interest rates and the economy

• In November 2003 the Bank of England’s monetary-policy committee (MPC) raised interest rates by 0.25%, the first increase in almost four years. With hindsight, it seems a straightforward decision. The economy was growing steadily, unemployment was low, house prices were shooting up and banks were lending freely. Yet at the time there was great anxiety about the change. The fear was that the increased burden of consumer debt would make even a small rise in interest rates bear down heavily on spending.
• That worry is all the greater now, as the bank contemplates a similar move. As The Economist went to press on April 7th the MPC was expected to keep its benchmark rate at 0.5%—but a quarter-point increase seems likely as soon as next month. Debt is worse, relative to incomes, than in 2003 (see chart). Other pressures on household finances are greater now than then. Wage growth is sluggish; inflation is far higher; job prospects are poorer. And taxes are going up. In the circumstances, an increase in interest rates could easily provoke a damaging cutback in spending by nervous consumers. One big, if subtle, reason for concern is the stark polarisation between the cash-rich and the debt-poor.
• If each household had an equal share of the cash and debt held by all, there would be little to worry about. True, personal debt is around 1.5 times post-tax income, which means that a percentage point increase in interest rates, if fully passed on by lenders, would take up 1.5% of income in higher debt-service costs. On the other hand, the income effects of interest-rate changes do not work in only one direction. Households in aggregate also have large cash deposits, and higher interest rates raise the income that is earned on them. The stock of cash is a bit smaller than the stock of debt, so the overall effect of interest-rate increases would be to depress household income. But as long as deposit rates rise in tandem with borrowing costs, the cost of a percentage point rise in rates would be less than 0.3% of incomes.
• That reckoning, however, understates the likely impact. Analysing the debt and cash holdings of all consumers lumped together reveals little about the effect of interest-rate increases on spending. That actually depends on how the aggregate cash hoard and debt burden is divided.
• People typically do not have both large debts and piles of cash, since it would make sense to use the latter to pay off the former. Rather there is a financial spectrum with, at one end, debt-laden householders, usually young, who have recently taken on a hefty mortgage and have little spare cash; and at the other end, older savers who have paid off their mortgages, or who have traded down to smaller homes and banked the proceeds.
• These different sorts of consumers will respond to interest-rate increases in ways that are unlikely to be neutral for the economy. The indebted will cut their spending to free up the extra cash to service their loans. Once rates start to rise, those with the biggest debts might be anxious to save harder to pay down those debts at a faster pace. At the other financial pole, the cash-rich and debt-free (by definition savers not spenders) might well spend little, if any, of the extra income they gain from higher deposit rates.
• Any squeeze on debtors’ incomes might be mitigated if banks chose not to pass on any increase in funding costs stemming from higher base rates. That scenario is optimistic. The gap or “spread” between the Bank of England’s rate and the average interest rate on mortgages (which account for four-fifths of household debt) has narrowed a bit recently, though it is much higher than before the financial crisis. This narrowing owes little, it seems, to banks competing more vigorously for mortgage business. Rather it reflects lower rates for borrowers whose fixed-rate deals had expired and lapsed into cheaper variable-rate mortgages.
• In one sense, this is helpful: it has lifted the incomes of some borrowers at the banks’ expense. But it has also made the economy more sensitive to changes in short-term interest rates. Before the crisis, around half of mortgages were at variable interest rates; by the end of last year, the share had risen to 69%. This greater sensitivity is heightened by the fragile state of Britain’s housing market. Higher rates will crimp the already-weak demand for homes and weigh on house prices—perhaps spurring anxious borrowers to spend less and pay off their mortgages quickly.
• A big enough interest-rate shock would start a downward spiral in debtors’ finances, spending and house prices. Rising defaults would exacerbate the damage. For this reason, the MPC is likely to tread carefully. The “glacial pace” at which interest rates are likely to rise—perhaps 0.25 percentage points every three months or so—is unlikely to be dangerous, reckons Kevin Daly of Goldman Sachs. If spending suffers unduly, “the MPC would be able to deal with it,” he says.
• The polarisation of household finances that makes the impact of a rate rise so uncertain also helps to explain why some MPC members feel the need to act. Debtors are hoping that interest rates stay low, but savers and bondholders need to be reassured that today’s high inflation won’t be allowed to persist. A small rate increase would be a victory for savers. The needs of the economy mean that, overall, monetary policy will continue to favour debtors.

