An argument for keeping interest rates low

I blogged recently about Ann Pettifor’s book Just Money which explains what money is and how understanding money and our monetary system can help us build more productive and less environmentally damaging economies. It’s this latter point from Ann’s book that I want to quote now. There is quite a lot of debate about interest rates at the moment. On the one hand, we have those who want rates to stay low to prevent indebted homeowners and businesses from getting into trouble, and on the other, there are those who express concern for savers and want rates to go up. This is generally the argument – between borrowers and savers, but Ann raises another issue that should also be considered:

“But high rates have implications for the ecosystem too. First, ‘easy credit’ leads to an expansion of consumption. Shopping malls become the temples of the High Street. In order to pay for credit-financed consumption, seas have to be fished out; forests have to be stripped; and the ‘productivity’ of the land intensified – at the same exponential rate as interest rates rise. High-yield crops, the use of fertilisers and pesticides; the containing of animals indoors; increases in food production, not just for the world’s growing population, but to make food production more profitable then debt – all this must be done in order to repay debt. The effects are well known: soil degradation, salination of irrigated areas, over-extraction and pollution of groundwater, resistance to pesticides, erosion of biodiversity, etc.

In other words, the earth’s limited resources have to effectively be cannibalised to repay the world’s creditors.”

This is an argument I haven’t really heard before with reference to interest rates, but it seems quite a strong argument for keeping rates low to me, although I suppose it would depend on how strong an impact on the economy the interest rate set by the central bank has.  It seems to me that managing interest rates are quite a blunt tool for controlling economies, and raising them to ‘help savers’, or too try to cool down a boom could have quite serious unforeseen consequences.

High government debt doesn’t lead to high interest rates

At some point I seem to have got myself on the email distribution list for Tory Party spam, so I regularly get updates from the likes of Michael Green (Grant Shapps) and Mr Egg (Sajid Javed) about how wonderfully the current government are doing. A phrase they often include is “tackling the deficit to keep interest rates low”. This repeats the widely held belief that once government debt gets too high, the interest rate ‘the markets” demand to lend more money to the government will start to rise, at which point debt interest payments will get out of control and BAD THINGS WILL HAPPEN. Thank god for the coalition eh?

Today I came across these helpful charts presented by Paul Krugman in a recent conference paper which help us examine this assertion more closely (I found them in this post, which makes the same points I make here).

51062179debt-interest-rates-krugman-fig.1-2013-nov

In this chart, each dot is a country. The debt-GDP ratio is on the bottom access, and the interest they pay on 10-year debt is on the left-hand axis. Broadly speaking, there seems to be a clear positive relationship between higher debt and higher interest rates. The dot on the far right is Japan, which doesn’t fit the pattern, but they must be a special case right? Maybe Green/Shapps and Mr Egg are right then?

6981316debt-interest-rates-krugman-fig.2-2013-nov

Hang on though. This chart is the same, but Krugman has distinguished between Euro and Noneuro countries. The relationship between high debt and high interest rates for the Noneuro countries (like the UK) has disappeared. So what can we conclude:

1. High government debt does not lead to high interest rates if you have your own currency. Tories and Lib Dems are talking rubbish when they say “tackling the deficit to keep interest rates low”.

2. If we don’t need to fear high government debt, austerity is an even more horrendous policy

2. Don’t join the Euro. Ever. That means you too Scotland.

Osborne says he won’t take us back to square one. We never left

George Osborne has been coming under increasing pressure to change course of his austerity strategy. Even the IMF – who originally backed austerity – have deserted him. Osborne is sticking to his guns however and last night, in a speech at the annual CBI dinner said:

“Now is not the time to lose our nerve. Let’s not listen to those who would take us back to square one. Let’s carry on doing what is right for Britain. Let’s see this through.”

So the message is that doing anything additional to help the economy would “take us back to square one”. But how does “square one” compare to now? Assuming square one would be the situation Osborne inherited in May 2010, have far have we come since then? Here’s a few quick stats and commentary.

1) The Deficit

2009/10: £159bn

2012/13: £121bn

So the deficit down by a quarter. This seems to be the thing Osborne is most proud of, but – putting aside the fact that the deficit on its own is neither good nor bad – this reduction has been achieved primarily by cutting capital expenditure in half. From right to left, almost all commentators believe capital spending is precisely the thing not to cut, so in trying to lower that headline deficit figure, he’s actually setting us up for problems further down the road. Square one with double the capital spending actually sounds quite attractive.

2) Unemployment*

3 months to March 2010: 2.51m

3 months to March 2013: 2.52m

Yes, you read that right. Unemployment is actually higher now than in the comparable quarter in 2010. We are still at square one!

3) Employment*

3 months to March 2010: Employment rate – 72%; Total Employed – 28.83m

3 moths to March 2013: Employment rate – 71.4%; Total Employed – 29.71m

The Coalition like to say it has created 1 million private sector jobs. The net additional jobs since March 2010 though has been just under 1 million, and the working age population has risen faster than that, so the employment rate has actually fallen. Square one would actually be an improvement here.

4) Real Incomes

Median hourly earnings 2010 (constant prices): £11.92

Median Hourly earnings 2012 (constant prices): £11.21

Real incomes then have fallen since 2010, so again, square one doesn’t look too bad.

