Only budget cuts will create saving graces

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The Independent Online
KENNETH CLARKE last week persuaded the finance ministers of the leading industrial countries to carry out a study into the behaviour of global interest rates. When you consider the sort of return investors are demanding to finance his government's debt, the Chancellor's concern is easily understandable.

Last month's pounds 2bn gilt auction was a case in point. The Bank of England had to offer an interest rate of 8.9 per cent to tempt investors to take the gilts - in effect IOUs issued on behalf of the Government to help bridge the gap between what it spends and raises in taxes. This is pretty generous if you believe Mr Clarke is serious about hitting and then sticking to his 1-2.5 per cent target for underlying inflation. Between January and August alone, the yield on long-maturity gilts rose by 2.3 percentage points. Why did this happen?

First, the markets became more nervous that economic recovery would fuel inflation, a fear which in the US prompted the Federal Reserve to begin raising its interest rates in February, and which persuaded Mr Clarke to follow suit last month. High inflation means investors can buy fewer goods with the income they receive from holding or selling their bonds, so they demand a higher interest rate to compensate.

Secondly, the markets may have become over-excited. Last year's rise in bond prices - and the consequent fall in market interest rates - was exaggerated by the aggressive behaviour of the so- called 'hedge funds', the high- rolling gamblers of the global financial system. When the bubble burst, it was therefore natural for the fall in bond prices - and rise in interest rates - to be just as exaggerated in comparison to any change in the underlying prospects for growth or inflation.

Thirdly, the prospects for growth and inflation were particularly uncertain as the economy passed the turning-point from recession to recovery. So investors demanded a risk premium, because they were unusually nervous about how things would turn out.

These explanations are relatively uncontentious. But Mr Clarke wants to know whether a more fundamental change has taken place in the balance between the supply of funds to the world capital market from savers and the demand for those funds by companies wishing to invest and governments needing to borrow. The rise in world interest rates may be explained by a rise in the demand for capital relative to supply. If so, what can be done about it?

Movements in bond yields vary quite dramatically between countries. The rise in yields on long- dated bonds between January and August varied from 1.2 percentage points in Switzerland to 4.4 percentage points in Sweden. These variations reflect different inflation prospects, different degrees of risk and uncertainty, and the possibility of exchange rate changes. Exchange rate movements affect what the return on a bond denominated in one currency is worth to overseas investors once they have converted the proceeds back into their own currencies.

But the fact that bond yields in all industrial countries turned up during the early part of the year suggests global factors were important. Once the international differences in bond yields have been stripped away, the world's 'real' interest rate - which excludes the impact of inflation - appears to have risen by about one percentage point, a more dramatic change than it sounds. The world's real interest rate stands at around 4 per cent, compared with 2.5- 3 per cent in the 1970s.

Rising real interest rates are not just a problem for governments trying to finance their borrowing. By increasing the cost of credit for companies and individuals, they threaten to weaken the pace of economic growth and forestall efforts to boost capacity. This could make the world economy more vulnerable to inflation and prevent cuts in unemployment.

As the Chancellor pointed out at the annual meeting of the International Monetary Fund in Madrid last week, higher real interest rates have been accompanied by a fall in saving and investment as a proportion of global spending, from around 25 per cent in the early 1970s to 21-23 per cent now.

This is worrying at a time when the demand for funds for investment is growing. Strengthening economic recovery is slowly persuading industries around the world to expand their capacity. The IMF has forecast that the economies of the industrial countries will grow by 3.6 per cent next year and those of the developing countries by 5.6 per cent. Meanwhile, the plunge in output in countries making the transition from communism is expected to come to a halt. The hotels of Madrid were packed with representatives of developing and transition economies pitching for funds from financial institutions.

If demand for capital is expanding, what about supply? The biggest problem is that governments are swallowing up too much of savers' money because they are borrowing to meet the shortfall between their spending and revenue. Governments will have to raise taxes and cut spending further.

The World Bank made a useful contribution to the debate with a report last week entitled Averting the Old Age Crisis. It reiterated the familiar point that rising life expectancy and falling birth rates around the world will force a shrinking working population to support a growing number of relatively unproductive elderly people. The report urged that most of the population should be forced to save money themselves to finance their old age, a move which would be politically contentious but would help to boost the volume of private sector savings.

Savings might also be boosted by changes to the tax system, which treats them in inconsistent ways. This distorts incentives and means people are as much influenced in the way they save by the tax treatment of particular alternative vehicles as by their underlying attractiveness.

It remains to be seen whether the Chancellor has a 'Budget for savers' up his sleeve for next month. He neatly sidestepped the question in Madrid last week. But Treasury officials are known to be wary of apparently novel schemes in this area, believing they redistribute existing savings rather than boost their total volume.

Concern about the inadequate level of savings also helps explain the resistance of the Group of Seven leading industrial countries to the IMF's plans to boost world foreign exchange reserves by printing special money that countries could cash in for dollars. The IMF's plan, defeated last Sunday, would not create new capital. It would merely redistribute existing capital towards relatively badly off countries in which the money is more likely to be spent than saved.

It is difficult to tell whether the global capital shortage has the makings of a crisis. The least painful solution would be for savers in Japan to put their money into overseas bond markets rather than keeping it at home on short-term deposit. If Japanese institutions become more sanguine about the risk of unfavourable exchange rate movements, this could help inject new life into world bond markets.

But this hope is no substitute for tough action on budget deficits. Unfortunately, the incentive for any individual government is limited. Because the capital market is global, rather than national, only global action will bring about the fall in real interest rates for which central bankers are hoping.