Shorting Fiscal Consolidation

NEW HAVEN – Real long-term interest rates – that is, interest rates on inflation-protected bonds – have fallen to historic lows in much of the world. This is an economic fact of fundamental significance, for the real long-term interest rate is a direct measure of the cost of borrowing to conduct business, launch new enterprises, or expand existing ones – and its levels now fly in the face of all the talk about the need to slash government deficits. Nominal interest rates – quoted in terms of dollars, euros, renminbi, etc. – are difficult to interpret, since the real cost of borrowing at these rates depends on the future course of inflation, which is always unknown. If I borrow euros at 4% for ten years, I know that I will have to pay back 4% of the principal owed as interest in euros every year, but I don’t know what this amounts to. If inflation is also 4% per year, I can borrow for free – and for less than nothing if annual inflation turns out to be higher. But, if there is no inflation over the next ten years, I will pay a hefty real price for borrowing. One just doesn’t know. Economists like to subtract the nominal government bond yield from the inflation-indexed bond yield of the same maturity to get a market estimate of the inflation rate from now to that maturity date. But such forecasts of “implied inflation” can be wild, if not absurd. During the heat of the 2008 financial crisis, for example, the inflation-indexed yield in the US rose so high for a brief period that implied annual inflation for the next seven years suddenly dropped to -1.5%. (A subsequent study by PIMCO bond traders Gang Hu and Mihir Worah concluded that this was linked to technical and institutional factors concerning the Lehman Brothers bankruptcy.) The real reason inflation-indexed bond yields are an interesting economic variable is that they report on a market in which both investors and borrowers know exactly what is coming, in real terms. Notably, the issuer, that is the borrower, can rationally plan such borrowing to make real investments. The supposed threat posed by government debt levels hasn’t hurt these markets, at least in the relatively few countries that have inflation-indexed bonds. Long-term inflation-indexed bond yields have fallen to around 1% a year, or less, in the United States, Canada, the United Kingdom, and the eurozone. Elsewhere, yields have been a little higher – around 2% in Mexico, Australia, and New Zealand – but still very low by historical standards. All these countries have shown roughly the same downward trend in real interest rates for many years, and notably since 2000. If one were to extrapolate this trend, ten-year interest rates would move into negative territory in a few years or so for most of them. In the US and the UK, yields on intermediate-term (5-year) inflation-indexed bonds are already actually negative this year. One may ask: how can an interest rate be negative? Why would anyone lend (buy a bond) for less than nothing?One can never have negative nominal interest rates (except through some oddity of taxes or regulations), since lenders would rather hold their cash than effectively pay borrowers. But there is nothing to stop negative real interest rates, since routine investors may have no alternative risk-free instrument that offers a positive real return. The low level of real interest rates does not appear to be due to the 2007-2009 financial crisis. In fact, there was a temporary upward spike in real long-term interest rates during the financial crisis in countries with indexed bonds. The rate has come down to low levels only during the period of recovery from the immediate crisis. Instead, low long-term real interest rates appear to reflect a general failure by governments over the years to use the borrowing opportunities that the inflation-indexed markets present to them. This implies an arbitrage opportunity for governments: borrow massively at these low (or even negative) real interest rates, and invest the proceeds in positive-returning projects, such as infrastructure or education. Opportunities for governments to do this exceed those of the private sector, which in many cases continue to be constrained by slow economic growth. Moreover, unlike private firms, governments can count as profits on their investments the benefits of positive externalities (benefits that accrue to everyone). Surely, governments’ levels of long-term investment in infrastructure, education, and research should be much higher now than they were five or ten years ago, when long-term real interest rates were roughly twice as high. The payoffs of such investments are, if anything, higher than they were then, given that many countries still have relatively weak economies that need stimulating. It is strange that so many governments are now emphasizing fiscal consolidation, when they should be increasing their borrowing to take advantage of rock-bottom real interest rates. This would be an opportune time for governments to issue more inflation-indexed debt, to begin issuing it, or to issue nominal GDP-linked debt, which is analogous to it. Robert Shiller, Professor of Economics at Yale University and Chief Economist at MacroMarkets LLC, is co-author, with George Akerlof, of Animal Spirits: How Human Psychology Drives the Economy and Why It Matters for Global Capitalism.