There are two schools of thought on interest rates: what might be called the conventional theory of the “blip”; and the longer-term monetary cyclical theory. The first has the current rates as a hiatus caused by current high inflation, itself the product of the energy price spikes caused by Russia. The second sees the last 30 years as an aberration, and the current rates as a step towards the “normal” real rates, exacerbated by the monetary laxity since 2000, as inflation falls faster than nominal interest rates.
Which one is right matters: the first means that we can resume the world of very low nominal and negative real rates, and the “wall of money” for infrastructure spending. The latter means “higher for ever” and higher costs of capital and hence bills. At stake is whether the net zero transition is going to be expensive, or, as many advocates suggest, almost a free ride; whether the water bills will go up a lot to fix the sewers and the water resources; and what it will cost to fix transport. More generally, it matters for the cost of debt to governments, whether there is any room for the state to invest in infrastructure and whether public expenditure is going into the deep freeze for maybe a decade, given the overhang of debt built up through the financial crisis, quantitative easing (QE) and the Covid lockdown.
Put simply, the stakes are incredibly high. The future path of real interest rates is one of the most important issues facing utilities and infrastructure, and their regulation and contracting going forward.
The Bank of England’s fairytale
When it comes to signalling the path of future nominal interest rates, the Bank of England’s record is awesomely bad. The Bank of England starts with its inflation target, which it has spectacularly failed to hit for some considerable period of time, and indeed its actions suggest it has not been following the letter of its mandate from the Treasury. If the Bank of England seriously wanted to hit its target, nominal interest rates would have been increased much more aggressively. The reason they have not is a very faulty analysis and very faulty models of the economy, and the implicit aim not to cause a big recession (which is not in its mandate).
Much has been made of the Bank of England’s failures with its economic models. So bad has the performance been that an independent review of them has been set up. With its neo-Keynesian approach, it is hardly surprising that the independent reviewer is none other than one of the high priests of QE and lax monetary policy – neo-Keynesian Ben Bernanke.
Why has the record been so bad? Part of the reason is the core modelling and the assumptions that go with it, and part with the assumptions that have been fed into the models. The modern neo-Keynesian models are an amalgam of neo-classical economic theory, with perfect competitive markets as the benchmark, and the Keynesian obsession with aggregate demand and especially consumer spending. These models enable the Bank of England to calibrate what the “natural” rate of interest should be, and in particular to work out what interest rate produces the result of 2% inflation.
There are two problems with this. There is no natural rate of interest, what is known as r*; and there is no single causal link between the interest rate and the inflation rate.
The reason why there is no r* is because the economy is not one that tends to the perfectly competitive theoretical loadstar. Contrary to the neoclassical economists, the future is not best described in terms of probabilities and expected utilities. It is open-ended, fundamentally uncertain. Events are not just exogenous shocks; the economy is permanently open to “shocks”. Technology keeps surprising us; entrepreneurs keep trying things out; geopolitical stuff happens; and bubbles happen. There is no equilibrium to revert to. Asking what the fundamental equilibrium values are for stock markets, for house prices, for commodity prices is hopeless. The forces of supply and demand affect all of these, but not in a neo-classical way.
The reason why interest rates do not neatly determine the inflation rate is because interest rates have multiple and complex consequences, and some of these are best described as psychological. If, for example, everyone believes the theory about fundamental equilibria and the tendency to perfectly competitive markets, then they will act as if the theory is true, and not surprisingly this will create the illusion that the theory is indeed true. It was a mistake Milton Friedman made, and it underpinned the great revival of classical monetary theory in the 1980s.
It is always possible to reinterpret economic events as if they are consistent with a particular theory about how interest rates impact on inflation. For example, higher interest rates may slow down investment in mining and the development of new oil and gas wells. This in turn cuts supplies in the future, and commodity prices rise. Rising commodity prices can feed through into inflation: QED. Except there are lots of other reasons why commodity prices might rise. Russia might invade Ukraine. The result is that commodity prices go up, and then inflation rises, and then interest rates are increased.
A (interest rates) might cause B (inflation); B might cause A; and A and B could be separately caused by C, D and E. The Bank of England’s models need to cope with the possibilities that B causes A, and that B (and A) might be caused by lists of other things.
