Interest Rates, Growth, and Public Debt

Variations in nominal interest rates have a larger impact on the distribution of income in the corporate sector than changes in wages. If the interest rate rises from, say, 5 percent to 8 percent, then interest payments on loans (taken up at variable interest rates) will go up by 60 percent (other things being equal), thereby weakening the corporate revenue position. If capacity utilization is high and business expectations optimistic, firms will still stick to their investment plans and offset the interest-rate-induced fall in savings by higher borrowing. Yet, if the interest rate hike lasts for two or even three years (as has repeatedly been the case in industrialized countries except Japan) the debt-to-earnings ratio will jump and force enterprises to consolidate their financial position: by sharply cutting investment and borrowing they will exacerbate the cyclical downturn caused inter alia by the rise in interest rates. In a recession, rising public transfers and shrinking tax revenues blow up the deficit; from an aggregate financial balances perspective, the cut in the corporate debt burden entails a rise in government debt. The recession may be overcome by expansionary fiscal and monetary policies, with lower interest rates contributing towards an improvement in the corporate debt/revenue position. As profit expectations turn more optimistic and capacity utilization improves, firms resume capital spending and borrowing such that their financial position starts weakening again while that of the government improves. This cyclical pattern, typical for the industrialized countries, has not been observed since the early 1980s as, since that time, the rate of interest has come to lie permanently above the rate of growth. Under such conditions, net debtors like the corporate or the public sector may stabilize their debt-to-GDP ratio only if they achieve a surplus in their primary balances, i.e., if revenues exceed expenditure net of interest payments. Over the last fifteen years, enterprises have indeed turned their aggregate primary deficit to a permanent surplus, by shifting investment from real towards financial assets. Thus, physical capital and corporate debt have both expanded less than GDP, leading also to a slower rise in employment. With net financial assets of the household sector staying high, it was impossible for the government sector to accumulate primary surpluses; as a result, its debt rose relative to GDP in almost all industrialized countries since the early 1980s. The "switch" from a negative to a positive interest rate/growth differential therefore caused private savings to be channeled less into productive capacity (and employment) and more into government bonds. The hypothesis whereby government deficits push up interest rates ("crowding out") is not confirmed by the data: government deficits tend to fall in cyclical boom and early downturn periods while at the same time interest rates rise, and vice versa. The major determinant of interest rate developments, whose role is often underestimated, appears to be policy action by central banks.