December 8, 2016

A Low-Interest-Rate Future

  • Allan H. Meltzer

    Allan H. Meltzer University Professor, Carnegie Mellon University
Series Information

This essay is the eighth in a twelve-essay colloquium on the effect of low interest rates on the economy. To read other essays in the series, click here.

Eight years after a very deep recession, interest rates are near zero. Some investors must think the rates will stay there because they buy long-term bonds that pay very little or no interest. In fact, Germany has sold 10-year bonds that pay less than 1 percent.

Nothing similar has happened before. 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 investments at interest rates that are close to or below zero and that investors expect the rates to continue.

Some economists, notably Larry Summers and Robert Gordon, explain that investment remains low. Summers revives “secular stagnation,” which is an explanation from the 1930s that, he recognizes, was wrong then, but he says it might be right now. He proposes, correctly, that business has little demand for investment currently. When many large firms are buying back their shares at very high prices instead of investing, it is easy to believe that managers are pessimistic about future returns. My problem with Summers’ explanation is that it doesn’t explain the very low 30-year or possibly 50-year bond rate. It isn’t believable that stagnation will last that long.

Gordon claims that the future will not have any large innovations that transform society and accelerate investment as in the 19th and 20th century. Perhaps he will be right. I am skeptical, but there is no way to know what will be true in the future.

A very different answer is that the long-lasting problem is increased saving. Suppose investors believe that the world economy is in transition from the policies followed in many countries for the past 50 years—especially France, Italy, Japan, and the United States. Such policies boosted debt by using large-scale public and private debt finance to propel the countries’ economies and to help them recover from recessions.

At some point, debtors, including governments, begin to retire debt. They can 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 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 and by spreading the debt reduction over a long period. A crisis that forces action should not be ruled out, but that move is not what the market anticipates. Low long-term rates are expected to continue, which is consistent with a gradual debt reduction sustained over a long period.

However achieved, spending reduction increases national saving. I believe that the expected increase in saving would be the main driving force behind exceptionally low market rates and negative long-term real interest rates. The United States’s large debt and unfunded promises to pay are problems for both the states and the federal government.

First, look at the states. Although all but one of the states has a constitutional requirement to maintain a balanced budget, together the 50 states have a massive debt of as much as $5 trillion, mainly for future pension and healthcare liabilities. Unresolved budget struggles in governments around the world—from the state of Illinois to the country of France—show how difficult it is to find a compromise that powerful interest groups will accept to balance their budgets 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, one must add the nearly $20 trillion of currently outstanding federal debt.

On its current track, the debt-to-GDP ratio will rise from about 70 percent currently to an unprecedented 106 percent within a few years. No one knows whether that increase will precipitate a crisis that forces actions to reduce debt by greatly reducing spending and raising tax rates.

For current purposes, accepting the market view assumes that the United States will avoid a crisis by adopting a plan to reduce debt gradually over the next 30 or more years. The government 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 to run small surpluses that will slowly retire debt, as it did following the Civil War and again after World War I.

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. Getting to long-run budget balance with much less debt will take decades of government saving. Some debt will remain.

Presidential candidates, including those in the most recent election cycle, have not recognized that, in the future, government must change from being a borrower to becoming a saver. The Democrats offer huge new spending programs for pensions and free college tuition, while the Republicans propose massive tax cuts. Either way, the results are larger deficits and more debt.

A more balanced approach that recognizes how much the United States has mortgaged its 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 future tax increases, given that debt needs to be repaid through higher taxes, lower spending, or both. They also know that tax increases 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. Because 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 deficits and to add to the problem by requiring more spending cuts in other areas 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 members of the public are pessimistic about future income, they 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.

Michael Walker (chairman of the Fraser Institute) has an interesting empirical study that explains long-term real rates as a response to demographic changes affecting saving rates.  His findings do not seem inconsistent with the massive fiscal change that has mortgaged the nation’s future and that must sooner or later be reversed.

Government 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 low efficiency of many programs offers opportunity for reducing spending. But the main task will be getting agreement on a humane program to reduce projected healthcare spending because 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 new approach to resolve many problems in ways that more clearly reflect the heterogeneity of our highly diverse population. The Constitution invites 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 the nation’s future. Therefore, the government’s future promises to pay are far greater than any conceivable ability to honor them. That policy is coming to an end because the United State is approaching a debt limit. No one can be certain about when the nation will reach the limit, but it 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.

Note: This essay was originally written before the recent election. After the election, real interest rates rose in the United States, thereby reflecting expectations of increased growth. But real rates remain low.