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The Coming Interest Rate Squeeze

Somebody please e-mail a copy of the McKinsey Global Institute's new report, "Farewell to Cheap Capital," to Paul Krugman and Ezra Klein. Krugman, a New York Times columnist, and Klein, a Washington Post blogger and cable TV talking head, are among the nation's more voluble deficit deniers. Citing the currently low yields on U.S. Treasury securities as a sign of investor confidence in the nation's fiscal integrity, they argue that cranking up federal spending to stimulate economic growth is worth the risk of continuing to engorge the national debt.

Klein's myopia is somewhat understandable: At 26 years old, the liberal scribbler has never lived through a time when interest rates were not falling. Krugman's blind spot is harder to fathom. Not only did the Princeton professor win a Nobel Prize in economics, he personally experienced the high interest rates of the late 70s/early 80s and their subsequent 30-year decline. Only someone ideologically committed to feeding the leviathan state could will himself to believe that interest rates will stay low forever.

If the economy picks up steam, U.S. interest rates will rise. Even the Obama administration expects 10-year Treasury bonds to reach 5.3% in several years, up from 3.2% Monday, propelling interest payments on the national debt from roughly $200 billion yearly to $800 billion by 2020. If the sovereign debt contagion spills out of Europe, U.S. Treasury rates will rise even higher as investors charge a risk premium. Now comes McKinsey arguing that a third force -- increased global investment and shrinking global savings -- will lead to yet higher interest rates over the next two decades. States the report:

Nominal and real interest rates are currently at 30-year lows, but both are likely to rise in coming years. If real long-term interest rates were to return to their 40-year average, they would rise by about 150 basis points from the level seen in the fall of 2010, as we write this report. And they may start moving up within five years.

There has been a decades-long glut of capital as the mature economies of industrialized economies experienced slower growth and declining investment, McKinsey contends. Saving rates have dipped, too, especially in the U.S., but not enough to offset the weaker demand for investment capital. Meanwhile, developing countries, China especially, began saving phenomenal amounts of money as their economies took off. This global shift in the supply and demand of capital -- not just Federal Reserve monkeying with interest rates -- contributed to the global credit bubble of the mid-2000s.

Now the tide is turning, the report argues. China, India and other developing countries are embarking upon a massive wave of capital investment, much of it driven by infrastructure spending as their societies urbanize. The demand for new roads, rail lines, ports, water and power systems, schools, hospitals and other public infrastructure will reach a fever pitch not seen since the rebuilding of Europe after World War II. McKinsey also predicts massive growth in residential real estate investment to provide better housing for the emerging middle class, as well as strong growth in productive capacity. Global investment could increase from $11 trillion annual today to $24 trillion annually by 2030 (measured in constant 2005 dollars), or from 23.7% of global GDP in 2008 to more than 25% by 2030.

The surging demand for capital will not be matched by a commensurate increase in savings. The world's largest economies are fast aging, and larger retired populations will draw national savings down, not build them up. The shift will be most dramatic in China, where the government is encouraging people to consume more and the one-child policy will lead within a couple of decades to a lopsided demographic profile of too many retirees and too few young workers entering the workforce.

The shift in the global supply of and demand for capital will likely push up long-term interest rates. And that will present businesses, consumers, investors and governments with very different challenges in the next 30 years.

Consumers are moving in the right direction -- they're sloughing off debt. Corporations are saving more, too, if one counts share repurchases as a return of cash to shareholders. But governments are stuck with deep structural deficits. With the national debt as large as it is, roughly 90% of GDP, the U.S. budget is extraordinarily sensitive to increases in interest rates. If economic growth picks back up, the sovereign debt contagion spreads and McKinsey's looming global capital shortage materializes on schedule, the U.S. could easily see 8% interest rates on its 10-year bonds by 2020. That would boost budget deficits by $500 billion yearly or more above current forecasts -- about the same amount we spend today on all discretionary domestic spending.

In that case, interest rates -- not spending, not tax rates -- will become the prime driver of U.S. budget deficits. The U.S. truly will be at the mercy of the bond vigilantes. And Krugman, Klein et al will have moved on to new apologetics for gargantuan government.


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