Balance is an extremely important concept in economics, but with a somewhat ambiguous meaning. Thus, macroeconomists might speak of an “imbalance” outcome, where nominal shocks distort labor and goods markets due to wage and price stickiness. But from the perspective of a more complete model of behavior (including pricing), a recession could be considered an “equilibrium” outcome.
The “natural” or equilibrium rate of interest also has several meanings, but generally refers to the interest rate that provides some sort of macroeconomic equilibrium, such as stable prices. In most of the world, the equilibrium interest rate has been on a downward trend since the early 1980s. So far. . . .
A more comprehensive model of the equilibrium interest rate could also capture the political economy of fiscal policy. Suppose the natural rate of interest falls so low that politicians are tempted to run larger budget deficits. Eventually, the deficits become so large that the equilibrium interest rate begins to rise again.
Under recent US administrations, budget deficits have become much larger than usual (even pre-Covid.) With interest rates so low, there is little to hold back politicians focused on the short term. In the late 2010s and early 2020s, warnings that debt might eventually have to be rolled over at much higher interest rates fell on deaf ears. (I’ve given this warning many times, but couldn’t find many other experts who agreed.)
Last week, there were widespread media reports that UK bond yields were soaring in response to Prime Minister Truss’ aggressive program of debt-financed tax cuts. There are also rumors that the next Italian government (likely led by right-wing populists) may increase government borrowing.
All of this makes me wonder if ultra-low interest rates aren’t a stable equilibrium, at least in most places. I continue to believe that low rates are a technically feasible equilibrium, but it is perhaps inevitable that politicians in many countries abuse the privilege of borrowing almost free of charge, to the point where that privilege is removed.
This argument can also be applied to other cases. Perhaps a 2% inflation rate is not politically stable over the long term. After a long period of low and stable inflation, policymakers begin to assume (wrongly) that low inflation is “structural,” or inevitable. They come to believe that they can stimulate the economy without the risk of inflation.
This may even apply to cycles of crime. During times when crime rates have fallen to relatively low levels (say the early 1960s or early 2010s), politicians come to believe that we can be a little more lenient with criminals. They reduce the incarceration rate, which leads to an increase in crime. Finally, there is another crime-fighting phase in the crime cycle.
Or maybe all this speculation is just the daydream of an old man who has just retired, worried that he is no longer relevant. An aging boomer who hopes his memories of the political mistakes of the 1960s will still have some relevance for young readers.