Eight years after the financial meltdown of 2008, interest rates are near zero. Some investors must think they will stay there because they are buying long-term bonds that pay very little or no interest. Germany sold 30-year bonds that pay negative rates. The buyer pays the seller a little bit!
This is an unprecedented situation. The challenge to economists is to explain what has changed. Why are low or negative real interest rates expected to last for a long time? The simple, not very illuminating answer is that savings exceed investment at current interest rates and investors expect that to continue.
Some economists, notably Larry Summers and Robert Gordon, point out that investment remains low. Summers revives the “secular stagnation” explanation from the 1930s that, he recognizes, was wrong then but could be right now. That theory holds that investment opportunities have dried up, so business has little demand for investment. When we see many large firms buying back their shares at very high prices instead of investing, we have no trouble believing managers are pessimistic about future returns. The problem with Summers’ explanation is that it doesn’t explain the very low 30- or possibly 50-year bond rate. It isn’t believable that stagnation will last that long.
Robert Gordon, in his book The Rise and Fall of American Growth, claims that the age of great innovation in America is over. There will be no more major inventions or discoveries, he argues, that will transform society and accelerate investment as in the nineteenth and twentieth centuries. Perhaps he is right, but I am skeptical. In any case, there’s no way to know what will happen in the future.
A better answer is that the problem of low real interest rates is increased saving. The world economy is in transition from the policies followed in many countries over the past 50 years—especially Japan, France, Italy, and the United States—of using large-scale public and private debt to propel their economies and recover from recessions. At some point, debtors, including governments, will begin to retire debt. They might try to inflate it away or retire it as it comes due. Governments can raise future tax rates to pay interest rates on outstanding debt and to retire existing debt, or they can reduce spending. They might even reach a compromise that both reduces spending and raises tax rates to avoid a bond market crisis that forces action. Prudent governments will avoid crises by taking their time, spreading the debt reduction over a long period as happened after the Civil War and World War I. A crisis that forces action should not be ruled out, but that is not what the market anticipates. Low long-term rates are expected to continue. That’s consistent with gradual debt reduction sustained over a long period.
However achieved, spending reduction increases saving. I believe that the expected increase in saving is the main driving force behind exceptionally low market rates and negative long-term real interest rates. For the United States, large debt and unfunded promises to pay are problems for both state and the federal governments.
First, look at the states. Together they have massive debts of as much as $5 trillion mainly for future pension and healthcare liabilities. Unresolved budget struggles in both Illinois, France, and elsewhere show how difficult it is to find a compromise that powerful interest groups will accept to balance the budget by raising tax rates and reducing benefits. Adjusting to the new future will be painful.
The Federal government cannot solve the states’ problems. It has a massive problem of its own. The Congressional Budget Office estimates the unfunded future liability as $62 trillion, but private estimates run as high as $110 trillion. The difference includes the debts of Fannie Mae and other agencies. To each estimate add the nearly $20 trillion of currently outstanding federal debt.
On its current track, the debt-to-GDP ratio will rise from about the current 70 percent to an unprecedented 106 percent within a few years. No one knows whether that will start a crisis that forces actions to reduce debt by greatly reducing spending and raising tax rates.
For current purposes, let’s accept the market view and assume that we avoid a crisis by adopting a plan to reduce debt gradually over the next 30 or more years. We will no longer borrow freely. In place of the policies followed during the past 50 years, the federal government will aim to balance its budget or run small surpluses to slowly retire debt as it did following the Civil War and WWI. The federal government will be forced to save. Some combination of lower spending and higher taxes will replace government deficits with budget surpluses. The objective will be to reduce future obligations gradually so as to avoid a decline in output. Balancing the budget with much less debt will take decades of government saving. Some debt will remain.
Presidential candidates have not recognized that the government must change from a borrower to a saver, nor are they likely to awaken to this fact in this election cycle. The Democrats are proposing huge new spending programs for pensions and free tuition while the Republicans are proposing massive tax cuts. Either way, we will get larger deficits and more debt.
A more balanced approach that recognizes how much we have mortgaged our future would join tax reduction to a well designed program that reduces future deficits. Knowledgeable citizens recognize that reducing future deficits is a way of avoiding the future tax increases that will almost certainly be part of any agreement to reduce future deficits. Thus, reduced current and future spending lowers current income but increases future income by reducing expected future tax rates. Since labor produces and earns two thirds of total income, workers will bear a large part of future tax increases with major consequences for future wages and employment. The popular, simple solution—tax just the highest incomes—does not provide enough revenue.
As time passes and the population ages, promises for pensions and healthcare become actual budget spending. The effect is to push up future budget deficits and add to the problem by requiring more spending cuts and more tax increases.
Markets are ahead of the politicians. Real long-term interest rates are near zero throughout the developed world. That’s the market speaking about the future it sees. Because they are pessimistic about future income, members of the public willingly buy long-term debt at negative real interest rates to shift consumption to the future.
The Federal Reserve and other central banks can affect nominal rates, not real rates, so they follow along but do not cause and cannot change low real rates.
Governments should begin to develop plans to reduce future spending. The easiest first steps would eliminate the many duplicate programs that aim at employment, job training, and other welfare benefits. The inefficiency of many of these programs offers opportunities for reducing spending. But the main task will be getting agreement on a humane program to reduce projected health care spending since that is the main driver of future spending as the population ages.
A desirable change would transfer health care spending to the states as a way of encouraging program competition. The tenth amendment offers a way to resolve many problems that more clearly reflect the heterogeneity of our highly diverse population. The Constitution invites the Congress to call on the states to become agents of change.
The old way of bailing out problems by pushing the costs to the future has mortgaged our future. Our future promises to pay are far greater than any conceivable ability to honor them. That policy is coming to an end because we are approaching a debt limit. No one can be certain about when we will reach the limit, but we will. A wise public will demand that its government adapt now before being forced by a crisis. A wise government will plan for a different future.