Night or interest rates must fall

Kit McMahon

THE DEBT THREAT by Tim Congdon

Blackwell, f25, f7.95, pp.256

find it difficult to write a balanced review of this book. On the one hand, and most important for the general reader, the book sets out very clearly a number of ways in which the world's financial position has deteriorated in recent years and the dangers which this roses for us. all. Mr Congdon says in his first sentence that his book is 'self-consciously and deliberately alarmist'; but the serious dangers ' tie sees ahead are in fact drawn very fairly and calmly. He describes extremely well the Latin American debt problem — both the way it developed up to 1982 and why it has been so difficult to solve since then. Similarly, he is good on the way the US has gone into debt in recent years and the vulnerability this implies for the future.

On the other hand, his analysis is quirky and partial; what he leaves out almost beggars belief. And he is subject to the two besetting sins of the polemicist, which together so often lead to debating suicide: under-rating one's opponents and reckless- ness in the use of Occam's Razor.

Mr Congdon's central thesis is that in the 1970s, when real interest rates were nega- tive (inflation raged and interest rates rose less than enough to allow for it) borrowing by public and private sectors alike was everywhere stimulated, so that debt/ income ratios rose. Then in 1979 policies changed. A major battle was launched against inflation involving a shift to posi- tive real interest rates. There followed first a recession in most countries and then some recovery. Inflation was scotched but not completely killed and real interest rates remain substantially positive to this day. Unless real interest rates fall there is bound to be serious trouble ahead. While they remain high they may choke off some new borrowing but they work with the frighten- ing power of compound interest on the old debt so that total debt tends to increase. Mr Congdon makes much play with the (probably true, indeed probably tautolo- gous) proposition that real interest rates cannot remain higher than real growth rates indefinitely. But his warnings can perhaps be as effectively sounded simply by reference to the obvious and increasing vulnerability of debtors to shock.

Mr Congdon concludes that real interest rates must come down if we are to be saved and argues (or perhaps asserts) that for this it will be necessary for governments every- where to return to the 'old-time fiscal religion', ie public sector surpluses (and he really means 'old-time' since neither Ger- many nor Japan — nor, by implication at least, the UK — are spared).

The two chapters on the sovereign lend- ing saga from 1973 to today are excellent. His analysis of why and how the enormous growth in bank lending to developing countries took place is thorough and ba- lanced. He makes what I believe is a good distinction between the lending that took place before 1979 (broadly justifiable) and that which took place afterwards (in- creasingly unjustified). He also describes well the problems for both the borrowing countries and the banks since 1982 when both have been caught in the macro- economic trap set for them by the world's fiscal and monetary authorities of high interest rates, low growth and low com- modity prices. He is judicious in his evalua- tion of the various financial devices mooted to alleviate the situation from the point of view of the banks. As far as the debtor countries are concerned he assesses the problems they face, the successes and failures in their economic management and their options in handling their debts very fairly, though in my view he substantially underplays the long-run dangers of default to a defatilting country.

The account of what he calls the 'lever- aging' of America is also good. With a nice mixture of anecdotes and statistics he shows the ways in which farmers, corpora- tions, real estate developers, home buyers, mortgage institutions as well as the govern- ment went into debt when interest rates were low and were dragged further in when interest rates rose.

But now we begin to reach what Mr Congdon leaves out. Almost incredibly, he does not mention what is surely the most dangerous aspect of the leveraging of

America, what is most likely to upset the apple-cart in the short term: the external debt of over half a trillion dollars. Nor, even in discussing the farm problem, and the dangers of general protectionism, is there any reference to the extreme and damaging volatility of exchange rates, in recent years especially that of the dollar. Although Mr Congdon refers often to individual government fiscal positions and the need for them all to be in surplus, his description of what has been happening is singularly free of any sense that the world is made up of a number of sovereign states whose economic decisions and develop- ments affect one another, often greatly complicating economic management. Thus it appear to be a matter of no moment to him that Japan and Germany are in exter- nal surplus; which is strange, since in a book devoted to the problems of being in debt one would expect at least some treatment of societies who are net lenders.

