The Staying Power Of Low Interest RatesRudi Dornbusch
A few years ago, high interest rates seemed a safe prediction for the 1990s. It was assumed that a world boom would take place and that the enormous investment requirements of run-down communist economies would strain capital markets. But no boom occurred: Indeed, the opposite is true.
The silver lining is that the world can expect a period of low interest rates. In the U.S. and Japan, real interest rates are already near zero for short-term debt, although yields on long-term bonds have a great distance to go. The breakup of Europe's exchange rate mechanism frees countries such as France and Spain to pursue competitive interest-rate cuts. Under the pressure of an appreciating currency, even Germany will eventually join in that game.
Massive investment in post-communist economies is simply not happening. Resource flows don't amount to much, because post-communist societies offer far less promising opportunities and bigger risks than were apparent in the immediate aftermath of the fall of communism. Reconstruction will proceed at a moderate pace, with no prospect of a strain on world savings. What investment there is flows to the Czech Republic, Hungary, and Poland. West Germany is investing heavily in its eastern region. There are ambitious plans by industrialized countries to shore up and support reform in Russia by means of a large aid package. But when you add up all these flows, it is hard to reach $200 billion a year--a minuscule sum measured against world savings of some $3.5 trillion.
TOKYO SITS TIGHT. More important, fiscal restraint in Europe and the U.S. will add to the world savings pool. Germany is introducing additional taxes and spending cuts to finance its costs of unification. Italy is pruning its public sector, as are France and most other European economies. In the U.S., the Clinton Administration's fiscal program provides for substantially lower budget deficits over the next few years.
Japan is the only country that has ample room and every reason to go the other way--by introducing fiscal stimulus to move out of recession--but it is refusing to do so. The Finance Ministry, mesmerized by the prospect of an aging population 30 years from now, sits tight and refuses to yield to increasing pressures for a tax cut. So even Japan is doing its share to keep world interest rates low.
World private-investment trends add to an outlook of soft capital markets and low interest rates. European economies are in a deep recession that will last well into 1994 and perhaps beyond. No chance there for an investment boom. In the U.S., investment in plant and equipment is doing well, but only when judged against the abysmal record of the 1980s. But the overhang of commercial real estate--the aftermath of the 1980s--limits the scope for investment revival. Japan, with its recession, bankrupt banks, and businesses strained by poor growth prospects and the collapse of asset prices, is most unlikely to see an investment boom. Finally China, so much in the news now because of its extraordinary growth, should begin to cool off soon, as officials try to counter uncomfortably high inflation.
SKEPTICAL MARKETS. All of this suggests interest rates will keep moving lower. Just how low is best judged from the historical record. The real yield on U.S. Treasury bills in the 50 years from 1930 to 1980 barely averaged zero. In the 1980s, with the fight against inflation, massive fiscal expansion, huge consumer borrowing, and the public-works program in commercial real estate now known as the savings and loan crisis, bill yields rose to an average of 3.5%. But the 1980s were atypical, and the rest of the 1990s will be more in line with the historical record. Real interest rates on long-term debt averaged just above 1% in the five decades before 1980. We should expect rates to head in that direction. There is still a ways to go, with long-term rates still just under 7% and inflation well below 4%.
The working assumption of capital markets continues to be that inflation is taking a cyclical holiday and is bound to return, as continued growth tightens labor markets and pushes up capacity utilization. Budget-tightening proposals are not taken seriously, either because there is doubt that they will actually be enacted or because of the belief that even if passed, as was the Gramm-Rudman Act, they will not be implemented. The most skeptical capital market will ultimately have to come to terms with the facts. In the 1970s, the market was slow to recognize a decade of very high inflation. Today, it is overly slow to accept a decade of low inflation and the increasing prospect of sluggish growth for the world.
Capital markets are reluctant to accept the message because they have been disappointed too often; they expect bad news to jump at them from behind every tree. Luigi Einaudi, Italy's great postwar leader, said the capital market has the memory of an elephant, the legs of a hare, and the heart of a deer. With continued good inflation performance and firm, substantial budget cuts, lenders will grudgingly back away from the 1980s experience and accept historically low rates, which are the counterpart of a world economy that is not doing well.