The first section explains some basic ideas, and those familiar with arbitrage and the natural real rate of interest can skip to the austerity section. Basics Longer term interest rates, rates on borrowing for a number of years, are what helps determine the cost of government debt, the cost of long term borrowing by firms and the cost of mortgages. A lot of popular discussion links these longer term rates to the short term interest rate set by central banks. The reason is arbitrage. Someone who buys a longer term asset with a fixed return over five years, say, could instead hold that money in a variable rate account, and arbitrage means that rates will move until lenders are indifferent between the two, so longer term rates and short rates are linked. By that logic, interest rates on a 5 year bond, say, are just equal to expectations about how the central bank will set short term interest rates over the next five years. It’s not that simple because of liquidity and uncertainty. Having money in a variable rate account normally gives you instant access, while investing in a longer term asset will either tie your money up for a long time or to a potential loss by selling it before term, so lenders want some compensation for this. In addition, what is going to happen to short rates is very uncertain, so most lenders want compensation for taking the risk of betting on a particular forecast. Guessing how independent central banks will set interest rates in the future is not easy, but the logic behind their actions are pretty clear. Most aim to hit an inflation target, so they will set interest rates at whatever level is required to either keep inflation at target, or get inflation back to target. In crude terms, interest rates act to control aggregate demand, and keeping inflation steady involves getting demand matched up with available supply. A critical question is therefore what level of interest rates will stabilise inflation in a few years time. That depends on what will happen to aggregate demand, but it also depends on how demand is influenced by interest rates. Demand is mainly determined by real rather than nominal interest rates, where the real rate is the nominal rate less expected inflation, so we want to know what real interest rate will match aggregate demand to supply. That level is often called the natural real interest rate. Judging by historical data the natural real interest rate seems to vary a lot over time. [1] Most measures of real interest rates fell steadily from 1980 until at least 2000. Above is an example based on US rates (source). While you could argue that rates were unusually high in the 1980s because central banks were squeezing demand to bring inflation down, that doesn’t explain the continuing fall in the 1990s. We need two more conceptual ideas before going further. The first is the importance of the supply and demand for savings. If, say, a technological revolution produces a large increase in borrowing by firms, but there is no increase in the supply of savings to meet it, real interest rates will rise to encourage more saving and discourage some borrowing. While I tend to discount the idea that the supply of particular assets, like an individual government’s debt, is the critical factor determining the interest rate on that debt [2], at the aggregate level the supply and demand for assets does matter. The second idea is the distinction between safe assets, where the person borrowing is almost certain to pay back the loan, and other investments where the loan may be only partially paid back. Equities are the main example of the latter, because not only do aggregate share prices move around but any individual company may, in the extreme, go bust. The difference between the two types, returns on safe assets and the return on equity or capital more generally, is called the ‘equity risk premium’, but that gap may not just be about risk. In particular the overall supply and demand for either type of asset can influence this risk premium. The Financial Crisis and Austerity Period For more detail on this and the next section I strongly recommend this fascinating discussion between Paul Krugman and Ricardo Caballero. Caballero argues that after 2000 there was a continued fall in the real interest rate on safe assets, much greater than anything happening to the return on capital, and he described this (at the time) as a shortage of safe assets. (This study suggests that the return on capital in the US actually started rising in the 90s.) In other words rather than there being too much government debt around (as many politicians and journalists claimed) there was actually too little. Was this shortage one reason that the private sector tried to make its own safe assets with mortgage backed securities, the failure of which was the spark that led to the Global Financial Crisis (GFC)? Caballero suggests it was a factor. It would be horribly ironic if the GFC, the impact of which was often misattributed to excessive government borrowing, might itself have been partly caused by governments borrowing too little! But what Caballero’s argument certainly tells us is that attempts in most countries to cut government deficits from 2010 because government debt was dangerously high were especially wrong. The original sin of austerity was of course to cut government spending in a recession, going against basic macroeconomic teaching understood since Keynes. We now...