Interest rates at, or below, zero and massive monetary expansion by central banks is helping the Republic and other countries to meet the cost of the pandemic. But how long will this last? Is it back to austerity to pay for the pandemic or on to a future boosted by cheap money?
Introducing an Irish Fiscal Advisory Council conference on the topic this week, chairman Sebastian Barnes said that the central question for budget policy is how to make sense of today's very high national debt levels and very low interest rates. This may generate, he said "the biggest questions macroeconomics had faced in decades with major implications for fiscal, monetary and financial policies."
1. What has happened
Governments have borrowed massively to combat the pandemic. The State’s national debt is set to rise from just over €200 billion before the pandemic to €239 billion by this end of this year and is likely to increase further for a few more years.
Ireland's borrowings – and those undertaken by other countries – are the classic response to an economic shock. Government cash replaces some of the cash not being spent by the private sector and, crucially, supports business and individuals and helps to preventing longer-term damage. The vital factor which has allowed countries to spend, without worrying about immediate problems on the markets, is rock bottom interest rates combined with massive Central Bank support.
2. The role of lower interest rates
For years, the sustainability of national debt was assessed on the basis that the interest rate being paid was generally – though not always – higher than the country’s growth rate. Now this vital equation has been reversed.
As interest rates fell ever lower after the financial crisis, things have changed and growth rates here and in most other countries are now above the interest rate paid on national debt. The cash cost of servicing the Republic’s debt has fallen – despite taking on more borrowings – because the country has been refinancing old debt and taking on new borrowings at such low rates. Frank O’Connor, director of funding and debt management at the NTMA, pointed out at the IFAC conference that the cost of paying interest on the debt at €3.5 billion has halved since its 2013 post-crisis peak. The average interest rate on all our national debt is below 2 per cent and could fall to 1.5 per cent by the end of the year.
3. The future – what is at stake?
Now, post pandemic, economists are asking how this will look in future. Interest rates have been on a generally declining trend since the mid-1980s. But while there are theories about why this is happening – ageing populations and rising savings, for example – even Olivier Blanchard, former chief economist at the IMF, told the conference that it was impossible to be definitive. And this means forecasting what happens next is difficult.
Whether the cost at which countries borrow can remains below the economic growth rate in the longer term is the vital consideration. If we assume that it will, then countries have more leeway coming out of the pandemic – a lot more – and can even plan to remain in deficit without having to hike taxes. But if debt interest rates rise above growth, then the dynamics for countries with high debt burdens move in the other direction again. Quickly.
IFAC economist Eddie Casey presented new research at the conference which showed that countries with high debt ratios can see them fall quickly if the rate of growth remains above the debt interest rate.
But on the flipside, the ratio can shoot upwards very quickly and dangerously for high debt countries if the interest rate goes back above growth. (Technically he showed that at lower debt ratios the maths operates differently, but this won’t be a factor for a long time.)
4. Can we rely on rock-bottom interest rates?
The unprecedented nature of the pandemic has left economists uncertain about what happens next. Financial markets believe interest rates will remain low – forward interest rates imply no increase in the ECB’s base rate in the medium term, in other words the next three to five years. But economists are uncertain. No-one expects an early move upwards, but forecasting the world in five years’ time is very difficult.
Blanchard acknowledged the difficulty of forecasting this, depending in part on whether we are really in an era of secular stagnation – an era of semi-permanent low growth and inflation like Japan. And ECB chief economist Philip Lane pointed out that one reason interest rates had been so low before the pandemic hit was that Europe was still working through the longer-term implications of the financial crisis ten years ago. The ECB hopes inflation and growth can revive.
The bottom line is that there will be no early move to tighten monetary policy, but that looking out beyond, say, three years is still seen as very difficult.
5. How to manage policy?
Divisions are appearing internationally. For example, the massive $1.9 trillion (€1.6 trillion) budget stimulus planned by the Biden administration has been criticised by Blanchard and others such as former treasury secretary Larry Summers as more than is required to close the gap between the likely level of economic output and what it should be – and thus they fear it will spark inflation.
As a result, long-term US interest rates have moved back over 2 per cent, a trend worth watching. Others disagree and say that times are not normal and that the Biden package is in part a rescue for stranded businesses and individuals after a massive economic hit and is thus unlikely to spark inflation, particularly as people have become accustomed to low inflation rates.
In Europe, the ECB’s job is to get inflation back up towards 2 per cent and the central bank has forecast that inflation could be running at 1.5 per cent by the end of 2021. There is no suggestion it will quickly withdraw post-pandemic support, but for the years ahead this is another trend worth watching.
In the longer term, there is disagreement about the appropriate mix of budgetary and monetary policy. Central banks would like to be able to push up interest rates at some stage – and to see higher inflation emerging as a reason to do so as economies recover, if only to allow scope to cut them again if there was a new crisis arrives in future. But the relationship between monetary and fiscal policy is an active area of debate in economics, with some arguing that this traditional view is outdated and that the separation of the two policies is false. The more traditional view is that Central Bank must retain independence to manage monetary policy and set a stable framework for people’s expectations of inflation.
6. What it means for Ireland
In his presentation, Eddie Casey said Ireland could afford to carry a higher level of debt, but that the higher the debt burden rose, the more exposed the country would be if interest rates rose or growth rates were low. As the vast bulk of national debt is at fixed rates, the risk comes as borrowing levels come to be refinanced – or from a loss of confidence in markets because investors feel debt is getting out of control. Casey showed how a turn in interest rates or growth could require Ireland to go back to an era of austerity-type cutbacks, possibly for five years or more, to regain control.
For this reason, the the council is calling on the Government to develop a medium-term strategy to reduce borrowing after the crisis ends and plan to start the debt ratio on a downward path. This is also vital, Casey, said, to give room for manoeuvre if another crisis hits in the years ahead. He also pointed to the need to leave room to pay for the ageing of the population.
The Republic’s path will also be determined by what happen with the EU fiscal rules, now suspended due to the pandemic. Economists argue that the targets based on debt ratios of 60 per cent and maximum 3 per cent deficits need to be revamped. While proposed formulas vary, many believe that appropriate targets now need to be based on the burden and sustainability of debt repayments, though working out how to construct actual rules is difficult.
7. A world turned upside down
Zero interest rates – were they to persist – turn much of the economic rulebook upside down, affecting investment decisions and personal finance as well as the national finances and leaving central banks effectively stuck. As economies recover from the pandemic, the trends in growth and inflation will be vital. The key factor will be whether the low growth/low inflation world will continue, keeping interest rates low, or whether the future will look different.
