The Federal Reserve Bank of the United States raised interest rates last December. This was the first rate rise in almost ten years. At the time three more rate increases were forecast this year. The Federal Reserve’s policy on interest rates can have a global effect.
Ireland’s fiscal squeeze of the 1980 to 1987 period, of which I had direct experience, was caused by the Federal Reserve’s decision to tackle US inflation by raising interest rates and restricting the money supply.
A rise in interest rates this year would affect countries differently.
If a country has a big government debt, by comparison with its annual tax revenue, it will have to make more cuts or tax increases to accommodate to a higher interest rate.
If a country’s economy is growing slowly, and it has low future growth potential, because it has an ageing society, the effect of an interest rate rise will be even more severe.
Goldman Sachs recently compared the situations of Germany, France , Italy and Spain.
If there was a 100 basis points increase in interest rates ,
+ Germany would have to trim its budget by 0.5% of GDP,
+ France and Spain by 0.75% of their GDP, but
+ Italy would have to trim its budget by 1%.
This is because the
+ Italian government debt is 140% of the Italian annual GDP,
+ the French and Spanish debts around 100% of their GDP while
+ Germany’s is only around 75%
These effects would come about slowly. If countries have debts with long maturities , it will take a while for a rise in interest rates to have their full effect. General inflation is not a problem today, but sectors of the global economy can become over heated.
Goldman Sachs did not do similar calculations for smaller countries like Greece, which has a debt/ GDP ratio of 180%, or for the UK, whose ratio is 90%.
But both countries are facing difficult futures, partly because of their own freely taken democratic decisions, in Greece’s case quite long ago, but in the UK’s case very recently. Euro zone countries are able to keep interest rates low because the ECB is buying their bonds, but there are prudential limits to this. If a country’s banks buy an undue amount of their own government’s bonds, that can create an unhealthy linkage between to solvency of the banks and the solvency of the government.
The Goldman Sachs calculations do not take full account of human factors like the lack of dynamism which can arise when countries come to believe they are “entitled “ to a certain standard of income, without taking account of the value of what they can sell to the rest of the world.
Ageing societies, with large retired populations, are particularly prone to this sense of entitlement because they feel that the work that they did in the past, entitles them to a good standard of living today. Unfortunately the money their work earned is long spent, and pensions can only be paid out of what can be earned in the future.
If that money does not come in, people will look for someone to blame. Often the blame takers are immigrants, even though these immigrants are often the ones who are paying the taxes and earning the money ,that support the entitlements of many native residents. For example , EU immigrants in the UK pay much more in taxes than they take out in benefits, but that was ignored by UK voters.
This gap between expectations and what can be afforded , is the explanation for the so called “populism” we see among ageing populations in the UK, the US and elsewhere.
Populism is really a crisis of entitlement.
Populism will become more severe if , and when, interest rates rise.
We need an informed electorate that votes knowledgeably, an electorate that accepts that interest rates, free trade, immigration and demographics are all interlinked with one another.
We need to find better ways of explaining the links between
+ the prospect of higher international interest rates, and the desirability of reducing government debt levels
+ the importance of preserving open markets and overseas earnings if we are to afford decent pensions,
+ the link between allowing immigration, and having enough young people to work and pay taxes in future
+ the fact that decisions, twenty years ago, to have fewer children, are liable to affect what welfare states will be able to afford , twenty years from now