economic and financial indicators:overview

• Corruption is dreadful in India, as shown by a current “season of scams”—over mobile-phone licences, the Commonwealth games and more. Politicians, notably the ruling Congress party, are now feeling the public’s ire. Worries have also grown that graft is scaring away foreign businesses.
• Circumstantial evidence points that way. A spokesman for a big Western firm mutters into his cappuccino about a recent High Court decision, which if upheld would cost his company billions. It was so strange, he says, it could be explained only by judicial graft. A representative of a British media firm, SIS Live, which broadcast the Commonwealth games from Delhi, in October, is furious—along with other contractors—at being left millions of pounds out of pocket because, he says, payments have been frozen by investigators digging up evidence of corruption at the event.
• Across the board, surveys regularly tell how graft is an unusually heavy tax on Indian business. An annual one published on March 23rd by PERC, a Shanghai-based consultancy, shows investors are more negative than they were five years ago. Of 16 mostly Asian countries assessed, India now ranks the fourth-most-corrupt, in the eyes of 1,725 businessmen questioned. Being considered worse than China or Vietnam is bad enough; being lumped with the likes of Cambodia looks embarrassing.
• Outsiders may get an exaggerated view. India’s democracy, with a nosy press and opposition, helps to trumpet its scams and scandals, more than happens in, say, China. Yet locals tell similar tales. A cabinet minister frets that there is so much ghotala(fiddling), “it tells the world we are all corrupt. It may be a dampener to investment.” Others agree. KPMG this month reported on 100 bosses who were asked about their own experience of graft. One in three said it did deter long-term investment.
• Judging how much difference it makes is tricky. Right now, investors may be spooked as much by the fight against graft as by the corruption itself. Arpinder Singh of Ernst & Young in Mumbai says foreigners, especially those with some connection to America, increasingly hire firms like his to help them comply with America’s Foreign Corrupt Practices Act. Once a foreigner holds more than about 5-10% equity in an Indian firm, it is seen as having some responsibility for how it is run.
• Now even Indian firms, if they want to raise money abroad, or if their bosses want to protect their own professional reputations, are doing the same. As other countries, such as Britain, bring in tough anti-graft laws like America’s, the trend will continue. Yet many Indian firms still fail to comply with higher standards, so deals falter. Mr Singh ticks off a list, “in infrastructure, ports, toll roads, irrigation, microfinance”, of deals he has worked on that collapsed over “governance problems”.
• None of this is enough to prove that graft, alone, is scaring off business. Pranab Mukherjee, the finance minister, insists there is no correlation between corruption and foreign direct investment (FDI). Jeffrey Immelt, the boss of GE, in Delhi last week, cheerily agreed, insisting that a fast-growing market trumps all other concerns.
• But something is keeping investors wary. In 2010 the country drew just $24 billion in FDI, down by nearly a third on the year before, and barely a quarter of China’s tally. There is no shortage of other discouragements: high inflation, bureaucracy, disputes over land ownership, and limits on foreign ownership in some industries.
• Even so, India is home to an unusually pernicious form of corruption, argues Jahangir Aziz of JPMorgan. Elsewhere graft may be a fairly efficient way to do business: investors who pay bribes in China may at least be confident of what they will get in return. In India, however, too many crooked officials demand cash but fail to deliver their side of the bargain. Uncertainty, not just the cost of the “graft tax”, may be the biggest deterrent of all.

