DeLong noted here, both Gregory Mankiw, the current chairman of the Council of Economic Advisers, and his predecessor, Glenn Hubbard, made the same argument in their respective macroeconomic textbooks.
The Federal Reserve's unprecedented rate-slashing has certainly helped keep interest rates low. But interest rates aren't determined solely by Alan Greenspan and his cloistered colleagues. In a system like ours, where money is created on demand, interest rates respond in part to the laws of supply and demand. The more eager people and companies are to borrow money, the higher its price—as expressed by interest rates. Since American consumers' urge to go into debt certainly has shown no sign of abating, is the demand to borrow falling somewhere else? The answer is yes: American businesses have lately been showing remarkable restraint. Their belt-tightening behavior should give pause to those among us who have been celebrating the Bush boom and relishing low interest rates.
Consumers borrow cash in relatively small chunks: $5,000 on a credit card, $30,000 for an auto loan, a $400,000 mortgage. But companies borrow in gigantic gulps, millions or tens of millions of dollars at a time. For many companies, the preferred vehicle for short-term purposes is commercial paper. Commercial paper is one of those little-known, unglamorous, and yet enormously important sectors of the capital market. Cheaper and more hassle-free than bank loans or bonds, these unsecured loans enable companies to borrow money for the short term—anywhere from two to 270 days. Companies rely on commercial paper to finance inventory or to tide themselves over between when orders are made and when companies actually collect on sales. Here is the Fed's description of commercial paper.
So if the economy is red-hot, and companies are engaged in a frenzy of investment, purchasing, and selling, you might expect demand for commercial paper to be rising. But demand for commercial paper has in fact been falling. In this document, which shows the amount of commercial paper outstanding each month since 1991, the figures show huge growth throughout the 1990s, when demand for private capital of all sorts was high. The amount peaked at $1.62 trillion in November 2000, and then began to slide rather dramatically. In November 2003, it stood at $1.3 trillion, down 20 percent from its peak. Since January 2003, the amount outstanding has fallen about 5 percent. The chart contained in this Fed release graphically illustrates the downward trend of the past two years.
When you examine the two main sources of demand for commercial paper—nonfinancial companies and financial companies—a stark divide emerges. The amount of commercial paper held by financial companies has been relatively stable. It stood at $1.18 trillion as of November 2003, off just a few percentage points from the April 2001 peak. But look at the amount of commercial paper outstanding to domestic nonfinancial companies—admittedly a far smaller figure. It stood at $110 billion in November 2003, down 18.5 percent from the December 2002 total—and off a whopping 65 percent from the $315 billion peak in November 2000. That's telling because nonfinancial firms are likely to use proceeds of borrowing to buy things—goods and services—whereas financial companies are likely to use proceeds of short-term borrowing to buy other financial assets. The most recent data shows that as of Dec. 3, nonfinancial domestic companies had further reduced their commercial paper borrowing to $104.2 billion.
In other words, amid the growth of the last few quarters—stimulated in large part by tax cuts to consumers and mortgage refinancing—companies haven't been clamoring for cash. Ah, but couldn't companies simply be eschewing short-term financing for longer-term debt, like bank loans? After all, interest rates are low; banks are healthy and should be in an expansive mode.
The Fed follows the amount of loans outstanding to U.S. companies, too. And here again, the numbers have been surprisingly weak. Line 6 in this release, which documents bank loans outstanding to commercial and industrial companies, shows the figure fell from $968 billion in October 2002 to $892.4 in October 2003—a decline of 8 percent. A look at the historical data shows that the amount outstanding has fallen for 20 straight months. And as of Nov. 19, the total was off 18 percent from the February 2001 peak.
Ordinarily, a prolonged period of rock-bottom interest rates should be an excuse for consumers and corporations to party. And the recent data showing job creation, high growth, massive productivity gains, and cheap borrowing rates make a pretty potent cocktail. The problem is that not everybody is joining in the revelry. Indeed, interest rates remain low in part because far too many corporate executives are sitting on the sidelines, sipping club soda.