The result is painfully witnessed in the numerous select committee hearings and public statements by Andrew Bailey, Governor of the Bank of England. Inflation would be back down towards 2% by the autumn of 2022, and then that inflation would stay higher for longer. Now yet another story is emerging, with inflation falling much faster. He has been spectacularly wrong. His central thesis seems to have been that current inflation is a blip, and will fall back towards the status quo ex ante, and then nominal interest rates can be expected to fall. But that is nominal not real interest rates. Nominal rates can fall while real rates rise.
Higher real interest rates for ever
Suppose that the Bank of England has got the wrong theory, and the wrong diagnosis of the A causes B relationship. There are lots of reasons for thinking this. At their heart is a bit of economic history, focused on the period of ultra-low nominal and real interest rates since 1990. Was this the new normal or an aberration in the longer cycles of economic history? Three things are very unusual about the post-1990 period. The first is the collapse of the Berlin Wall, introducing a new period of geopolitical calm. The “end of history” culminating in the liberal, democratic, market-driven globalisation has been remarkably peaceful. Now it is not: China and the US are serous rivals; trade sanctions and tariffs are back; China is reverting to a statist model; Russia is expanding into Ukraine; and it is no longer obvious that the world is going ever more democratic. The US is retreating towards isolationism and populist politics, with Biden keeping most of the Trump “Made in America” policies – notably on China and trade. In the EU the populists are back: in Germany with the Alternative for Germany party (Alternative für Deutschland, AfD), in France, in Hungary, and, with BREXIT, in the UK.
This new world of geopolitical tensions and popularist politics is not abnormal; it was quite normal pre-1990. It is the post-1990–2020 world that is abnormal. Geopolitical tensions mean a re-shoring, a focus of friendly supplier countries, protectionism, and anti-immigration sentiments, and all of these raise costs. These costs are likely to feed through into inflation as these new higher costs bed down.
The second, related, abnormality of the 1990–2020 world is the dramatic rise of China and, in particular, the depressing impact on world prices. China dumped all sorts of manufactured and consumer goods into world markets, and these outcompeted domestic production in the US and the EU, whilst driving down prices. China’s expansions and its associated trade policies have been a big deflationary force. This is now largely over, as is the great spurt in the economic growth of China.
The third abnormality has been the “savings glut”. This is the supply of seemingly infinite capital flows in search of returns, so much so that governments in the EU and the US (and especially in the UK) assumed that finance at negative real interest rates should underpin not only the great net zero projects, but core infrastructures, housebuilding and especially public expenditure. Debt was cheap, borrowing became costless in real terms and hence the great financial engineering of the 1990–2020 period became an automatic assumption, not a worry about whether it might one day come to an end.
But what was this savings glut? It was not a desire by US or EU citizens to save more. In the UK and the US cases, quite the contrary. Governments in the US, the UK and the EU became very big dis-savers, companies focused on increasing gearing and paying out dividends, so that profits = dividends became the norm, and retained earnings much less common. Where there were big investors – notably the great new tech companies of the US – real investment was a feature. But these were all in the US; none of substance were in the UK or indeed most of the EU. That left consumers, and cheap debt increased spending, reduced savings and built up piles of domestic debt, including the mortgages that were a trigger for the great sub-prime crisis from 2006 to 2008. In the UK net saving has been negative for over a decade.
So where did the savings of the savings glut come from? The answer is in two places. First, the usual suspects – notably the commodity countries of OPEC. Depleting non-renewable natural capital produces surpluses which producers find hard to absorb when commodity prices rise. Second, and more significant, have been the capital flows associated with trade surpluses and deficits. Just as Japan had once done in its great economic expansion up until the end of the 1980s, China’s trade surpluses with the US, the UK and the EU meant current-account trade deficits in the US, the UK and the EU. In effect, China exported and then lent the importers the money to pay for these exports. Some of this went to fund government debts in the importing countries – and hence China followed Japan before it in having major holdings of US Treasury bills. But part went into buying up companies in the importing countries. In effect, the importers sold their family silver to enable them to carry on living beyond their means, because they imported more than they exported.
The effects have been extraordinary, and notably in the UK. Much of British industry has been taken over by foreigners. And with the dis-saving of UK governments, the financial engineering of UK industry reducing retained earnings for investment, and the consumers maxing out on credit, capital flows for investment in the UK are now overwhelmingly from foreigners, over which the UK government has little or no control.
