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Even as wars intensify and the geopolitical landscape darkens, the global economy remains an irresistible source of energy. Just a year ago, everyone agreed that high interest rates would soon cause a recession. Now even optimists are perplexed. The U.S. economy boomed in the third quarter, growing at an impressive annual rate of 4.9%. Inflation is falling around the world, unemployment rates remain near low, and major central banks may be halting monetary tightening. China, hit by a real estate crisis, is likely to benefit from modest economic stimulus. But unfortunately, this cheer doesn't last long. The foundations for growth today look shaky. Looking ahead, there are many threats.
Unbridled economic conditions have meant that interest rates are no longer rising as quickly, but there is growing belief that they will not fall significantly. Over the past week, the European Central Bank and the Federal Reserve have kept interest rates on hold. Shortly after we announced this on 2 November, the Bank of England was expected to take similar action. Correspondingly, long-term bond yields rose significantly. The U.S. government currently has to pay 5% on its 30-year borrowing, compared to just 1.2% at the height of the pandemic recession. Even countries known for having low interest rates are seeing rapid interest rate increases. Not long ago, Germany's borrowing costs were negative. The yield on its 10-year bond is currently close to 3%. The Bank of Japan has largely abandoned its promise to keep borrowing costs fixed at 1% for 10 years.
Some, including U.S. Treasury Secretary Janet Yellen, argue that these interest rate increases are a good thing and reflect that the global economy is not at its healthiest. In fact, they are a source of danger. Because interest rates are likely to continue rising, today's economic policy will fail, and so will the growth it brings.
To see why today's good situation cannot continue, let's consider one reason, in particular, why the American economy is doing better than expected. Consumers are spending the cash they saved from benefits and staying home during the pandemic. These excess savings were expected to have already been depleted. But recent data shows that households still have $1 trillion left in their budgets, which explains why they can save less of their income than at any point in the 2010s.
Once the excess savings buffer is depleted, high interest rates begin to take effect and consumers are less able to spend freely. And, as our briefing explains, if interest rates remain high for an extended period of time, problems will begin to arise across the global economy. Corporate bankruptcies are already on the rise in Europe and America. Companies that have fixed low interest rates by issuing long-term bonds will eventually face rising funding costs. Home prices will fall, at least when adjusted for inflation, as mortgages become more expensive. Also, banks with long-term securities that have been supported by short-term loans from the Fed and elsewhere will need to raise capital or merge to fill the hole left on their balance sheets by rising interest rates.
Massive fiscal spending has spurred a sugar rush in the world economy. In a world of long-term highs, that too seems unsustainable. According to the IMF, the UK, France, Italy and Japan are all likely to post deficits of around 5% of GDP in 2023. In the 12 months ending in September, the US deficit was a staggering $2 trillion, or 7.5% of adjusted GDP. In terms of accounting distortions, it is approximately double the amount expected in mid-2022. In an era of low unemployment, such borrowing is shockingly reckless. Overall, government debt in the rich world is now higher as a percentage of GDP than at any time since the Napoleonic Wars.
When interest rates were low, it was possible to cope with huge amounts of debt. Now that interest rates have risen, interest is draining your budget. Therefore, a prolonged period of rising prices could lead to a conflict between the government and central bankers who set inflation targets. Already, Ms. Yellen feels obligated to insist that there is no risk premium on U.S. Treasuries, and that Fed Chair Jerome Powell will never cut interest rates or let inflation spike to ease pressure on the government's budget. He claims that there is no.
Regardless of what Mr. Powell says, a prolonged period of high levels will cause investors to question the government's commitment to keeping inflation low and paying down debt. The ECB's bond holdings are already leaning heavily toward Italian government debt, an implicit backstop, but that task becomes much more difficult in a world of high interest rates. Even when Japan's government bond yields were just 0.8% last year, 8% of Japan's budget went toward interest payments. Imagine the burden if yields reached even Germany's relatively modest levels. As a result, some governments will tighten their grip. But doing so can cause financial pain.
These tensions are obscuring how the global economy can simultaneously achieve many of the things markets now expect: avoiding recession, low inflation, high debt, and high interest rates. It is more likely that a prolonged period of high levels will self-destruct, resulting in an economic slump that allows central bankers to cut interest rates without causing inflation to spike.
A more hopeful possibility is that productivity growth could skyrocket, perhaps thanks to generative artificial intelligence (AI). The resulting increase in income and revenue will make it possible to withstand higher interest rates. In fact, numbers released on November 2 are expected to show America's measured productivity soared in the third quarter. The potential for AI to bring further productivity gains may explain why high-priced stocks haven't punctured the stock market so far. The S&P 500 index of U.S. stocks would have fallen this year if it weren't for the rise in valuations of seven tech companies, including Microsoft and Nvidia.
please don't look down on me
But despite that hope, the world is beset by threats to productivity growth. Donald Trump has vowed to introduce significant new tariffs when he returns to the White House. Governments are increasingly distorting markets through industrial policy. National spending is an increasing share of the economy as populations age, the transition to green energy progresses, and conflicts around the world require increased defense spending. In the face of all this, anyone betting that the global economy can continue as is is making a big bet. â–
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