Shorting Fiscal Consolidation

NEW HAVEN – Real long-term interest rates – that is, interest rates on inflation-protected bonds – have fallen to historic lows in much of the world. This is an economic fact of fundamental significance, for the real long-term interest rate is a direct measure of the cost of borrowing to conduct business, launch new enterprises, or expand existing ones – and its levels now fly in the face of all the talk about the need to slash government deficits.

Nominal interest rates – quoted in terms of dollars, euros, renminbi, etc. – are difficult to interpret, since the real cost of borrowing at these rates depends on the future course of inflation, which is always unknown. If I borrow euros at 4% for ten years, I know that I will have to pay back 4% of the principal owed as interest in euros every year, but I don’t know what this amounts to.

If inflation is also 4% per year, I can borrow for free – and for less than nothing if annual inflation turns out to be higher. But, if there is no inflation over the next ten years, I will pay a hefty real price for borrowing. One just doesn’t know.

Economists like to subtract the nominal government bond yield from the inflation-indexed bond yield of the same maturity to get a market estimate of the inflation rate from now to that maturity date. But such forecasts of “implied inflation” can be wild, if not absurd. During the heat of the 2008 financial crisis, for example, the inflation-indexed yield in the US rose so high for a brief period that implied annual inflation for the next seven years suddenly dropped to -1.5%. (A subsequent study by PIMCO bond traders Gang Hu and Mihir Worah concluded that this was linked to technical and institutional factors concerning the Lehman Brothers bankruptcy.)