Governments betting on low interest rates may experience rude awakening

 

Governments in Canada and around the world have run large budget deficits and greatly added to their debt loads due to their pandemic response and the accompanying economic downturn. Moreover, they are poised to add even more debt in coming year to provide further stimulus to kickstart moribund economies.

Indeed, the new Biden administration plans a $1.9 trillion economic package on top of the $2 trillion relief bill in March and additional $900 billion in December. As for Canada, the Trudeau government is poised to spend $100 billion in stimulus on top of a record deficit approaching $400 billion.

Clearly, governments worldwide went into the pandemic with large debt loads and will emerge with even bigger ones. However, the large deficits are justified on the grounds that we need to kickstart the economy and it’s a good time to do so because interest rates are at historic lows, making debt-service costs extremely manageable. In many respects, there’s a great gamble underway. We’re rolling the fiscal dice, anticipating that interest rates will not rise anytime soon and will remain below the growth rate of the economy, thereby ensuring sustainable debt burdens.

On the surface, the grounds for such optimism are supported by economic history. The long-term trend for interest rates over the last few centuries has gradually been downward as economic development and capital-labour ratios have grown, raising the return to labour (wages) and reducing the return to capital (interest rates). Indeed, this process has been documented by Jorda, Singh and Taylor with medieval interest rates of about 10 per cent falling to four per cent by the 19th century and now approaching one per cent.

In the wake of pandemics such as the Black Death and the Spanish Flu, the long-term downward trend has been amplified by further short-term depression of interest rates. Essentially, pandemics increase mortality, making labour scarcer, and also increase savings rates as people hunker down and spend less. Both effects make capital more abundant relative to labour and lower the return to capital. If the COVID pandemic is true to form, one might expect the next decade to also feature ultra-low interest rates, justifying the current debt acquisition gamble.

Yet, there are reasons why this time may be different.

First, the current low inflation environment may soon end. The large budget deficits worldwide, competing for funds and resources, may eventually put upward pressure on prices and interest rates.

Moreover, the rise in trade barriers may lead to rising costs as global supply chains become less smooth, further adding to inflationary pressure. Indeed, some think Canada may be among the first countries to start raising interest rates due to stronger commodity prices as economies recover despite Bank of Canada positions to the contrary.

Second, in historical pandemics, the mortality impact has been on much younger populations and as a result the labour force impact has been more severe. Unlike the Spanish Flu, for example, COVID’s mortality impact has been disproportionately felt by seniors as opposed to prime working-age younger demographics more engaged with the labour force. Indeed, the labour force disruption and reductions of COVID are mainly the result of measures taken to reduce the spread of the virus. Once the virus is contained, these reductions should abate.

Taken together, governments around the world should not bet big by taking continued low interest rates for granted as they add to their debt pile. One year ago, nobody was thinking about COVID-19 and its economic effects. Today, few seem to be thinking about potential interest rate increases. Governments may feel lucky as they boost deficit-spending in a game of fiscal roulette. But the real question we must ask ourselves is: do I feel lucky?

 

This appeared in the Fraser Institute Blog on January 20th, 2021.

Deficits, Inflation and Interest Rates: A Very Simple Analysis

 

The immediate impact of COVID-19 on Canada’s economy - like many others - has been a drop in GDP and a massive ramping up of government deficits given the collapse in revenues and in increase in emergency spending and benefits.  At the federal level, the deficit for 2020 is anticipated to be closer to $400 billion. In the wake of Wednesday’s Throne Speech there should be a fiscal update or budget that will provide further fiscal details.  In the meantime, it is worth thinking a bit about what the ultimate impact of such large deficits will be not just in Canada but on the world economy.

 

The traditional aggregate demand(AD)-aggregate supply(AS) framework for looking at fiscal and monetary policy suggests that large deficits will shift AD to the right and raise price (P) and output (Y).  The increase in prices then triggers inflationary expectations which shifts the aggregate supply curve upwards starting a wage-price spiral.  Bringing inflation under control ultimately then requires tighter monetary policy that raises interest rates and brings down aggregate demand and inflationary expectations. It all seems simple enough except since 2008-09, the massive deficits incurred around the world do not seem to have done any of this.  Indeed, inflation is low and interest rates have gone lower.  The world is awash in cheap money.  And, Modern Monetary Theory (MMT) has been gaining ground with arguments that we can stimulate demand practically forever by having sovereign governments with their own currency increasing the money supply.

