INTEREST RATES REMAIN LOW? PROFESSOR DIETER HELM, UNIVERSITY OF OXFORD
We live in extraordinary times.
Realinterests are negative, have been negative for several years and the forward guidance from central bankers suggests that they believe they are going to stay that way for several years tocome. Yet this is a very unnatural state of affairs: the long run interest rate should roughly approximate thegrowth rate. Assuming that this isabout two per cent then that too is roughly what the long run interest rateshould be. There are good reasons for thinking that this long run rate will eventually re-impose itself. Economic growth is ultimately driven by technology pushing out the supply curve. Big technology shifts the coming of the railways, cars,electricity and the internet have triggered growth spurts in the past, and there are lots more to come, withgraphene, 3D printing, big data, smart grids, new generation solar andgenetic applications just some examples of things we already knowabout.
HOW WE GOT TO NEGATIVE
REAL INTEREST RATES
The causes of our current extraordinarily
low interest rates lie deep in the great boom of the late twentieth century, spurred in part by the arrival of the newinformation technology. It not onlyspawned great new companies like Microsoft, Apple and Google, butas a generally pervasive technology,it changed everything
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elseas well abit like the way
railwaystransformed the role of markets as suppliers and consumers were brought into ever-closer contact, and the way electricity brought light, power and appliances into factories, offices and homes. Anirrational exuberance took hold: thefuture looked dramatically better than the past, and because there wouldbe so much growth, why save when you could borrow and get a sliceof the expected golden future? As the late twentieth century boom gotgoing, debt-financed consumption replaced prudent savings. Banks lent on the promise of the golden future that borrowers were certain would bearound the corner. Governments resorted to ever greater deficit financing on the hope that the growth in tax receipts from that growth would pay back the loans. That borrowing inturn sucked in the savings from the one partof the world which still forced down consumption. China channelled itssavings into US Treasury bills, whichpaid for the demand for Chinasexports, and in turn fuelled Chinas phenomenal growth. Chinas low costsalso helped to keep the lidoninflation. In this Goldilocks economy, politicians,and indeed professional economists, convinced themselves thatthe businesscycle had been abolished andthe wiseuse of fiscal
policy would steer theeconomy
onastable path. Yet theunderlying fundamentals had not been altered asmuch as this irrational exuberance suggested. Whilst there had indeed been a technology-induced boom, theunderlying growth rate turned outto bemuch lower than expected andthebusiness cycle had not beenabolished. After the party, therewouldbe a nasty hangover as the debts that had been amassedcould not be supported bythe underlying economic performance. An accident was waiting to happenandas the economies of thedevelopedworld started to skid, thepolicy response made it worse. Thecrash of2000 was met with alargedose ofKeynesian and Monetarist medicine. Interest rates headed towards zero(andnegative inreal terms) andGeorge Bushs taxcuts in the USandGordon Brownspublic expenditure splurgeinthe UKfurtheradded todemand. What followed was textbook economics. The asset bubble in 2000became significantly worse and,in particular, ahousing bubble sustained by subprime lending tookoff.This became unsustainable asthese things always do and camecrashing down to earth in 2006when interest rates inevitably started torise.
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There is every prospect of a sustained
period of low interest rates for at least a couple more years
Governments can carry on getting away with low interest rates until inflation really gets a hold
DEFAULTING ON THE DEBT
The consequent credit crunch
andbanking crisis which unfolded in2007 reflected the fact that the enormous debts in both the private and public sectors were no longer credible. Thecredit crunch played outinto asovereign debt crisis. IntheUS andthe UK, now that interestrates were already close tozeroin nominal terms, rather thanexplicitly defaulting on the debt,bothgovernments resorted toprintingmoney. In the Eurozone, they tried German discipline with internal devaluation. We have been here before after bothWorld Wars when governments found themselves with debts beyond their capacities to pay. After the FirstWorldWar, Germany resorted tothe printing presses to pay forreparations demanded by the French,who in turnfaced demands from the US to payfortheir war loans.In the process, the German professionalmiddle classeshad theirsavings wiped out and this contributedto the Nazi disaster. Understandably, Germany has good historical reasons for its sound money approach to the Eurozone crisis. After the Second World War, debt waswritten off in part, but in the UKthedebt-to-GDP ratio was over
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240percent (compared with less
than90 per cent today). The solution then was low realinterest rates, butwith thebanks forced to hold government debt and crucially capital controls. Financial repressionpaid off the debt, aidedbythe economic growth ofthe1950s. The final example of unsustainable government debt came at the endofthe 1970s, when low growth andtheunion-pressurised Labour government induced a wage-driven inflation spiral. Margaret Thatcher inherited an economy with over 10 per cent inflation, which quickly accelerated to a peak of 22percent in1980. Inflation solved the problem indirectly writing off thegovernments real liabilities.