5) Interest Rates 

10 year bond yield May 2010: c3.6%                                          

10 year bond yield May 2013: c1.9%

Interest rates are another success Osborne likes to trumpet, and they have come down since 2010 (although by May 2010, they were already coming down). Whether this is a good or a bad thing depends on whether you are a borrower or saver, but assuming they are a good thing, how much credit should Osborne take for them? According to Jonathan Portes, not much.

In conclusion then, if Osborne were to change course, taking us back to square one, what would that look like? The deficit would be higher, but so would capital spending. Unemployment would be slightly lower, and a greater proportion of people would be employed. They’d also be paid more for that work. Interest rates would be higher (although on a downward trend). So the overall economic picture has barely changed since May 2010. I haven’t even mentioned the almost complete absence of economic growth since then. It looks like we never left square one. Going back there would actually be a slight improvement, and if we could go back there, but deploy our resources smarter than Gordon Brown in 2009/10, a huge one.

* Labour market figures sourced from ONS here: http://www.ons.gov.uk/ons/rel/lms/labour-market-statistics/index.html

Debt, Deficits and Interest Rates – Some More Charts

Following on from the last post on debt and deficits, this post will look at interest rates. This will be a somewhat superficial examination of the data as the reality of the link between debt, deficits and interest rates is a complex one, but I hope to show that the Government line on interest rates is at best simplistic, and at worst wildly misleading.

After the release of last week’s GDP figures, a succession of Ministers gave interviews where they mentioned the UK’s low interest rates as a positive outcome from austerity. The reasoning goes that if debt and deficits get too high, the markets will revolt and start demanding high interest rates on government debt. The Government’s argument is that since austerity began, the markets are now reassured that the Government is dealing with its debts (!!?) and so interest rates have remained low.

I think Jonathan Portes did a pretty good job of debunking this argument last year, but we are still hearing that this story that low interest rates indicate the success of austerity, so here are some charts that suggest something different. The data from all these charts comes from Trading Economics and is the latest available.

Debt-GDPa1

This first chart shows the debt-GDP ratios of a cross-section of countries (left hand axis) vs the interest rates they have to pay to borrow for 10 years (right hand axis). The Debt-GDP ratio remember, is the  total amount the government owes, expressed as a % of GDP. In this chart, apart from a couple of outliers, in particular Japan, the blue line does trend downwards, i.e the lower a country’s debt, the lower the interest rate it has to pay. Lets show this chart again though, but with the Eurozone countries excluded.Debt-GDPb2This time, something weird has happened. Whereas before it seemed like highly indebted countries had to pay high rates on their debt, now the opposite seems to be true. The country with far and away the highest government debt is Japan, but Japan also has the cheapest borrowing costs. And Australia, with the lowest debts, pay the highest rate. What’s different? All the five countries in the second chart have their own currencies, while the first chart contained countries that do not. But maybe it’s the size of the deficit rather than the debt that makes the market get anxious?

Debt-GDPc1

This is a similar chart, but this time the bars show each country’s deficit as a % of GDP. The UK is in the middle. If you squint a bit, you might be able to discern a slight negative relationship between the deficit and bond yields, but it’s pretty weak. So there doesn’t seem to be a clear link between deficit size and the rate governments pay to borrow money. All that’s left then is some sort of vague notion that markets don’t look at the numbers but at the intentions and credibility of each government. Does this sound convincing to you? It doesn’t to me.

Let’s just look at the Debt-GDP chart once more, but only including the Eurozone countries.

Debt-GDPd1

This time, it does seem that higher debts lead to higher interest rates. Why would this be true for Eurozone countries, but not other wealthy nations? Well, by joining the Euro, these countries gave up their right to set short term interest rates, devalue their currencies or to print money. This means when a crisis hits, these countries are unable to pull the usual policy levers. The bailouts of certain Eurozone countries have seen rates fall (Greek rates were aroung 35% a year ago), but ultimately, there is a real default risk on these nations debts, so yields are priced accordingly.

Nations with their own currencies do not have this inherent risk of default because they can always make any payment due in their own currencies. Ultimately, they can print money if needs be. So what does determine long term interest rates in these countries (the UK included)? Lets look at one more chart.

Debt-GDPe1

Here we have the 5 country’s central bank base rates next to the rate they pay on 10 year bonds. They are quite closely correlated. That’s because as Portes points out in his post I link to above:

“…theory suggests that the low level of long-term interest rates in the UK reflects low expected future short-term rates.”

Short term rates are low today, and market actors expect them to be low tomorrow, so long term rates are low. Central banks can manage expectations by pre-announcing their intentions on rates, as Ben Bernanke has done in the US. The markets are also crying out for safe assets, so there is a rush into bonds and away from more risky investments.

So to conclude then, the take-away messages from this post are:

  • The link between high deficits/high debts and high bond yields only applies to countries like those in the Eurozone which do not have full control over their own currencies.
  • The Government’s belief that their economic policies have ensured interest rates stayed low is based on magical thinking. The idea does not stand up to scrutiny.
  • The real reason long term rates are so low is partly because short term rates (set by supposedly independent central banks) are so low, as are expectations about future rates, and partly because the world economy is so depressed and so the markets are looking to invest in safe assets.