June 3, 2012
With the past week’s dismal US jobs data, signs of increasing financial strain in Europe and discouraging news from China, the proposition that the global economy is returning to a path of healthy growth looks highly implausible.
It is more likely that a pessimistic view is again taking over as falling incomes lead to falling confidence that leads to reduced spending and yet further declines in income. Financial strains hurt the real economy, especially in Europe, and reinforce existing strains. And export-dependent emerging markets suffer as the economies of the industrialised world weaken.
The question is not whether the current policy path is acceptable. The question is what should be done? To come up with a viable solution, consider the remarkable level of interest rates in much of the industrialised economies. The US government can borrow in nominal terms at about 0.5 per cent for five years, 1.5 per cent for 10 years and 2.5 per cent for 30 years. Rates are considerably lower in Germany and still lower in Japan.
Even more remarkable are the interest rates on inflation-protected bonds. In real terms, the world is prepared to pay the US more than 100 basis points to store its money for five years and more than 50 basis points for 10 years. Maturities would have to reach more than 20 years before the interest rates on indexed bonds become positive. Again, real rates are even lower in Germany and Japan. Remarkably, the UK borrowed money last week for 50 years at a real rate of 4 basis points.
These low rates even on long maturities mean that markets are offering the opportunity to lock in low long-term borrowing costs. In the US, for example, the government could commit to borrowing five-year money in five years at a nominal cost of about 2.5 per cent and at a real cost very close to zero.
What does all this say about macroeconomic policy? Many in both the US and Europe are arguing for further quantitative easing to bring down longer-term interest rates. This may be appropriate given that there is a much greater danger from policy underreacting to current economic weakness than from it overreacting.
However, one has to wonder how much investment businesses are unwilling to undertake at extraordinarily low interest rates that they would be willing to with rates reduced by yet another 25 or 50 basis points. It is also worth querying the quality of projects that businesses judge unprofitable at a -60 basis point real interest rate but choose to undertake at a still more negative real interest rate. There is also the question of whether extremely low safe real interest rates promote bubbles of various kinds.
There is also an oddity in this renewed emphasis on quantitative easing. The essential aim of such policies is to shorten the debt held by the public or issued by the consolidated public sector comprising both the government and central bank. Any rational chief financial officer in the private sector would see this as a moment to extend debt maturities and lock in low rates – exactly the opposite of what central banks are doing. In the US Treasury, for example, discussions of debt management policy have had exactly this emphasis. But the Treasury alone does not control the maturity of debt when the central bank is active in all debt markets.
So, what is to be done? Rather than focusing on lowering already epically low rates, governments that enjoy such low borrowing costs can improve their creditworthiness by borrowing more not less. They can also invest in improving their future fiscal position, even assuming that no positive demand stimulus effects are likely to materialise. At a time of negative real rates, accelerating any necessary maintenance project and issuing debt leave the state richer not poorer; this assumes that maintenance costs rise at or above the general inflation rate.
As my fellow Harvard economist Martin Feldstein has pointed out, this principle applies to accelerating replacement cycles for military supplies. Similarly, government decisions to issue debt and then buy space that is currently being leased will improve the government’s financial position. That is, as long as the interest rate on debt is less than the ratio of rents to building values, a condition almost certain to be met in a world of government borrowing rates of less than 2 per cent.
These examples are the place to begin because they involve what is in effect an arbitrage, whereby the government uses its credit to deliver essentially the same bundle of services at a lower cost. It would be amazing if there were not many public investment projects with certain equivalent real returns well above zero. Consider a $1 project that yielded even a permanent 4 cents a year in real terms increment to GDP by expanding the economy’s capacity or its ability to innovate. Depending on where it was undertaken, this project would yield at least 1 cent a year in government revenue. At any real interest rate below 1 per cent, the project pays for itself even before taking into account any Keynesian effects.
This logic suggests that countries regarded as havens that can borrow long-term at a very low cost should be rushing to take advantage of the opportunity. This is a view that should be shared by those most alarmed about looming debt crises because the greater your concern about the ability to borrow in the future, the stronger the case for borrowing for the long term today.
There is, of course, still the question of whether more borrowing will increase anxiety about a government’s creditworthiness. It should not, as long as the proceeds of borrowing are used either to reduce future spending or raise future incomes.
Any rational business leader would use a moment like this to term out its debt. Governments in the industrialised world should too.
The writer is the Charles W. Eliot university professor at Harvard University and a former US Treasury secretary.
Copyright The Financial Times Limited 2012.