There are other things that are not mentioned either. The only references to unemployment are for the 1930s. There is almost no reference to UK policy since 1979 — or even since the war. And Mrs Thatcher is not mentioned once. Some of these omissions stem from the very simple view Mr Congdon has of the way the world works. He appears to believe that there is nothing much that official policy can do except reduce inflation by fiscal rectitude and cause havoc by the reverse. He thus parts company with the monetarists (though he refers to them very sparingly) almost as completely as he does with the Keynesians, to whom he refers often.

His references to Keynes, Keynesians and 'naive Keynesians' are themselves extraordinarily naive. If he had any serious idea of what a 'Keynesian' thought or thinks he would not have been surprised (as he is) that James Tobin, perhaps the most distinguished Keynesian economist alive, is alarmed about US fiscal policy: nor would he have persuaded himself that there was after all no 'Keynesian' consen- sus at the Treasury before the 1960s.

General readers should also be warned that the connections Mr Congdon makes between public deficits, private borrowing, real interest rates and the state of the economy depend as much on assertion as on argument. In fact they are highly complicated and the causal link may run from the state of the economy to the public deficit as well as the other way round. Moreover, there is the strange case of Italy, baffling to many observers as well as Mr Congdon, where over a long period the most appalling fiscal mismanagement and mounting public debt have been accompa- nied by a fairly spectacular performance by the Italian economy.

None of this is to deny that Mr Congdon has put his finger on a number of very disturbing trends which need to be recti- fied. But it is possible to see the problems and their potential solution somewhat dif- ferently. In particular, there may be other reasons for the persistence of damagingly high interest rates.

A slightly different version of recent events, though one sharing much with that of Mr Congdon, including his forebodings, might run as follows. By 1979, all major governments and central banks realised that the broadly accommodating stance which had been adopted since 1973 to the massive public sector surpluses accumu- lated by OPEC countries had to be re- versed in the face of extremely serious inflationary dangers. Broadly, all agreed in principle on programmes of tight monetary targets — which in the short-run were bound to mean very high interest rates and fiscal restraint, reducing public deficits steadily over a period. Outside the US everyone more or less stuck to this prog- ramme. Inside the US Paul Volcker im- plemented the monetary policy spectacu- larly and with great courage. But the US Government did not keep their part of the bargain. While talking restraint, they went in for a policy of major fiscal expansion (which they called supply side economics). The result was that the rest of the world went through the pain of the disinflation but did not get the fall in real interest rates which they had a right to expect. The funds that were attracted to the US by the high dollar interest rates meant that the US was able to dampen the inflationary effects of its own fiscal expansion, by sucking in Imports and by an extraordinary rise in the dollar. The disinflationary effects else- where were correspondingly reduced.

It could not last and, as we all know, the destabilising rise in the dollar has been succeeded by a destabilising fall. The world's biggest nation is now hugely in debt to foreigners and this debt will (Mr Congdon's compound interest at work) go on getting bigger for at least several more Years. The financing of this debt is clearly a serious potential problem and is seen as one by the markets.

Might it not be the huge imbalances in the world economy, and the uncertainties over how they are to be resolved which lay at the heart of the world stock market fall last October? If so, there could be disturb- ing implications, since little discernible progress to the resolution of the imba- lances has been made since then.

This line of thought might suggest at least part of the reason for the persistence of high real interest rates. The prevailing conditions of extremely volatility and un- certainty in virtually all financial markets are rather likely to result in the inclusion of a significant risk premium in the return on all financial instruments.

There are probably a number of reasons for the persistence of high interest rates and to get them down, or even to stop them rising, we shall need a many-pronged attack on the problem, involving multi- lateral commitment towards greater stabil- ity. Of course this would not imply simply trying to stabilise exchange rates by in- tervention, still less working to reduce interest rates directly. Central to any credi- ble programme will be a serious attack on the US budget deficit; but granted that, the appropriate behaviour for other countries would differ with circumstances. Specifi- cally, some might follow the lead that Japan is already giving in shifting her economy towards a greater dependence on domestic demand.

One way or another we shall get a fall in real rates. The danger, which I am sure Mr Congdon sees, is that this will be achieved only as a consequence of a serious reces- sion starting in the US.