Why are interest rates so low?

In his book "Can it happen again?" the late Hyman Minsky argued that western economies were subject to regular financial crises. These crises were the result of multi-decade periods of increasing debt relative to GDP followed by multi-decade periods of decreasing debt relative to GDP.

Minsky argued that debt would rise relative to GDP until the total interest payments relative to GDP would consume too high a level of national income. The peak in debt would lead to a sharp lift in savings. This increase in savings and fall in consumption was often experienced as a crisis. From this point, the growth in debt would come to an end and savings would sharply rise. This rise in savings and fall in consumption would lead to a long term period of falling debt relative to GDP.

Minsky was talking about cycles in private debt. The transition from rising debt to falling debt has been called by some commentators "a Minsky moment". These commentators tended to refer to the global financial crisis as just such a "moment".

Hyman Minsky died in 1996. The two best commentators on the historical process of financial crises currently living are Kenneth Rogoff and Carmen Reinhart. Together, they have published the most authoritative works this century on the history of the transition to and the transition from major financial crisis.

Rogoff and Reinhart note that one of the distinguishing features of the global financial crisis is that the world has emerged from it with extremely high levels of public debt. In Figure 1 above we show the level of net sovereign debt as a

percent of GDP owed by developed economies. The data for this series is published in the International Monetary Fund International Outlook database. We can see that the level of net debt owed by developed economies rises from 43.6% of GDP in 2007 to 71.3% of GDP in 2012. This is a rise of 27.7% of GDP in only five years. Our objective in this paper is to examine the effect of this high level of developed country net debt upon financial markets and ask the question as to how this high level of developed country debt may be paid back.

When has this happened before?

The precedent for the repayment of high levels of public debt can be found by examining the repayments of large levels of war debt by allied countries after World War II. The United States, the United Kingdom and Australia, all built up very high levels of sovereign debt in World War II. This was successfully paid back over the period from 1946 to 1980. How was this done? What can we learn from this?

Carmen Reinhart has done work in this area with a number of other collaborators. One of her papers on this issue is aptly called "The Liquidation of Government Debt". She wrote this in 2011 with Belen Sbrancia. I attended her presentation of this paper at the American Economic Association annual meeting in Chicago in 2012. In this paper she talks about "financial repression".

Reinhart says that financial repression usually includes long periods where the interest on government bonds is persistently below the rate of inflation. She says that this allows the reduction in sovereign debt relative to GDP to continue over a long period of time without giving rise to political disorder. She says "given that deficit reduction usually involves highly unpopular expenditure reductions and/or tax increases in one form or another, the relatively stealthier financial repression tax may be a more politically palatable alternative to authorities faced with the need to reduce outstanding debts".

Reinhart tells us that the major way of repaying this debt after World War II was to run extended periods where the nominal interest rate on the debt was below the inflation rate that year. This is what we call 'negative real interest rates'. The numbers for Australia published in her paper are most insightful.