Global interest rates on the march

Over the years, the annual economic summits of the leaders of the developed world have become increasingly weighed down with red tape, photo opportunities and black tie dinners, so the original idea of promoting informal discussions at top level has disappeared from view. Instead of circumventing national political arenas, the summiteers have increasingly focused on 'grandstanding' for the audience back home, and their ambitious communiques - on the Gatt Uruguay Round, for example - have soon turned out to be worthless. It would be optimistic to expect much better this time.

One item which should be the subject of detailed international discussion, but almost certainly will not be, is the question of global real interest rates, and their relationship to budget deficits, savings and investment in the developed economies. This is a suitable question for international discussion because real interest rates are nowadays determined in the global marketplace for savings and investment, with one country's savings shortage turning into another country's rising real interest rates. In other words, there are 'externalities' at work - budget deficits, for example, have spill-over effects throughout the world.

Why are global real interest rates currently 'so high'? According to a useful study in the OECD Economic Outlook published last week, real interest rates have typically fluctuated between 4 per cent and 7 per cent since the early 1980s, compared with a normal range of 1-3 per cent during the period before inflation took off in the late 1960s.

There are several reasons why real rates rose in the 1980s. Generally speaking, monetary policy was held deliberately tight during this period in order to achieve disinflation, so high real rates at the short end of the yield curve were imposed deliberately by the central banks. Indeed, real interest rates are always high when inflation is falling because markets are slow to accept that improvements in price stability will be permanent.

BITTER MEMORIES

Perhaps more importantly, savers had bitter memories of being robbed by unexpectedly high inflation in the 1970s, so they demanded much higher risk premia on yields in subsequent years to ensure that this did not happen again. Furthermore, fixed-income investments were competing during the 1980s with equity investments that yielded unprecedentedly high returns. Real rates on bonds therefore had to adjust upwards to divert savings away from the excitement of the equity market.

Finally, the process of liberalisation in the financial markets which has swept across the developed economies in the past 15 years has clearly had implications for the level of real interest rates.

In the era of strictly regulated financial markets there were absolute limits on the amounts that individuals could borrow, and even on the rates that lending institutions could charge. Nowadays, in the absence of such controls, credit rationing relies entirely on the price mechanism, which means the level of interest rates. It is natural to assume that rates will on average be higher than they were when quantitative controls were in place.

Some of these factors - a disinflationary thrust to monetary policy, and the effects of financial deregulation - are likely to remain as permanent features of the landscape, so there may be no reason to suppose that the trend level of real interest rates will ever fall back to the 1-3 per cent range seen in the 1960s. Indeed, as the OECD points out, the present level of real rates in most countries is already considerably below the post- 1980 average, so it is possible that the cyclical decline in real rates that has been eagerly awaited in the financial markets has already taken place. If so, there may be no further fall to look forward to.

Does any of this matter? If the level of real interest rates is thought to be an equilibrium phenomenon, determined by the interplay of savings and investment flows in a global marketplace, then it is hard to argue that they are 'too high'. They simply reflect the forces of supply and demand, and are no more 'too high' or 'too low' than any other price in the system.

However, while there may be some sense in this approach in the very long term, it is quite difficult to believe that the massive fluctuations seen in real long bond yields in the past two decades are entirely the result of an equilibrium market process. There is little doubt that the actions of central banks have led to large variations in short-term rates, and that these have caused 'sympathetic' changes at the long end of the yield curve. Furthermore, there is no doubt that extremely high levels of borrowing by the governments of the developed economies has contributed to the long-term upward march in real interest rates.

This is now becoming a subject for intense concern. The G7 governments will together record a budget deficit of around 4 per cent of GDP in 1993, and the OECD calculates that only about one-third of this deficit has been caused by the automatic effects of the global recession on the government accounts. In other words, two-thirds of the deficit in the major economies is structural, and will not melt away when the world economy recovers.

DEBT RATCHET

It is certainly possible to argue with the details of this arithmetic, and the OECD appears to be too pessimistic when it concludes that about two-thirds of the UK government's deficit is structural. Nevertheless, the broad thrust of its conclusions must be accepted. Furthermore, there is one awkward fact that cannot be disputed. The level of outstanding government debt for the developed economies has risen from only 38 per cent of GDP in the early 1980s to 68 per cent now.

In each successive recession, governments have been willing, quite rightly, to allow the automatic budgetary stabilisers to work, so that budget deficits have risen markedly. However, they have not been willing to allow the inverse of this process to work during economic recovery phases. Instead, they have sought to take the credit for the automatic improvement in the government accounts, and have curried political favour by using the extra revenue to cut tax rates or (more usually) to increase spending. The consequence is that the debt taken on during the recession is not paid off during the boom, and there is a strong upward ratchet in the total of outstanding debt.

It is hard to believe that all this extra government debt has had no part to play in the explanantion of the rise in real interest rates in the past 15 years. And if this is the case, then it also explains part of the worrying drop in private investment that has occurred in all developed economies except Japan - which also just happens to be the one economy without a structural budget deficit.

These are not trends that will kill an economy in a year or two, but over a couple of decades they can have large adverse effects. Already, the rise in government debt has sharply reduced the scope for desirable Keynesian action in recessions (though some Neanderthals like Bryan Gould continue to argue for still more government borrowing, even in the UK, where the budget deficit is close to an all-time high). What is now needed is a prolonged period of budgetary retrenchment, along with easy monetary policy, in all the developed economies, to bring the public debt ratios under control.