Higher interest rates might mean lower government spending, is that a threat to the economy?
I’ve been saying for years that interest rates need to be above zero for the economy to work properly, and that low interest rates have led to a misallocation of capital which has slowed growth through creating highly valued companies which have no road to profitability. That case is easy to make, and to be honest I think recent events have supported my thesis to say the least. However, I’ve often neglected the effect a normalisation of interest rates will have on states. States are major economic actors, and with industrial policy coming back into vouge they will become even more imortant in the future. And just like firms governments have heard the siren song of dirt cheap debt. Now they are faced with the rocks and cliffs of servicing that debt.
Before we discuss the impact what I will pessimistically dub the ’house of cards’ scenario we need to rehash some basic macroeconomic theory for my argument to make sense. The output (Y) of an economy is determined by four factors: consumption (C), investment (I), government spending (G), and net exports (X-IM) which we can express as Y=C+I+G+X-IM. Different economies rely on different factors for the lion’s share of their output but all economies are dependent on all four factors. This is relevant to higher interest rates as a government’s ability to spend might depend on how high interest rates are if those governments run consistent budget defecits.
If a state has to devote more resources to paying its exisiting debts then it has less to spend and thus it becomes a drag on the economy, at least as compared to before. This could in extreme cases be a sort of house of cards where once the foundation of government spending is taken away the rest collapses. To be clear, that’s not a likely scenario, but it is also not an impossible scenario.
Why wouldn’t the indebted government simply default on at least part of its debt to make servicing its debt manageable? In some societies it could be very difficult politically given who owns that debt. After the Napoleonic wars Britain had monumental public debt which took it almost a hundred years to pay down. The reason it didn’t default was that its aristocracy was owed the money, and that aristocracy was both politically powerful and largely involved in running the government.
The big country with the highest ratio of debt to GDP is Japan. Japanese public debt has expanded so much in part because it has appeared safe for Tokyo to take on expanding liabilities given how much of the Japanese public debt is owned by Japanese banks, financial institutions, and individuals. The theory was that no foreign (and potentially hostile) power could call in the money owed as it wouldn’t be in their interest to undermine the financial stability of their own government. Coversely though, the Japanese government would be insane to default on its debt to its own citizens. Which elected politician would wipe out their voters’ pensions savings and imperil their domestic banks just to avoid some interest payments?
The public debt incurred during the zero interest years is not some inescapable sword of Damocles, it can be dealt with. Some states, such as Sweden, were responsible enough to resist the siren song, and some of those affected will be able to grow fast enough to make servicing their debts easier. But there is no such thing as a free lunch, much less free money. Or, to quote Göran Persson: ”Den som är satt i skuld är icke fri”.
If you liked this post you can read my last post about NATO here, or the rest of my writings here. It'd mean a lot to me if you recommended the blog to a friend or coworker. Come back next Monday for a new post!
I've always been interested in politics, economics, and the interplay between. The blog is a place for me to explore different ideas and concepts relating to economics or politics, be that national or international. The goal for the blog is to make you think; to provide new perspectives.
Written by Karl Johansson
Cover photo by jalil shams from Pexels, edited by Karl Johansson
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