Low for Ever or Higher for Longer?

Up until three years ago, economists were still arguing about whether the trend towards ever-decreasing interest rates that has prevailed since the early 1980s (Figure 2) was a decades-long or centuries-long development (The Economist, 4.11.23). Since 2021, however, we have been in an opposite trend, for which the Chairman of the US Federal Reserve Jerome Powell recently coined the catchphrase "Higher for Longer" on the subject of interest rates. Has an era of high interest rates begun?

Inflation, which had risen to levels of almost 10% in the US and Germany - levels not seen for 40 years - appears to be disappearing again as quickly as it appeared in 2021 (chart 1). This means that the rise in interest rates, which is already very moderate compared to inflation, could peak at 5% in the US and 3% in Germany for 10-year government bonds in October 2023 (chart 2) if Jerome Powell does not follow up his words with further interest rate hikes.

This would mean that interest rates would run out of steam well below the level of the 1970s and early 1980s (chart 2).

There is a reason for this that will continue to exist in the coming years or even decades, namely the extremely high level of international government debt (chart 3).

Only during the 20-year Napoleonic Wars over 200 years ago were international government debts as high as they are today. Even the geopolitically turbulent first half of the 20th century with two world wars resulted in lower national debt. The highly indebted states of 200 years ago used a large part of their tax revenues for interest payments and loan repayments from 1815 onwards and were therefore unable to stimulate economic development, with the result that consumer prices fell or remained stable for decades (chart 4, golden field), except during the Civil War in the USA (1861 to 1865). Governments were forced to operate frugally until the outbreak of the First World War, as currencies worldwide were backed by gold. Governments were therefore subject to the same rules as companies and private households today - they could not print money, so they had to earn it and pay off debts through increased thrift, otherwise they were threatened with bankruptcy. In the early days of the First World War, the monetary system in Europe changed fundamentally. Many countries stopped backing their currency with gold because the politicians sensed that this war would be very expensive. In the gray area of chart 4, we can see the lasting consequences of the introduction of paper money that could be multiplied at will. With the exception of the Great Depression from 1929 onwards, consumer prices have only moved in one direction since the First World War. They have risen uninterruptedly, from 1945 even without war. From the 1960s onwards, many governments began to expand social benefits and quickly end economic crises (oil crises in the 1970s, Iraq wars in 1991 and 2003, collapse of the European monetary system in 1992, Lehman Brothers bankruptcy in 2008, coronavirus in 2020) with debt-financed government spending, so that debt and consumer prices have continued to rise to this day. The owners of fixed-interest investments such as government bonds or savings accounts have been paying the price for decades, as the real interest rate for 10-year US government bonds averaged 3.8% p.a. until 1914, but has since fallen to just 1.5% p.a. (chart 4). In reliance on government assistance at any time in the event of a crisis, companies and private households also took on more and more new debt, with the result that total debt in the major industrialized countries has risen sharply since 1980 (chart 5) (chart 6).

Now, to make matters worse, new burdens are emerging from the not really surprising ageing of the population, geopolitical problems and the costs of coping with global warming (see the Capital Market Outlook from August 2021, which you can find here can be found here).

The International Monetary Fund estimates the additional annual costs resulting from these three special burdens in the industrialized countries at an average of 7.5% of national income in future (source: The Economist, 4.11.2023). It's like soccer. First, politicians have had no luck with debt-financed social and economic policies for 50 years because they did not lead to sufficiently high additional tax revenues to finance the debt incurred. Now there is also bad luck - there are suddenly the new burdens mentioned above and interest rates have risen sharply (Figure 7). This will lead to an unpleasant increase in government interest expenditure (example USA: chart 8).

The question now is how this historically huge problem could be solved. The usual 19th century approach - tax increases and spending cuts - is not feasible for any industrialized country. The economic and political risks would be incalculable.

The following charts suggest a possible way out, namely high inflation rates with moderate interest rates. First of all, we see that both the European Central Bank (chart 9) and the US Federal Reserve (chart 10) raised interest rates far too late, namely when inflation rates in both regions were already above 8%. It was not until around 1 year later that interest rates were slightly higher than inflation. As a pleasant consequence of high inflation and low interest rates, government debt fell in the western industrialized countries, as did total debt (chart 11), because high inflation led to a sharp rise in corporate sales and private household salaries and thus in government tax revenues. Interest costs, on the other hand, remained low; the rise in interest rates does not have an immediate impact.

