Politicians got used to cheap money. Now they're paying the price

Telegraph

a day ago

Almost without exception, governments in advanced economies face an uneasy combination of high public debt and growth rates that are far too slow to fund rising public spending without resorting to even more borrowing or further anti-growth tax increases.
Set against these serious policy challenges, it is no wonder that the surge in government borrowing costs that followed the gas-related inflation spike in 2022 has become a major source of concern for financial markets.
In the UK and the US, 10-year government borrowing costs – a key market benchmark – have fluctuated in the 4pc-5pc range since the start of the year. Whenever borrowing costs edge towards 5pc, genuine panic seems to take hold.
The commonly held view is that higher benchmark interest rates are a temporary issue that will disappear once inflation is under control, or that they are mostly a symptom of fiscal sustainability worries and can be resolved with sufficient budget discipline. But this is wrong.
I am not arguing that governments and central banks should not take serious measures to improve policy discipline. Quite the opposite – this matters more than ever. Instead, my point is that even if we achieved both monetary and fiscal sustainability across the advanced world, my guess is that interest rates would fall only slightly.
Why? Because the global economic forces that pushed interest rates to rock-bottom levels for more than a decade after the global financial crisis have gone into reverse.
First, the global balance of savings and investment has shifted to a state that more closely resembles the pre-2008 era. In the wake of the crisis, demand for borrowing in Western economies collapsed.
Along with a global rush to safety and excess savings in places like China, Japan and Germany, lower interest rates were required to balance global saving and investment. But Western debt demand is less depressed today, and the global savings glut is shrinking. In turn, the interest rates that balance these markets have risen.
Second, global trade is flowing less freely as trade barriers increase and the geopolitical order fragments.
US isolationism, the war in Ukraine and trouble in the Middle East put upward pressure on goods prices and increase the threat of conflict-related commodity price shocks. These inflation fears are reflected in interest rates.
Third, a decades-long global demographic tailwind has turned into a headwind that will only worsen over time. As societies age, labour shortages push up wage costs and structural inflationary pressures.
Fourth, with the return of inflation and the rise in global interest rates, central banks have ended their massive purchases of government debt — or quantitative easing (QE). In some cases, including the UK, central banks have been actively selling off their government debt portfolios.
During the financial crisis, the argument against bailing out institutions was that it would foster moral hazard. Banks, betting on future bailouts, would take on much more risk than they otherwise would if they had to bear responsibility for their decisions.
This rationale was partly behind the tragic decision to allow Lehman Brothers to fail. But, in a strange twist of fate, it was governments themselves that fell prey to moral hazard.
We knew back in 2008 that government debt was at risk of spiralling out of control and that excessive deficits needed to be curtailed. That is why the UK and US both embarked on belt-tightening once the recession ended, and why parts of peripheral Europe were forced to endure excruciating austerity.
But after a while, those fears about fiscal sustainability faded as structural forces drove down government borrowing costs and QE tranquillised bond investors.
By the time Covid hit in 2020 – when borrowing costs reached their nadir and governments had convinced themselves that inflation would never return, and that interest rates would stay low forever – they had no misgivings whatsoever about ramping up borrowing.
A German economist named Rüdiger Dornbusch, who spent most of his career in the US, said: 'Crises take longer to arrive than you can possibly imagine, but when they do come, they happen faster than you can possibly imagine.'
This roughly captures the story of fiscal policy in advanced economies over the past two decades. After interest rates stayed low for much longer than anyone imagined, they normalised faster than anyone thought they could.
The maths behind massive debt-financed green transitions, generous welfare states and rising defence spending – all while financing rising state pension costs and increased public healthcare demands – never really added up. But the era of ultra-low interest rates allowed policymakers to kick any hard policy choices into the long grass. Not any more.