 

I think if we had to draw a picture of the global economy under the current situation, it looks something like this (Figure 1):

 

 

 

If we think of the world economy as a giant AD and a giant AS curve, the AD curve has a traditional downward slope, but the AS curve is flat rather than upward sloping or vertical.  That is, world aggregate supply as a result of integrated international supply chains, trade, increasing capital mobility, technology and digitization – essentially the results of globalization since the 1990s – has become perfectly elastic.  As a result, even with deficits and cheap money shifting that aggregate demand curve repeatedly to the right, there has been no inflationary pressure.  Supply has expanded to accommodate demand and hence inflation has stayed low and there has been no upward pressure on interest rates.

 

This means that in a sense we are going to be able to both have our cake and eat it for some time.  Inflation will probably not rear up its head anytime soon and interest rates are going to stay low and probably below the rate of economic growth meaning that governments will not face immense debt service or debt burdens from their massively expanding debt.  However, I think eventually, the global economy is going to more likely start to resemble Figure 2 down below:

 

 

 

While one can argue that the economy has always been global, modern economic history has been marked by two distinct periods of globalization: 1870 to 1914 and 1990 to 2016.  The first great globalization coincided with the hegemony of the Pax Britannica, the  industrial age and the liberalization of the world economy which came to a crashing halt with World War I and which then took decades to resume.  After the shocks and trauma of trade restrictions, world wars, political extremism and the Depression, the post-World War II era saw slow steps to more trade and the fall of the Berlin Wall marks the start of the second age of globalization and trade liberalization which moved together with the internet and rapid technological change in communications, and China’s rapid industrialization and development. Much of this growth of trade occurred under the hegemony of the Pax Americana and included shifting of production to lower labour cost environments.  This age was dealt a blow by the 2008-09 recession and came to an end with the rise of populism and trade restrictions which officially begin with the election of Donald Trump in 2016 and the American retreat from a more global role.

 

The second great globalization essentially flattened the aggregate supply curve which is why inflationary pressure has been muted.  Because of technological change, improved transport and communications, the shifting of production to the cheapest spot with integrated supply chains, and freer trade – the aggregate supply curve became perfectly elastic and able to accommodate rising AD at an almost infinite pace.  However, we are now in a volatile  transition period that has been aggravated by the pandemic. Since 2016, there have been more trade disputes, concern and push back against China’s seeming unwillingness to play by the rules of a more liberal-democratic world economic order, and trade disruption by populist politicians.  The end result of this will be an AS curve marked by higher costs of production with output expansion – in other words, more of an upward sloping curve. 

 

The result of expanding demand with an upward sloping AS curve will be rising prices and hence the return of inflation.  Combine this upward pressure on prices with eventual competition for borrowers to take on more and more government debt and there will be a rise in interest rates.  The events of the last five years have ensured that interest rates will rise – it is not a question of if but when.

A Saudi Recession Trigger?

Recessions do not just happen.  They are made.  They spring from the accumulation of a long-period of underlying contributing economic factors, but then along comes a trigger - or two if you are really unlucky - and before you know it there is a recession underway.  We have had a particularly long stretch of economic prosperity in Canada and indeed the United States and the world that has seen rising employment.  However, the last few years have seen turmoil on the trade front and still high public and personal debt levels which have been sustainable only because of continuing record low interest rates.

Despite the threat of rising interest rates, they have remained low and this appears to have encouraged consumers to continue taking on personal debt.  Indeed, consumers in Canada have been maintaining their standard of living by extending their credit not just for mortgages but also for all kinds of other things - if there is an expenditure, there is a monthly payment plan for it.  And of course, governments have also enjoyed the bounty of low rates by taking on more debt despite the good economic times.