China and Japan did not experience this effect, as both countries had much lower inflation rates and China suffers from a huge real estate problem that contributes to growing debt (see the September 2022 Capital Market Outlook, which you can find here can be found here).  

Inflation has been falling significantly in both the USA and the eurozone for several months (chart 1) and is expected to continue to fall (charts 12 and 13).

There is also a risk of recession in these regions in 2024 (see the capital market outlook from September 2023, which you can find here can be found here). Deleveraging with the help of high inflation and low interest rates has therefore only worked in the short term. Inflation is already lower than interest rates again (charts 9 and 10); in addition, government debt usually rises during recessions (example USA, chart 14) because tax revenues fall and social benefits (unemployment benefits) rise as economic output shrinks. The significant fall in interest rates in every recession (example USA, chart 15) cannot compensate for this.

Based on these considerations, the question of "low for ever" or "higher for longer" seems to have been decided in favor of low interest rates, at least for the next one to two years. A solution or at least stabilization of the problem of enormous government debt in a situation in which further high burdens for the state coffers are foreseeable depends in the long term on whether future economic growth and thus the growth of government revenues from taxes and social security contributions will be sufficiently high to be able to bear these burdens.  

In the era of gold currencies before the First World War (1914 to 1918), real economic growth was driven by population growth, particularly in the USA, but hardly at all in France (chart 16). China's minimal growth during this period can only be recognized on closer inspection. The economically weak phase of the two world wars was followed by the economically strongest years of the global economy from 1950 until the first oil crisis in 1973, during which no government economic aid was necessary and government debt could even be significantly reduced (chart 17). Germany had largely got rid of its domestic debt through the currency reform of 1948, so that only a small further reduction in debt took place afterwards. The 40 years following the first oil crisis (1973) up to 2012 also brought high growth rates, albeit with rising government debt again. In the last 10 years, the major industrialized countries, with the exception of the USA, have hardly been able to grow at all; China's high growth from 2012 onwards is not sustainable, as it was associated with very strong growth in government debt (chart 17).

Both components of economic growth, namely the growth in the number and productivity of the workforce, have become significantly weaker since the 1950s.

With the exception of the period around the turn of the millennium, when investment in computers in the USA was glossed over by assessing the sharp increase in computing speed at constant prices as real growth in investment, productivity growth rates have fallen from 3% p.a. in the 1950s to around 1% p.a. today (examples USA: chart 18, UK: chart 19). The reasons for this are disputed among economists.

Population growth in the western industrialized countries has also fallen by a third and is now only being driven by migration (chart 20, the most recent decline is related to coronavirus). In China and the eurozone, the labor force has begun to decline sharply, while the situation in the USA looks much better (chart 21).

If the mass use of mainframe computers from the 1950s, personal computers (PCs) from the late 1970s and the internet from the early 1990s did not bring about sustainable productivity growth in the economy as a whole, then artificial intelligence (AI) will not succeed in doing so either (Goldman Sachs expects AI to bring about 1.5% productivity growth in developed countries, chart 22). These optimistic forecasts are questionable, however, because AI is likely to cause numerous workers - often referred to as tax advisors, controllers, analysts, journalists, etc., perhaps even chief investment officers - to lose their well-paid jobs and no longer find equivalent employment, as has already happened to millions of sales staff in bricks-and-mortar retail outlets worldwide as a result of the spread of online retailing. The disadvantages of the internet, such as the mass dissemination of tall tales through social networks, are likely to be paralleled by the use of AI in deceptively real images and films of events that never happened.

In summary, we can state that even with a sustained increase in productivity growth of perhaps 1% p.a. - a rather optimistic assumption - economic growth could only increase accordingly in the USA, while the AI growth spurt in China and Europe since 2020 is likely to be neutralized for several decades by a significant decline in the number of workers. The demographic advantage of the US compared to Europe could be offset by higher interest rates (4.5% instead of 3.5% for 10-year government bonds) and government debt as a percentage of national income (129% compared to 90.9%, source for interest rates and government debt: Trading Economics) will be canceled out again. If all government debt had to bear interest at these rates by 2030, the US government's interest costs would amount to over 5% of national income (see chart 8, estimate to 2026). Europeans would then only have to spend 3.2% of national income each year. This means that future economic growth in the USA, particularly in the case of "Higher for Longer", will be just as insufficient as in Europe to cope with the future burdens of geopolitics, the energy transition and an ageing population amounting to the aforementioned 7.5% of national income per year.