without faster growth,the world’s rich economies will be stuck

• What will tomorrow’s historians see as the defining economic trend of the early 21st century? There are plenty of potential candidates, from the remaking of finance in the wake of the crash of 2008 to the explosion of sovereign debt. But the list will almost certainly be topped by the dramatic shift in global economic heft.
• Ten years ago rich countries dominated the world economy, contributing around two-thirds of global GDP after allowing for differences in purchasing power. Since then that share has fallen to just over half. In another decade it could be down to 40%. The bulk of global output will be produced in the emerging world.
• The pace of the shift testifies to these countries’ success. Thanks to globalisation and good policies, virtually all developing countries are catching up with their richer peers. In 2002-08 more than 85% of developing economies grew faster than America’s, compared with less than a third between 1960 and 2000, and virtually none in the century before that.
• This “rise of the rest” is a remarkable achievement, bringing with it unprecedented improvements in living standards for the majority of people on the planet. But there is another, less happy, explanation for the rapid shift in the global centre of economic gravity: the lack of growth in the big rich economies of America, western Europe and Japan. That will be the focus of this special report.
• The next few years could be defined as much by the stagnation of the West as by the emergence of the rest, for three main reasons. The first is the sheer scale of the recession of 2008-09 and the weakness of the subsequent recovery. For the advanced economies as a whole, the slump that followed the global financial crisis was by far the deepest since the 1930s. It has left an unprecedented degree of unemployed workers and underused factories in its wake. Although output stopped shrinking in most countries a year ago, the recovery is proving too weak to put that idle capacity back to work quickly (see chart 1). The OECD, the Paris-based organisation that tracks advanced economies, does not expect this “output gap” to close until 2015.
• The second reason to worry about stagnation has to do with slowing supply. The level of demand determines whether economies run above or below their “trend” rate of growth, but that trend rate itself depends on the supply of workers and their productivity. That productivity in turn depends on the rate of capital investment and the pace of innovation. Across the rich world the supply of workers is about to slow as the number of pensioners rises. In western Europe the change will be especially marked. Over the coming decade the region’s working-age population, which until now has been rising slowly, will shrink by some 0.3% a year. In Japan, where the pool of potential workers is already shrinking, the pace of decline will more than double, to around 0.7% a year. America’s demography is far more favourable, but the growth in its working-age population, at some 0.3% a year over the coming two decades, will be less than a third of the post-war average.
• With millions of workers unemployed, an impending slowdown in the labour supply might not seem much of a problem. But these demographic shifts set the boundaries for rich countries’ medium-term future, including their ability to service their public debt. Unless more immigrants are allowed in, or a larger proportion of the working-age population joins the labour force, or people retire later, or their productivity accelerates, the ageing population will translate into permanently slower potential growth.
• Faster productivity growth could help to mitigate the slowdown, but it does not seem to be forthcoming. Before the financial crisis hit, the trend in productivity growth was flat or slowing in many rich countries even as it soared in the emerging world. Growth in output per worker in America, which had risen sharply in the late 1990s thanks to increased output of information technology, and again in the early part of this decade as the gains from IT spread throughout the economy, began to flag after 2004. It revived during the recession as firms slashed their labour force, but that boost may not last. Japan’s productivity slumped after its bubble burst in the early 1990s. Western Europe’s, overall, has also weakened since the mid-1990s.
• The third reason to fret about the rich world’s stagnation is that the hangover from the financial crisis and the feebleness of the recovery could themselves dent economies’ potential. Long periods of high unemployment tend to reduce rather than augment the pool of potential workers. The unemployed lose their skills, and disillusioned workers drop out of the workforce. The shrinking of banks’ balance-sheets that follows a financial bust makes credit more costly and harder to come by.
• Optimists point to America’s experience over the past century as evidence that recessions, even severe ones, need not do lasting damage. After every downturn the economy eventually bounced back so that for the period as a whole America’s underlying growth rate per person remained remarkably stable (see chart 2). Despite a lack of demand, America’s underlying productivity grew faster in the 1930s than in any other decade of the 20th century. Today’s high unemployment may also be preparing the ground for more efficient processes.
• Most economists, however, reckon that rich economies’ capacity has already sustained some damage, especially in countries where much of the growth came from bubble industries like construction, as in Spain, and finance, as in Britain. The OECD now reckons that the fallout from the financial crisis will, on average, knock some 3% off rich countries’ potential output. Most of that decline has already occurred.
• The longer that demand remains weak, the greater the damage is likely to be. Japan’s experience over the past two decades is a cautionary example, especially to fast-ageing European economies. The country’s financial crash in the early 1990s contributed to a slump in productivity growth. Soon afterwards the working-age population began to shrink. A series of policy mistakes caused the hangover from the financial crisis to linger. The economy failed to recover and deflation set in. The result was a persistent combination of weak demand and slowing supply.
• To avoid Japan’s fate, rich countries need to foster growth in two ways, by supporting short-term demand and by boosting long-term supply. Unfortunately, today’s policymakers often see these two strategies as alternatives rather than complements. Many of the Keynesian economists who fret about the lack of private demand think that concerns about economies’ medium-term potential are beside the point at the moment. They include Paul Krugman, a Nobel laureate and commentator in the New York Times, and many of President Barack Obama’s economic team.
• European economists put more emphasis on boosting medium-term growth, favouring reforms such as making labour markets more flexible. They tend to reject further fiscal stimulus to prop up demand. Jean-Claude Trichet, the president of the European Central Bank, is a strong advocate of structural reforms in Europe. But he is also one of the most ardent champions of the idea that cutting budget deficits will itself boost growth. All this has led to a passionate but narrow debate about fiscal stimulus versus austerity.
• This special report will argue that both sides are blinkered. Governments should think more coherently about how to support demand and boost supply at the same time. The exact priorities will differ from country to country, but there are several common themes. First, the Keynesians are right to observe that, for the rich world as a whole, there is a danger of overdoing the short-term budget austerity. Excessive budget-cutting poses a risk to the recovery, not least because it cannot easily be offset by looser monetary policy. Improvements to the structure of taxation and spending matter as much as the short-term deficits.
• Second, there is an equally big risk of ignoring threats to economies’ potential growth and of missing the opportunity for growth-enhancing microeconomic reforms. Most rich-country governments have learned one important lesson from previous financial crises: they have cleaned up their banking sectors reasonably quickly. But more competition and deregulation deserve higher billing, especially in services, which in all rich countries are likely to be the source of most future employment and productivity growth.
• Instead, too many governments are determined to boost innovation by reinventing industrial policy. Making the jobless more employable should be higher on the list, especially in America, where record levels of long-term unemployment suggest that labour markets may not be as flexible as many people believe.
• Faster growth is not a silver bullet. It will not eliminate the need to trim back unrealistic promises to pensioners; no rich country can simply grow its way out of looming pension and health-care commitments. Nor will it stop the relentless shift of economic gravity to the emerging world. Since developing economies are more populous than rich ones, they will inevitably come to dominate the world economy. But whether that shift takes place against a background of prosperity or stagnation depends on the pace of growth in the rich countries. For the moment, worryingly, too many of them seem to be headed for stagnation.