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GUEST ARTICLE

Globalisation has globalised


low interest rates

HOW LONG CAN


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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GUEST ARTICLE

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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