Government can afford to do more to fund a clean transition and enable private investors to make a healthy return. They need to increase the credibility of decarbonisation policies to reduce the policy risk premium, and to stop holding investment back, writes Dimitri Zenghelis.
The interest rate, or cost of borrowing, is one of the most important indicators in economics. It balances the market for total saving and investment and contains important information reflecting society’s choices regarding consumption today versus consumption tomorrow and the return to forgoing spending today in favour of investment.
Investors, businesses and governments need a useful definition of the ‘real’ rate of interest, adjusted for inflation. The real rate of interest can be defined and measured in many ways. On one definition favoured by the International Monetary Fund (IMF), the three-month interbank rate minus realised inflation currently ranges between -2 and -7% for the US, Japan, France and Germany, even though nominal interest rates have jumped during the past year. This is because inflation has increased even more.
They also need an indication of how it is likely to evolve as the world economy and financial markets work through an unusually large number of shocks: as inflation settles down; China’s post-Covid GDP (gross domestic product) bounce-back runs its course; saving-rate distortions work themselves through; the strength of investment intentions, both private and public, becomes more apparent; and the world economy starts to reveal its new trend paths for growth and inflation. Among other things, the real interest rate will ultimately determine the cost of the necessary investment in the clean transition required to reduce global emissions and resource use.
The ‘neutral’ real interest rate
The ‘neutral’ (also known as the natural, or ‘equilibrium’) real interest rate is the implied rate at which an economy is neither overheating nor being reined back, where output is close to potential and where people expect inflation to be at its target. The natural rate is therefore a reference point for central banks that use it to gauge the stance of monetary policy. Differences between a neutral rate and the actual rate set by policymakers are in theory transitory and reflect the use of monetary policy to get the economy back to its notional ‘equilibrium’.
Economies and financial markets of course seldom, if ever, settle in an equilibrium, life being “just one damn thing after another”, but currently it feels they are particularly far away from one. This is precisely why the ‘neutral real rate of interest’ is a much-needed concept to understand the underlying economy and guide decisions. And while it is empirically unobservable, important inferences can be made; and various attempts have been made to estimate it. It is widely accepted that the world real neutral rate fell sharply in the 1980s, declining by around 300 basis points (three percentage points) and settled at close to zero after 2000.
‘Big investments, say in infrastructure projects, are funded through borrowing. More investment means more borrowing, and the competition for debt means that lenders can increase the price – the interest rate – on loanable funds. This would result in a higher rate of interest. It can therefore be inferred that over the past several decades – at the world level and thereby in many countries individually – desired investment has been systematically less than desired savings. To balance savings and investment, real interest rates have not only been low by historical standards, but have fallen almost continually.
The drivers of historically low real interest rates
The determinants of underlying saving have received much attention. Factors potentially boosting desired saving include demographic and social conditions such as: baby-boomers being of prime earning age; increased female participation in the workforce; growth in more productive urban working populations, especially in Asia; globalisation; the opening up of the former Soviet Union and China; and rising inequality (the rich tend to save disproportionately more). Debate continues over whether these will be as important in the future as they have been in recent decades.
The determinants of long-run investment seem to have received somewhat less attention. This is surprising, given that real rates have fallen yet investment (as a percent of GDP) has not increased for advanced economies. Why has investment in advanced economies not risen in the presence of ‘free money’?
Much of the problem seems to stem from the perceived level of risk and a shortage of what Keynes dubbed investors’ ‘animal spirits’, particularly important since the 2008 Global Financial Crisis. The perception of a secular slowdown in the return on capital becomes collectively self-fulfilling, as expectations of lower output breed lower investment – the so-called ‘accelerator’ mechanism going into reverse.
A notable aspect of risk that seems to be holding back investment is policy risk. This is particularly associated with investment in decarbonising heavily regulated and policy-driven sectors such as infrastructure, energy, transport and buildings. Investors we spoke to tell us there is no shortage of money, but they have long felt unable to trust the policy environment to be able to generate a relatively risk-free long-term return.
The growing need to boost investment
In recent years the role for policy in boosting investment may have become even more important. The low-cost technologies of tomorrow require significant investment today. Yet economies of scale in production and discovery and the strategic advantage from developing supply lines and knowledge clusters in fast-growing clean sectors, means that early investment can yield outsized returns.
Investment and productivity growth rates were highest after post-WWII publicly- steered efforts at reconstruction: the Marshall Plan, and Cold War competition provided a credible policy steer to channel investment. Today, competition with China means industrial strategy is coming back in vogue. The Inflation Reduction Act in the US may even be a game changer, helping drive global efforts to scale-up clean investment and boost productivity growth.
The sustained fall in global neutral real interest rates suggest there has been, and still is, scope for the public sector to borrow to invest without prompting a sharp rise in rates or crowding out private investment. If fiscal incontinence and excess public borrowing had shaped capital market conditions, then real rates would have risen as profligate governments bid for limited funds. This did not happen. Indeed, by creating capacity through investment in infrastructure, skills and new technologies, targeted public investment has the potential to restore productivity growth and drive enduring declines in public debt/GDP. Of course, in the short-run, higher spending will add to inflationary pressures, but a targeted shift from consumption to investment will not.
Higher inflation has recently eroded the real value of public liabilities, while the jump in policy interest rates have lowered the price of public bonds, shifting trillions of dollars from the balance sheet of bond issuers to that of bond investors. The two together are generating unexpected fiscal space. Italy’s debt-to-GDP ratio, for example has fallen 7 ppts in the year to 2022 Q3, while that of the US is estimated to have fallen 20 ppts from its pandemic peak.
In a recently published research piece, Dimitri Zenghelis, John Llewellyn and Silja Sepping conclude there is plenty of money in the form of desired saving to fund a clean transition. Governments can afford to do more, enabling private investors to make a healthy return. Indeed, beyond funding obvious investment needs, putting public skin in the game increases the credibility of decarbonisation policies and reduces the policy risk premium: the very thing which has been holding investment back.
The views and opinions expressed in this post are those of the author(s) and not necessarily those of the Bennett Institute for Public Policy.