On the one hand, the global economy has been stagnating for five years and it can be argued still requires monetary stimulus in the form of low interest rates and fiscal stimulus in the form of deficits and expansionary fiscal policy. On the other hand, low interest rates are having perverse economic effects in the form of encouraging excessive risk taking and potential asset bubbles as well as reducing the returns to savers. Moreover, much like the case for home buyers, low interest rates have also been a factor in reducing the burden to governments of acquiring debt.
Here is the policy box. Low interest rates and the size of public sector debts and deficits are not mutually exclusive policy choices. Any move that raises interest rates will substantially raise debt-servicing costs and actually worsen many countries fiscal positions at least in the short run. Let’s take the example of Canada. For the 2011-12 fiscal year, total expenditures for the federal government were 271.423 of which 31 billion dollars was debt service costs with a net debt of 650.1 billion dollars (see Federal Fiscal Reference Tables). The debt service share of total federal government expenditures is 11.4 percent and the “effective interest rate” on the net debt was 4.8%. If the effective interest rate is simply one percentage point higher – at 5.8% - then debt service costs would have been 37.7 billion dollars or 14 percent of total federal expenditure. Just one percentage point in the effective interest rate on the entire net debt increases spending by almost seven billion dollars without any stimulus increase on government programs or spending on goods and services. It is simply a transfer to bondholders.
Take the United States federal budget as a second example. In 2012, total spending by the US federal government was 3.537 trillion dollars of which 220 billion was net interest for a debt service share of 6.2 percent of federal expenditure (see US federal budget documents). Net financial debt in 2012 was 10.282 trillion dollars resulting in an “effective interest rate” of only 2.1 percent. An increase in the effective interest rate by 1 percent to 3.1 percent raises debt service costs to 319 billion dollars thereby raising federal spending by 99 billion dollars and bringing the debt service share of federal spending to 9 percent.
By historic standards, these are small
increases in the effective interest rate on net debt. Larger increases would
have even greater impacts on the bottom line. A return to the rates of even the mid to late 1990s would be
nothing short of catastrophic in terms of the havoc they could wreak on public
sector budgets. Now of course,
interest rate increases are phased in gradually as debt rolls over but my point
remains the same. Despite the
perverse long-term impact of low interest rates on economic incentives when it
comes to private saving and investment behaviour as well as government debt
accumulation, the short-run impact of raising interests on government budgets
will also be harsh and substantial.
Borrowing from Nick Rowe’s recent pole analogy – policy makers are like
tightrope walkers with a balancing pole that has interest rates on the one side
and government budgets on the other. If interest rates are raised, the other side will not necessarily move up
to counterbalance without deliberate fiscal policy action – it can move down and toss you over. At the same time, raising interest rates and new austerity on the fiscal side to counteract the effect of high interest rates on government budgets - well, that is the kind of nightmare that must keep central bankers and finance
ministers on the edge of their seats. The C.D. Howe piece by Paul Masson on why interest rates should go up outlines and deals with two major objections to raising them - yet the effect on public sector budgets is not one of them.