The perfect storm 2020–23
By 2020 almost all that could unwind did so. Commodity prices increased on the back of rising gas and oil prices after the Covid lockdowns were relaxed, and then got a big additional kick upwards when Russia invaded Ukraine. Inflation rose to over 10% – something no one in the Bank of England saw coming and especially not its Governor. Suddenly government debt was costing a lot more, with debt interest going up the league table of the main items of public spending, and overtaking education. An affordability crisis ensued, with the government bailing out the whole of the electricity market. And all the while the geopolitical clouds got ever darker.
It is possible that these multiple shocks eventually trigger a major recession, and that a collapse of demand reduces inflation. The energy shock will unwind (and indeed already has unwound to some extent), sharply reducing headline inflation. These could (and probably will) encourage the Bank of England to start relaxing nominal interest rates, while real interest rates stay higher. Some would say that this proves that the past 30 years were not an aberration, but rather that the current inflation and interest rates are indeed a blip. It might even look like this for a bit, but what really matters is that this relies on the theory that what we get back to is a stable, low nominal inflation and negative real interest rate equilibrium.
There are few reasons to believe this. Not only is the theory suspect, as discussed above, but there are deep reasons for thinking that any fall-backs might be temporary – or a sort of long-term economic recession that would exacerbate the politics and the further destabilisation of the political systems in the US and the EU. A deep long-term recession is anything but stable. Nominal interest rates may have to go back up again, for two reasons: the government needs to pay more to investors to hold what are called “risk-free” gilts; and investment might not follow a path which relieves commodity and manufacturing prices.
Government debt in the US, the UK and the EU is marching upwards. The US is following Italy towards the 130% debt to GDP ratio, and the UK is crossing 100%. China and Japan have much higher ratios, but in both cases quite a lot of the debt is owed to its own citizens. Not so for the UK, much of the debt is owned by foreigners and can easily go elsewhere. The US is big enough that the foreign owners of its debt have the problem too.
As to commodity prices, these have broadly fallen back since the great spikes of the last couple of years. But extrapolate forward to the demand for lithium, cobalt, nickel, uranium and copper – all core to the net zero transition – and demand is likely to outstrip supply. So, too, with the “rare earths”. Either the net zero pathways slow down (faced with the higher costs) or prices rise.
When it comes to oil, gas and coal, these comprise 80% of the world’s energy supplies. Investment has been constrained for several years, and ESG (environment, social and corporate governance) pressures have tried to make that investment more difficult. The net zero advocates are not concerned. Just Stop Oil encourages a rapid collapse of demand. Except that it is not happening. Oil demand is now around 104 million barrels a day (mbd). Gas demand is marching upwards. Only coal is flatlining, howbeit at a very high level. As the global economy witnessed after the Covid lockdowns, the world is a long way from freeing itself of the macroeconomic consequences of rising fossil-fuel prices.
There is also the stubborn persistence of wage inflation. Ageing populations in the UK and Europe, a reluctance of around 20% of the UK workforce to be employed, and a hostility to immigration all point to a continued tight labour market. Wage inflation is unlikely to be a temporary phenomenon.
The consequences for investment and infrastructure
The most remarkable fact about the years of low nominal and negative real interest rates is just how little investment there has been. Instead of investing in the new energy infrastructures, rebuilding the grids, the water and sewerage systems, the railways and roads fit for an electric car era (heavier cars, automated, with charging), the UK has largely enjoyed what might be called an investment holiday. So serious has this been that, for the main infrastructures, the UK has not even done the capital maintenance, let alone added many new assets. No new reservoirs at all. No offshore electricity grid, incomplete mobile and broadband networks with many not included on the systems, and a clear deterioration in rail and roads assets (the one exception is the new Crossrail Elizabeth London Underground line). Record low nominal and real interest rates meant more spending and higher dividends and financial engineering, not more physical infrastructure investment.
