Equilibrium is an extremely important concept in economics, but with a somewhat ambiguous meaning.  Thus macroeconomists might speak of a “disequilibrium” outcome, where nominal shocks distort labor and goods markets due to sticky wages and prices.  But from the perspective of a more complete model of behavior (including price setting), a recession might be viewed as an “equilibrium” outcome.

The “natural” or equilibrium interest rate also has multiple meanings, but generally refers to the interest rate that provides for some sort of macroeconomics equilibrium, such as stable prices.  Throughout most of the world, the equilibrium interest rate has been trending lower since the early 1980s.  Until now. . . .

A more complete model of the equilibrium interest rate might also account for the political economy of fiscal policy.  Suppose that the natural interest rate falls so low that politicians become tempted to run larger budget deficits.  Eventually, the deficits become so large that the equilibrium interest rate begins rising again.

Under recent US administrations, fiscal deficits have become much larger than usual (even before Covid.)  With interest rates so low, there is little to restrain politicians that have a short run focus. During the late 2010s and early 2020s, warnings that the debt might eventually have to be rolled over at much higher interest rates fell on deaf ears.  (I gave that warning several times, but couldn’t find many other pundits who agreed.)

This past week, the media is full of reports that British bond yields are soaring in response to Prime Minister Truss’s bold package of tax cuts, which will be financed by borrowing.  There are also rumors that the next Italian government (likely headed by right wing populists) might boost government borrowing.

All of this makes me wonder whether 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 borrowing—right up to the point where that privilege is removed.

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

Perhaps this even applies to cycles in crime.  During periods when crime rates have fallen to relatively low levels (say the early 1960s or the early 2010s), politicians come to believe we can be a bit softer on criminals.  They reduce the rate of incarceration, which leads to an upward spike in crime.  Eventually, there is another tough on crime phase in the crime cycle.

Or perhaps all of this speculation is just the musing of an old guy that just retired, worried about fading into irrelevance.  An aging boomer hoping that his memories of the policy mistakes of the 1960s still have some relevance to younger readers.