Fri, Jul 16, 2004 - Page 9 News List

Welcome to an era of financial incompetence

The inability of the West to implement sensible fiscal policies can be blamed on political parties and the system itself

By J. Bradford DeLong

Two diametrically opposed scenarios exist for what will happen to global real interest rates over the next generation.

Those who predict generally low interest rates over the next generation point to rapid growth of productivity and potential output in the world economy. According to this view, the principal problem faced by central banks will not be restraining demand as it shoots above potential, but boosting demand as it lags behind potential. They point to the fact that the world's major central banks -- the US Federal Reserve, the European Central Bank, and the Bank of Japan -- have so firmly established their anti-inflation credibility that the inflation risk premium has been wrung out of interest rates.

Believers in low interest rates also emphasize shifts in income distribution in the US away from labor and toward capital, which have greatly boosted firms' resources to finance investment internally and reduced their dependence on capital markets. They point to rapid technological progress, which has boosted output from new and old capital investments. With competition strong across the economy, they say that we can look forward to a generation of relatively high asset prices and relatively low real interest rates worldwide.

By contrast, those who predict generally high real interest rates over the next generation point to low savings rates in the US, high spending driven

by demographic burdens in Europe, and feckless governments running chronic deficits and unsustainable fiscal policies. Imagine a bunch of irresponsible Bush-like administrations making fiscal policy, forever.

They also cite investment opportunities in emerging markets, and make the obvious point that if China and India stay on track, their economies' relative weight in the world will double in the next decade or so, as rapid real growth is accompanied by appreciation in their real exchange rates. Sooner or later, the Chinese and Indian central banks' desire to hold down exchange rates to boost exports and their rich citizens' desire to keep their money in accounts at Bank of America will be offset by the sheer magnitude of investment opportunities. In this scenario, bond prices in post-industrial countries are heading for a serious fall -- as are real estate prices in California, New York, and London.

What, then, is an economist to do? One could emulate

J.P. Morgan, whose standard response to questions about stock prices, bond prices and interest rates was to say simply, "The market will fluctuate."

Another alternative is to recall the late Rudi Dornbusch, who taught that any economist who forecasts interest rates based on fundamentals is a fool, because fundamentals are complex and unstable, shifting suddenly and substantially. Even if an economist correctly understands fundamentals, Dornbusch warned, that doesn't mean that markets do. In forecasting interest rates one is engaged not in examining fundamentals, but in predicting what average market opinion expects average market opinion about fundamentals to be.

But Rudi never followed his own advice. So let me place my bet -- which I think is only 60 percent likely -- and say that my best guess is that world real interest rates will be high over the next generation, and that current bond prices (and real estate prices) are not sustainable. Four features of modern politics in the world's post-industrial core lead me to this conclusion:

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