June 29, 2015
The Bank of International Settlements (BIS) issued a new report warning of the dangers of low interest rates. Robert Samuelson wants us to take these warnings very seriously, effectively saying that another crisis could be around the corner due to the recent build up of debt.
First, it is worth noting that warning of disaster due to expansionary monetary policy is what they do at the BIS, sort of like basketball players play basketball. The BIS has been warning for years that inflation was about to kick up if central banks didn’t start raising interest rates. Of course, the exact opposite has happened, inflation rates have fallen and most central banks have been actively trying to increase the inflation rate from levels they view as too low to support growth.
The second point is that the rise in debt in a time of low interest rates is to be expected for two reasons. First, at low interest rates governments, corporations and individuals have more incentive to take on debt. This is not obviously a problem. For example, many corporations have taken advantage of extraordinarily low interest rates to issue long-term bonds. This gives them the opportunity to have cash to work with for decades into the future at very low cost. In these cases, they have the cash on hand and can easily meet their interest obligations.
The other point about low interest rates is that they directly increase the value of debt. The price of a bond is inversely related to the interest rate. This relationship matters most for long-term bonds. To take an extreme case, a bond that has a $3 annual payout forever will be worth $50 if the long-term interest rate is 6.0 percent. It will be worth $100 if the long-term interest rate is 3.0 percent.
This point is important, because the market value of the debt outstanding will plummet if interest rates rise, which is the implicit disaster story raised by Samuelson and others. If we want to focus on the face value of debt, then we will still have high debt to GDP ratios, but governments and corporations would be able to buy up the debt they had issued at low interest rates at large discounts, sharply reducing their debt to GDP or income ratios for those who fixate on such things.
For this reason, it is more appropriate to look at ratios of interest payments to GDP for most purposes, This is low in the United States and most other countries. Interest payments are currently about 1.3 percent of GDP (@ 0.8 percent if we subtract put the money refunded by the Federal Reserve Board). This compares to more than 3.0 percent of GDP in the early 1990s.
While interest payments may not be likely to pose a problem any time soon, there is an issue of bubbles deflating. While the U.S. stock market is not obviously out of line with fundamentals (don’t bet on 7.0 percent real returns going forward), there are several countries like Canada, the United Kingdom, and Australia where house prices are very high and appear to be driving the economy.
If house prices fall back to levels closer to their long-term trends, it will likely lead to sharp falls in consumption and construction spending. This will likely lead to sharp downturns in these economies. These downturns can be counteracted with deficit spending, but in countries where balanced budgets are worshiped, the bursting of these bubbles will almost always lead to large amounts of economic pain.
The underlying issue is that the world economy has been afflicted with a severe shortfall of demand for most of the last fifteen years. The underlying problem is that fast-growing developing countries like China are running large trade surpluses. This means that capital is flowing from poor countries to rich countries, the opposite of what the textbook story predicts.
The trade deficits in rich countries like the United States create a large gap in demand. This demand gap cannot be filled by the private sector, except through bubble-driven growth. With large government budget deficits ruled out by cultish economics, these economies are stuck with persistent unemployment.
Contrary to what you read in Samuelson’s columns and elsewhere, it really is not complicated. The problem is actually that it is far too simple for economists to understand.
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