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America’s Interest-Rate Puzzle

A great puzzle in today’s world economy is the continued low level of long-term real interest rates in the United States. Conventional macroeconomists like me look at America’s current-account deficit, now running at 7% of GDP, and know that such vast deficits are inevitably followed by large currency depreciations. So we expect a substantial depreciation premium on US interest rates.

If the dollar falls 20% more against the euro sometime in the next ten years, US long-term interest rates should be two percentage points higher than euro rates. If it falls 40% against the yen sometime in the next ten years, US long-term interest rates should be four percentage points higher than Japanese rates. If it falls 60% against China’s currency, the yuan, sometime in the next ten years, US long-term interest rates should be six percentage points higher than Chinese rates. But we are not seeing signs of anything like this.

The puzzle is not only that long-term rates are too low when viewed in the international context, but also that they are too low when viewed in America’s domestic context. The Bush administration continues to have no plans to sew up the veins it has opened with its medieval economic policy, which holds that bleeding revenue from the government cures all economic problems.

This means that unless America’s domestic savings rate rises mightily – which it shows no signs of doing – and unless investment expenditure remains abnormally low for the rest of this decade, the supply of loanable funds to finance investment will soon be much less than demand when the current-account deficit narrows to sustainable levels. But when supply is less than demand, prices rise sharply.