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 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 United States 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% 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:
· In the US, the collapse of "grownup" Republicans in Congress - the extraordinary failure of fiscal conservatives to mount any effective opposition to the Bush administration's renewed destabilization of American government finances. The deficit orgy of the Reagan era is looking less like a freak political accident and more like a structural feature of Republican Party governance - what the modern Republican governing coalition tends to do whenever it gains power;
· The parallel collapse of a grownup Republican presence in the executive branch. As Ron Suskind reports in his recent biography of Bush's first Treasury Secretary, Paul O'Neill, former Bush Budget Director Mitch Daniels once whispered to himself at the end of a disastrous meeting, "Not a typical Republican package. Definitely not." But Daniels decided he would rather run for office in Indiana than take a stand in support of sound fiscal finance;
· The failure of Western European governments to even begin to think about how to address the coming fiscal crisis of the social-insurance state as a result of their aging populations;
· The inability of Western European governments to enact sufficiently bold liberalizing reforms to create the possibility of full employment, together with the failure of western European monetary policy to be sufficiently stimulative to create the reality of full employment.
The arguments for low interest rates seem to me to require a degree of government competence that is unlikely, given political parties' current positions and the existing structure of the institutions that make fiscal policy. I hope to be surprised. I hope to see governments in Western Europe and the US face up to their responsibilities and conduct sensible, sustainable fiscal policies. But that is my hope, not my forecast.