Free Lunch Illusion: How could so many smart people fall for the fantasy?

• Author: Rogoff, Kenneth S.

With forward-looking measures of long-term real interest rates soaring, markets have suddenly become much less forgiving of undisciplined, open-ended spending increases and tax cuts, not just for emerging market governments, but for advanced economies as well. Has the free lunch era of fiscal policy, if there really ever was one, come to an end? My recent research with econometrician Barbara Rossi and economic historian Paul Schmelzing suggests that if one takes a long enough view of things (seven centuries, but a couple will do), it becomes clear that there is a distinct tendency for sharp changes in real interest rates (nominal interest rate adjusted for expected future inflation) to ultimately revert to trend. If so, the implication is that even after central banks are done with the current rate hiking cycle, and looking past any subsequent recession, one should not necessarily expect nominal ten-year rates to settle at the levels the world had become accustomed to after the global financial crisis. Instead, they might average something closer to the early years of the twenty-first century.

Real interest rates after the global financial crisis fell off a cliff. Measured by the yield on a ten-year inflation-indexed U.S. Treasury bond, the real interest rate fell from an average of around 2 percent 2003-2007 to around zero percent 2012-2021, with a drop of over 3.5 percent from peak to trough. It was a good ride while it lasted. Ultra-low real interest rates were a central driving force behind the massive run-up in the price of virtually every long-lived asset, from equities to housing to art to Bitcoin.

They also played a central role in the debate over fiscal policy, for example in Olivier Blanchard's celebrated (2019) argument that governments had scope to raise spending without ever raising taxes directly or-importantly--through unanticipated inflation; that is, there could be a free lunch. The belief that low real rates would be around forever was equally central to debates about how to recalibrate monetary policy to deal with the zero bound on nominal interest rates, and played an important part in the U.S. Federal Reserve's August 2020 change in its monetary framework.

When former Treasury Secretary and Director of the National Economic Council Larry Summers gave his famous 2013 "secular stagnation" speech, a central thesis was that real interest rates had been falling secularly throughout the twenty-first century even after the...