Equilibrium is a very important concept in economics, but with a somewhat ambiguous meaning. Macroeconomists may thus speak of an “inequality” outcome, where nominal shocks distort labor and product markets by causing sticky wages and prices. But from the perspective of a more complete model of behavior (including pricing), a recession can be seen as an “equilibrium” outcome.

“Natural” or equilibrium interest rate also has multiple meanings, but usually refers to the interest rate that provides some sort of macroeconomic equilibrium, such as stable prices. In most countries around the world, equilibrium interest rates have been declining since the early 1980s. Until now. . . .

A more complete model of the equilibrium interest rate can also account for the political economy of fiscal policy. Suppose that the normal interest rate falls so much that politicians are tempted to run larger budget deficits. Eventually, the deficit becomes so large that the equilibrium interest rate begins to rise again.

Under recent US administrations, fiscal deficits have become much higher than usual (even before covid.) Interest rates are so low, politicians have little focus on shortfalls. In the late 2010s and early 2020s, warnings that the debt could eventually spiral into much higher interest rates fell on deaf ears. (I’ve given this caveat several times, but haven’t found many other pundits who agree.)

This past week, the media has been full of reports that British bond yields are rising in response to Prime Minister Truss’ bold package of tax cuts, which will be financed by debt. There are also rumors that the next Italian government (probably led by right-wing populists) may increase public borrowing.

All of this makes me wonder if ultra-low interest rates are not a stable equilibrium, at least in most places. I still believe that low rates are a technically feasible equilibrium, but perhaps it is inevitable that politicians in many countries will abuse the privilege of almost costless credit – right up to the point where that privilege is removed.

One can apply this argument to other cases as well. Perhaps a 2% inflation rate is not politically sustainable in the long run. After a long period of low and stable inflation, policymakers began to (wrongly) assume that low inflation was “structural” or inevitable. They believe they can stimulate the economy without risking inflation.

Perhaps this also applies to criminal circles. During periods when crime rates have fallen to relatively low levels (say the early 1960s or early 2010s), politicians believe we can be a little too soft on criminals. They reduce incarceration rates, which lead to an upward spike in crime. Incidentally, a more difficult incident occurs in the crime phase of the crime cycle.

Or perhaps all this speculation is just the song of an old man who has just retired, worried about fading into irrelevance. An aging boomer is hoping his memories of the policy blunders of the 1960s still have some relevance to younger readers.

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