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?
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