As the new normal asserts itself, so too does the sheer inadequacy of UK infrastructure. No one would move to the UK to benefit from the quality of its infrastructure. This is another element of the perfect storm: just when the investment is most urgent, the real interest rates are much higher. And just when citizens are having an affordability crisis (in part caused by rising interest rates in response to rising inflation), they are being asked to pay even higher bills to underpin the investment now needed. Even worse, the bills are increasingly based upon pay-as-you-go, because the financial engineering has exhausted the balance sheets. It is now equity not debt that has to be the basis for quite a lot of investment going forward, and the cost of equity is higher than that for debt (and in many cases much higher). Finally, because the real returns on government debt are now higher, the one main source of domestic savings for investment – the pension funds – can cap a lot of their liabilities by investing in gilts rather than in infrastructure and utilities.
GDP growth is not the get-out-of-jail card
Never mind, says Labour, and also, in practice, the Conservatives, all we need to do is get GDP growth up, and then the government debt will decline as a proportion of GDP, tax revenues will go up and citizens will be better able to pay all those utility bills. The answer is simple: just do whatever it takes to increase GDP. For Labour, the UK is to become the G7 member with the highest growth rate by 2030.
Whilst there are very good reasons for concentrating on increasing the productivity growth rate and focusing on the causes of real economic growth, such as new technology and human capital, this is not the primary driver in Labour’s plan. On the contrary, it has two main other planks: building more houses and making the investments to get to net zero faster. For both there are good cases to be made, but the missing details are how exactly these are going to be funded and financed, and at what cost of capital.
Three obstacles stand in the way: the investment has to be mainly private sector (any government confronted with its debt and the pressures for health spending and other current public expenditure has no room for much capital spending); that private investment will be largely by foreigners; and the higher real interest rates may be normal.
Why would foreign investors flock to the post-BREXIT UK when they have lots of other destinations to turn to, even assuming that their savings glut driven by the trade balances and commodity production remains (which it may not)? Investment in housing depends upon citizens paying the rent and the mortgages, and investment in net zero technology depends upon citizens paying higher energy bills. For a foreign investor, none of this is obvious.
For Labour, the reason for more housebuilding is partly because the costs of housing are believed to be too high in rents and mortgages. Building lots of new houses is supposed to drive down these costs. That is not entirely a utopia for housebuilders – indeed, that is why housebuilders do not rush to use their very large banks of land with planning permissions now. They are not actually constrained by planning requirements. For housebuilders too, lots of green fields are much better than building in urban settings and building low-cost social housing. If the real interest rates stay high, whilst government tries to drive down housing costs, it is far from obvious why foreigners would pile investment into this sector.
For Labour, its other great idea is that faster progress on net zero is going to result in lower energy bills. It is win–win. Except this is not quite true. To get from here to a world of say 50GW offshore wind, to exit gas, to build the carbon capture and storage (CCS), to construct a fleet of new nuclear power stations, to rebuild the electricity grid, to create an electric car charging network, to get out of gas-fired boilers into heat pumps is all a massive investment. So far after over a decade, the UK has not even managed to convert to smart meters.
These issues face the Conservative government now, and not surprisingly the politics points to slowing down on the timetable. For the government, net zero should not raise bills. Labour believes it will not, so, for Labour, this is not a problem. But then where is all this investment going to come from? Where exactly is the funding from citizens’ bills going to materialise from if those same citizens expect bills to be falling, as promised by Labour?
These are just some of the worrying straws in the wind. The costs of offshore wind have gone up (a lot). The main renewable technologies and nuclear share a common economic feature: they are all high fixed and sunk costs, and low marginal costs. They are basically best seen as lumps of capital. That makes the real interest rate central to their costs. Labour must be assuming that the interest rates are going back to near zero nominal and strongly negative in real terms. For all the above reasons, this is probably an illusion, and believing it is delusional as a platform for economic policies.
The new normal and infrastructure and net zero investment
The above points to an unpalatable conclusion: for what the UK needs to invest, the costs of investment have gone up a lot. Real interest rates are probably higher for ever, relative to the aberration of the period 1990–20. The fact that the great opportunities of the last 30 years have been squandered, under both Labour and Conservative governments, is at best unfortunate. There has been a massive regulatory and political failure. Regulators could have stopped the financial engineering that has exhausted the balance sheets; they could have made sure that capital maintenance was properly done, and they could have had a lot more investment. Citizens have paid too much for too little. We could have had a lot more for the same bills. Now if we want a lot more, it is going to cost a lot more, just when voters have been told it is going to cost a lot less.