Without a significant redirection of government spending from the social system to investments (education, digitalization, infrastructure, ...) and in Germany without a reduction in overregulation and bureaucracy, public finances in the major industrialized countries will fall into growing disarray, as has already happened since 1913.

The two world wars brought enormous financial burdens not only to the losers, but also to the victors. We do not expect a world war, but the above-mentioned additional costs could well overstretch the financial capacity of some governments. The two most important later victorious powers in the world wars, the USA and Great Britain, had little or no debt in 1914, although their debts grew sharply in both wars (chart 23). In large countries that were among the losers in at least one of the two wars or that were fully or partially occupied (chart 24), debt in 1914 ranged from 47% (Germany) to 71% (Italy). However, the further course can only be followed continuously for Italy; complete data is not available for Germany, France and Japan due to the sometimes chaotic conditions during and after the wars.

The reason for this can be seen in the two charts 25 and 26 below. During this period, the inflation rate in the USA and the UK averaged a moderate 2.6% p.a. and 3.5% p.a. respectively (corresponding to an increase in consumer prices from 1 to 2.4 and 3.2 respectively, charts 25 and 26). Only these two countries had hardly any debt and thus sufficient financial leeway to survive the enormous burdens of the following three decades without high currency devaluation. In the countries shown in chart 24, on the other hand, the financial burdens were so high from 1914 onwards that the governments had to print money to service the exploding debts and accordingly had double-digit inflation rates in the following decades (France averaged 14.4% p.a., Italy 17% p.a. and Japan 18.4% p.a.). By 1948, consumer prices had risen from 1 to 98 in France, 210 in Italy and 308 in Japan (chart 26). In Germany, it took 4.20 marks to buy one US dollar in 1914; in November 2023, this would require 4,200 billion marks (hence the unusual shape of the green curve in chart 25). By the time the DM was introduced in 1948, inflation had risen again by around 1,000% (chart 25).

The burdens to be expected in the future will hopefully not be as high as in the first half of the 20th century, but the major industrialized countries are comparatively ill-prepared for this. This time, government debt at the beginning of a problematic era is not 0 to 71%, but 114%. Therefore, as after the Lehman bankruptcy and during the coronavirus pandemic, central banks will once again have to help by cutting interest rates wherever the burdens lead to excessive financial or political risks. The following two charts show the practical implications for investors.    

By 1975, the government debt from the two world wars had largely been paid off (chart 3). The real performance of government bonds in US dollars in the 17 industrialized countries that were already industrialized countries in 1900 was 34% in 75 years, which corresponds to an annual return of 0.4% p.a. (with interest reinvested, excluding taxes and costs). In the countries that were not among the winners, the real performance was -96% or -4% p.a. (chart 27). By contrast, real equity performance in the 17 industrialized countries reached +2,868% or 4.6% p.a. and even in the loser countries +1,179% or 3.5% p.a. At a time of high financial pressure on state coffers, equities were by far the better form of investment. In the three states with particularly high financial burdens and correspondingly high inflation rates, equity assets were 320 times higher after 75 years than those consisting of "safe" government bonds.

In view of the coming burdens, central bank support in the form of money printing or very low interest rates must be expected again in the future: Low for Ever, at least in terms of average real interest rates. However, investors who focus their wealth investments on entrepreneurial investments, i.e. shares and investment funds, need not worry too much about the real preservation of their wealth in the long term, despite all future problems.

Finally, our key statements from the November 2020 Capital Market Outlook, which you can find here here:

Three years ago, we analyzed the long-term and short-term correlation between economic growth and equity performance since 1900 in light of the economic slump caused by the coronavirus pandemic. The result was that there is no correlation. Even in times of weak growth, equity markets have delivered high returns in the past and vice versa.

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You can also download the capital market outlook here.