Can we count on low interest rates?
Rishi Sunak may wish to take the long view on this question
One thing we can definitely expect from Rishi Sunak is borrowing — lots and lots of borrowing. Just as well, then, that interest rates are so low.
Therefore a question as big as the national debt is whether they’ll stay that way.
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Rates — and in particular the rates at which governments can issue debt — have been on the floor for quite a while now. In some countries they’ve even gone slightly negative. But isn’t this a fluke? A historical anomaly?
It might help to take the long view — and it doesn’t get much longer than this study of real interest rates from the Bank of England. The author of the paper, Paul Schmelzing, doesn’t just present years or decades of data — but centuries of the stuff. Just feast your eyes on the following graph that summarises over seven hundred years of ups-and-downs:
Two things immediately stand out. Firstly, the shorter term variations; but secondly, and more significantly, the long-term trend towards ever lower interest rates.
In medieval times conditions were, well, medieval. You could lend money to a king, but he and half his subjects might die of the Black Death. Or any number of other horrible things might happen at any moment — so quite a lot of risk there to price in. Less so these days… let us hope.
Banking has also become more sophisticated over the last millennium. For instance, you don’t need your own castle to keep money safe anymore. Indeed, the bankers of the past would be surprised that most of our money doesn’t even take physical form.
Still, it’s interesting to see the downward trend continue through modern times. If it continues, then the extremely low rates of the last decade might not be a blip or a governmental fix, but just part of a broader historical pattern. The assumption that current rates have only one place to go (up) might therefore be mistaken. Indeed, Schmelzing suggests that “real rates could soon enter permanently negative territory.”
That’s a mind-boggling thought, but it doesn’t mean that Chancellors should lose all sense of fiscal discipline. As we saw in the case of Greece a few years ago, the money markets are still willing to pull the plug on governments that lose the plot.
After all, there’s one thing that hasn’t changed in 700 years — which is that lenders can always sniff out a bad risk and price it accordingly.
Yes, we can count on low or negative interest rates. (I am already paying negative interest on one of my accounts). Any increase in interest rates would see millions unable to service their mortgages, and no government can survive if people are losing their homes. It would also see the collapse of various ‘zombie companies’. So, we’re stuck with it, probably for many decades to come.
The big problem with real rates (inflation begin higher than nominal interest rates) being in permanently negative territory would be that people with access to credit could borrow, invest in assets that appreciated faster than inflation, or at least faster than interest rates, like houses. Just try to imagine the damage to a society of having a rentier class on one side, with workers unable to afford decent housing on the other.
A few points:
Risk may have declined over the decades but that does not mean it will continue to do so. Indeed, the extent of the economic damage the West has inflicted on itself during 2020 will significantly increase risk in coming years.
Banking may have “become more sophisticated” but, as we saw in 2007/8, that does not necessarily reduce risk. Indeed, it soon became evident that many people running the banks did not fully understand the complexity of the investment instruments they operated or the risks they posed.
The printing of money in the West, the worsening structural supply issues and the likelihood of VAT and other tax increases in coming months/years is likely to create significant inflationary pressures. In such circumstances, it will be hard to keep interest rates low.
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