Even with the recent partial decline in long-term real and nominal interest rates, they remain well above the very low levels to which policymakers are accustomed, and are likely to remain there even as inflation declines. It is now time to reconsider the widely held “free lunch” view of government debt.
The idea that interest rates would remain low forever seemed to support the view that any concerns about debt were an endorsement of “austerity.” Many believed that governments should run large deficits during recessions and run slightly smaller deficits in normal times. No one seemed concerned about the potential risks, especially those related to inflation and interest rates. The left has championed the idea that government debt can be used to expand social programs, beyond what can be generated by cutting military spending, while the right seems to believe that taxes exist only to be reduced.
The most misguided approach involved using central banks to buy government debt, which seemed costless when short-term interest rates were zero. This idea is the core of modern monetary theory and “Helicopter moneyIn recent years, even prominent macroeconomists have floated the idea of the US Federal Reserve writing off government debt after it absorbs it through quantitative easing, an apparently simple solution to any potential sovereign debt problem.
But this approach assumes that even if global real interest rates rise, any increase will be gradual and temporary. The possibility that a sharp rise in interest rates would significantly increase interest payments on existing debt, including debt held by central banks as bank reserves, has simply been dismissed. But here we are: The Fed, which previously paid no interest on these reserves, is now paying more than 5%.
With a few notable exceptions, those who advocated the idea that religion was a free meal did not acknowledge the possibility of a new reality. At a recent conference, I heard from a well-known financial commentator who was a staunch advocate of the “world is forever” narrative, and who seemed unaware that it had been completely debunked.
When pressed, this commentator acknowledged that if interest rates do not quickly return to their extremely low levels of the 2000s, the budget deficit may matter after all. But they were reluctant to acknowledge that current debt burdens might be a problem, because this would challenge their previous support for wasteful fiscal policies.
Likewise, in A Recent paper On record levels of global debt, presented to the world’s top central bankers at a Jackson Hole, Wyoming conference this year, Serkan Arslanalp and Barry Eichengreen She seemed reticent to discuss the consequences of current debt burdens or the relationship between rising government debt and slowing growth in countries such as Japan and Italy.
To be sure, the next recession, whenever it occurs, will likely bring a significant drop in interest rates, which could provide temporary respite for the debt-laden United States. Commercial real estate market, where today’s slogan is “Survive until 25.” If landlords can weather another year of lower rents and higher financing costs, the thinking is that a sharp drop in interest rates in 2025 could stem the wave of red ink that threatens to sink their businesses.
But even if inflation falls, interest rates are likely to remain higher over the next decade than they were in the decade following the 2008 financial crisis. This reflects a variety of factors, including rising debt levels, declining globalization, and increased defense spending. , the green transition, populist demands for income redistribution, and persistent inflation. Even demographic shifts, often cited as justification for continued low interest rates, may affect developed countries differently as spending increases to support rapidly aging populations.
Although the world can certainly adapt to higher interest rates, the transition is still ongoing. This shift could pose a particularly big challenge for European economies, because ultra-low interest rates have been the glue holding the eurozone together. european central bankWhatever you take – whatever it takesBailout policies looked inexpensive when interest rates were near zero, but it is unclear whether the bloc can survive future crises if real interest rates remain high.
as I did previously arguedJapan will struggle to move away from “zero forever” interest rate policies, with its government and financial system accustomed to treating debt as cost-free. In the United States, weaknesses in the commercial real estate sector, combined with increased borrowing, may spark another wave of inflation. Moreover, while major emerging economies have managed to handle high interest rates so far, they face enormous financial pressures.
In this new global environment, policymakers and economists, even those previously in the “forever low” camp, may need to reevaluate their beliefs in light of current market realities. Although it is possible to expand social programs or enhance military capabilities without running large deficits, doing so without raising taxes is not easy. We are likely to find out the hard way that we never had before.
Kenneth Rogoff is a former chief economist at the International Monetary Fund, professor of economics and public policy at Harvard University, and recipient of the 2011 Deutsche Bank Prize in Financial Economics. He is co-author (with Carmen M. Reinhart) of “This time is different: eight centuries of financial folly“(Princeton University Press, 2011) and author of “The curse of criticism“ (Princeton University Press, 2016).
This commentary is published with permission from Project Syndicate — High interest rates are here to stay
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