March 5, 2015 12:00 am JST

Carmen M. Reinhart: Are negative real interest rates the 'new normal'?

Some questions can only be answered by examining the broad sweep of history. Over the past 150 years, "world" real interest rates have ventured into negative territory (yielding less than the rate of inflation) on a sustained basis on only four occasions, including the present cycle starting with the global financial crisis of 2008. Those negative real interest rates tax bondholders and effect a transfer from savers to borrowers.

Past examples

Two of the previous three episodes of persistent negative real interest rates followed world wars and the high levels of public debt arising from those wars. Inflation spikes were significant forces behind the negative real interest rates recorded around World War I and again during the severe inflation crises at the end of World War II, most notably in Japan, Italy and France.

     Yet, entering the more stable 1950s, inflationary pressures subsided but negative real interest rates persisted. Between 1946 and 1980, real interest rates were negative approximately half of the time in advanced economies. Real interest rates during that era but prior to the surge in oil prices of the 1970s were low or persistently negative not predominantly because inflation was repeatedly taking financial market participants by surprise but because policymakers went to great lengths to keep nominal interest rates very low and comparatively stable.

     I have suggested elsewhere in my work with Belen Sbrancia that negative real interest rates provided governments a nontrivial form of "taxation" that helped liquidate the huge overhang of public debt that was a legacy of World War II and greatly eased the burden of servicing that debt.

     Such policies, known as financial repression, usually involved a strong connection between the government, the central bank and the financial sector.

     The financial repression route taken at the creation of the Bretton Woods system was facilitated by the conditions prevailing after the war, which had left a legacy of pervasive domestic and financial restrictions. Indeed, even before the outbreak of World War II, the pendulum had begun to swing away from laissez-faire financial markets toward heavier-handed regulation in response to the widespread financial crises of 1929-1931. But one cannot help think that part of the design principle of the Bretton Woods system was to make it easier to work down massive debt burdens.

     After a financial crisis, those policies could be packaged as prudential by supervisors and still yield benefits to government debt issuers. When regulations create a "captive audience" for government debt (as through capital controls or macro prudential requirements), rollover risk is reduced and interest rates will be lower than they would be absent the demand for government debt from the captive audience.

     The evidence from that historical episode provides the recipe for "successful" financial repression (strictly from the vantage point of delivering debt reduction): the capacity for the government to create and maintain a large captive audience for government debt and the ability to tax that captive audience systematically via consistently negative real interest rates.

The case today

To deal with the current debt overhang, similar policies have re-emerged since 2008 in the guise of prudential regulation rather than under the politically incorrect label of financial repression. Moreover, the process where debts are being "placed" at below market interest rates in pension funds and other more captive domestic financial institutions is under way in several countries in Europe. There are many bankrupt or nearly bankrupt pension plans at the state level in the U.S. that bear scrutiny, in addition to substantive unfunded liabilities at the federal level.

     Markets for government bonds are increasingly populated by nonmarket players, notably the central banks of the U.S., Japan, Europe and many of the largest emerging markets, calling into question what the information content of bond prices are relative to their underlying risk profile. This decoupling between interest rates and risk is a common feature of financially repressed systems.

     With public and private external debt at record highs, many crisis-battered European economies are increasingly looking inward for public debt placements. In this regard, Japan has been looking inwards for years, as its external liabilities remain low relative to other advanced economies and its pool of domestic savers has provided the captive audience for the burgeoning public debt since the onset of its financial crisis in the early 1990s.

     The ingredient Japan had been missing until recently in the two-ingredient recipe for financial repression was the ability to deliver negative ex post real interest rates. Persistent deflation was the main obstacle to debt reduction via financial repression.

     The conditions concerning the extent of global financial integration were vastly different at the outset of Bretton Woods in 1946 than they are today, but the direction of regulatory changes have many common features. The incentives to reduce the debt overhang are more compelling today than about half a century ago. After World War II, the overhang was limited to public debt, as the private sector had painfully deleveraged through the 1930s and the war.

Blurred lines

The current situation is more complex. The debt overhang that many advanced economies are facing encompasses, in varying degrees, households, firms and financial institutions, as well as governments. At any rate, the distinction between public and private debt is often overstated. What are private debts before a crisis often become public debts during and after the crisis. The "modern" debt overhang is broader -- it is economywide.

     There are compelling reasons, shared by advanced economies, policy should endeavor to keep rates low by historical standards and produce a high incidence of negative real rates as a part of the "new normal."

     These reasons include an anemic to nonexistent recovery from the crisis (as my recent work with Ken Rogoff shows, per capita income in most of the European crisis countries remains well below their pre-crisis levels) and unemployment that remains stubbornly high seven years after the crisis. Additionally, central banks in advanced economies are now having to worry about avoiding deflation rather than fighting inflation, and there are also financial stability concerns about how a highly leveraged private sector would cope with rising interest rates. Lastly, there is the growing realization that a steadily aging population will re-enforce one or more of the concerns listed above.

     In such an environment, it is no surprise that negative world real interest rates have made an extended comeback. Possibly more surprising has been the widely held view that monetary policy, at least in the U.S., would "normalize" over the near term with an accompanying rise in interest rates. "Normal" in the era of financial repression of 1946-1980 meant that negative real interest rates were as likely as positive ones.

Gradual approach

It is important to remember that financial repression is a more gradual approach to debt reduction than debt restructuring and "haircuts," unless, of course, it is coupled with surging inflation.

     Given the magnitudes of both public and private debt levels, financial repression may be necessary -- but is probably not sufficient -- to restore debt to more manageable levels. For such cases, it is best viewed as a complement to restructuring, not a substitute for it.

     At any rate, fiscal savings via lower interest rates, or even modest debt reduction when rates are negative, are not to be taken lightly when other alternatives are as unspeakable as restructuring and as unpalatable as perpetual austerity.

Carmen M. Reinhart is Minos A. Zombanakis Professor of the International Financial System at Harvard University.

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