Now, debt is a tool and Canadians have also been managing to build equity given the rise in housing prices but the question is if there is simply too much debt.  This piece in the Globe and Mail points out debt situations that apparently are common in a lot of Canadian suburban areas though the more interesting question is really how a 29 year old making $30,000 a year is able to obtain a $700,000 mortgage. When and if the reckoning comes, Canadian banks will have a lot of explaining to do - especially to the savers who been given low returns and have been financing this debt blowout for the last decade.

Responsible consumers who have taken on debt have nothing to worry about but many consumers have simply taken advantage of really cheap money to leverage themselves to the point where they have very little room to maneuver.  Apparently, nearly 15 percent of household disposable income is going to service household debt.  A loss of employment or an increase in costs - from say a rise in interest rates - will very quickly lead to unsustainable finances for a lot of Canadian households.  Fortunately, interest rates do not look like they are going anywhere soon and with a federal election underway in Canada now - and more importantly - an American election in 2020, one expects government policy to continue favoring low interest rates.

However, the events in Saudi Arabia over the weekend revealed a new trigger of financial stress - rising oil and gasoline prices.  All those suburban households around the world dependent on relatively cheap gasoline for their commute to work and home could face a new source of financial stress if gasoline prices go up. dramatically  Sure, its not a rise in interest rates but it will operate the same way - it will take money away from other things like food and groceries, lead to a rise in the cost of living and divert money away from debt service.

The ten percent spike in oil prices after the attack on Saudi oil facilities is unlikely to be sustained according to venerable sources like the New York Times but then who really knows?  The key here is uncertainty about what comes next.  Can any damage be repaired quickly?  Will there be other attacks?  How was such an attack even possible given the level of security and the amount of military hardware around to ensure that such things do not happen?  This uncertainty is the key issue and should there be another supply disruption, you can count on a more sustained price spike and economic fallout for consumers.  If one especially looks at how North American drivers  have been shifting to driving larger shiny new trucks - financed by debt of course - one can see a pretty severe impact.

However, it looks like for now that oil supplies are still abundant as the disruption occurred during a period of relative surplus.  And of course, there is the U.S. strategic oil reserve.  Nonetheless, watchful waiting is the word.

Crime and the Economy: Are Low Interest Rates a Factor?

The most recent set of crime statistics for Canada revealed that police-reported crime in Canada, as measured by both the crime rate and the Crime Severity Index (CSI), increased for the fourth consecutive year in 2018, rising 2%.  The accompanying figure below further reinforces the fact that after years of decline – a decline that stretches back to the 1990s – crime rates are rising.  Of course, all of this begs the question as to why crime rates are rising again after years of decline.

Explaining the drop in crime rates has been a source of some debate.  The fall in crime rates since the 1990s in Canada as well as the United States has been attributed to a number of factors including new policing strategies, changes in the market for illegal drugs, an aging population, a stronger economy, tougher gun control laws and increases in police numbers. As for the impact of the economy on crime, well that is also a source of debate. 

On the one hand, the intuitive feeling is that a weak economy should cause people to turn to crime.  Yet, many studies of the relationship between the economy and crime have found statistically small relationships between unemployment and property crime and often no relationship between violent crime and unemployment.  It has also been argued that economic downturns may actually reduce criminal opportunities as when unemployment is high more people are at home "protecting" their property and when out and about they carry less cash and possessions.

If the latter is the case, one could make the argument that the strengthening economy of the last couple of years has been a key factor in fueling the recent surge in crime.  Unemployment rates in Canada are at historic lows and to add fuel to the fire – so are interest rates.  Low interest rates mean that even if more employment today is part-time or uncertain, people are still able to consume more and go out more simply by borrowing more.  Indeed, Statistics Canada also noted recently that the seasonally adjusted household credit market debt to disposable income ratio increased to 178.5 percent in the 4^th quarter of 2018. 

More debt to fuel spending on homes and basic consumption frees up resources to spend on more illicit things like illegal drugs and much of the recent crime increase is drug related. 

With unemployment low and cheap money sloshing around both fueling spending and consumption, the opportunities for crime may have mounted. It is certainly a point worth considering.