WHAT HAPPENS NEXT?
These past episodes and a bit of
economics tell us a lot about what is likely to happen next. The facts are simple: the debts are not going away. Indeed they are getting bigger intheUK and the US, and indeed in much of Europe too. These debts are greater than the capacity of economic growth to pay them off anytime soon. Theresult isthat there will have to befurther defaults. Inflation makes thisalot easier at three per cent per annum itwould be halved in real terms inadecade. But it only works if that
inflation rate is above the interest
rateand debt is not index-linked. Put another way, suppose governmentswere now to raise interestrates to something like normal say two per cent real. Two things wouldfollow. First, government interestcharges on debt would rise sharply making it much harder to reduce thedebt and the deficits. Thatis the problem for Italy and Greece, where real interest rates havebeen more thantwo per cent. Second, real assets would fall invalue especially houses. Think whatamortgage rate ofsay fiveper cent nominal, plus amargin oftwoper cent, would do to houseprices. A moments reflection tells us that keeping interest rates low is more ofanelection-winning strategy than adjusting back to long-run normalcy. Itsuits politicians to keep rates very lowand central bankers panic about theconsequences to the fragile banking sector of a shock of rising realinterest rates. It is easier to keepthe printing presses going for abit longer in the US, and to hold tonegative interest rates in both theUSand the UK, than to face uptothepainful fact that the great latetwentieth century boom has leftthemajor economies with debts theycannot hope to repay.
HISTORY HAS NOT
BEENABOLISHED
So how long can they keep up the
fiction? Governments have the power toexpropriate their citizens as long asthey cannot leave and they cannot run away with their money. Eventhough there was a lot of capital flight from Germany in the period between 1918 and the final collapse inhyperinflation in 1923, the Weimar regime still managed to render its debtworthless. Ifa government wants to, it can radically alter the terms of theequation between savers andborrowers. One big difference is that although there are few capital controls in themajor Western economies now, moneycan run from a default-minded government. Indeed, in a proper panic such as the run on Northern Rock the possibility can quickly become the reality. Yet there is adifference thistime around. Althoughthe money can run, there isntanywhere obvious forit to run to.The US, still the worldslargest economy, can borrow with impunity atvery low interest ratesdespite havinga very high debt burden; theChinese and the Japanese have theproblem with $1.5 trillion US Treasuries each. The euro is not much better and sterling is in a similar place. Even Switzerland no longer looks thatattractive. Globalisation has globalised low interest rates.
As long as this remains true and
thereislittle prospect of a capital flightfrom the dollar, euro or sterling,governments can carry on getting awaywith low interest rates forthe foreseeable future. Until thatis,inflation really gets a hold. Three per cent inflation is a gentle waytodefault. 10per cent is not. Addinareturn toeconomic growth (whichraises tax revenues), and thereisevery prospect of a sustained periodof lowinterest rates for at least acouple moreyears. But history has not been abolished: thecredibility ofthe dollar, euro and sterling has taken a bashing and other countries, like China, may gradually gain thecredibility that these Western countrieshave been losing.
Dieter Helm, Professor of Energy
Policy, University of Oxford & Fellow in Economics, New College, Oxford Dieter Helm is an economist, specialising in utilities, infrastructure, regulation and the environment, and concentrates on the energy, water and transport sectors in Britain and Europe Dieter Helm, 2013
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