High interest rates are here to stay | Kenneth Rogoff - Project Syndicate

The longstanding economic consensus says lending rates will stay low indefinitely, making debt free. That opinion, however, is now unacceptable. Even if inflation falls, soaring debt loads, de-globalization and populist pressures will leave rates higher over the next decade than they were in the decade after the 2008 financial crisis.

Despite the latest partial retreat in long-term real and nominal interest rates, they remain well above the ultra-low levels to which policymakers have become accustomed and are likely to be held at similar levels even if inflation falls. It's time to revisit the popular notion of a "free lunch" regarding government debt.

The idea that rates would be low forever seemed to support the view that any concerns about debt were support for "austerity." Many have come to believe that governments should increase deficits during recessions and only slightly reduce them during normal times. No one seemed concerned about possible risks, particularly inflation and interest rates. Left-wing advocates championed the idea of using government debt to expand social programs beyond what could be generated by cutting military spending, while right-wing advocates seemed to believe that taxes existed only to lower them.

The most misguided approach was to use central banks to purchase government debt, which seemed free when interest rates were zero for a short period of time. This idea is the basis of modern monetary theory and the "monetary helicopter". In recent years, even prominent macroeconomists have floated the idea of the U.S. Federal Reserve writing off public debt after absorbing it through quantitative easing, a seemingly simple solution to any potential public debt problem.

But this approach assumed that even if global real interest rates rose, some increase would be smooth and temporary. The possibility of a sharp rise in interest rates and a consequent large increase in interest payments on existing debt, including debt held by central banks as bank reserves, was simply dismissed. But here we are: the Federal Reserve, previously paying no interest on those reserves, is now paying more than 5%.

With a few glaring exceptions, those who have championed the idea that debt is a free lunch have failed to recognize the likelihood of the new reality. At a recent conference, I listened to a prominent financial commentator who was a strong proponent of "perpetually inferior" provisions and was unaware that this view had been completely debunked.

In a recent paper on record high global debt presented to the world's top central bankers at this year's Jackson Hole conference, Serkan Arslanalp and Barry Eichengreen appear to be implicitly discussing the implications of the current debt skew or the link between high government debts and slow growth in countries like Japan and Italy.

The next recession, whenever it comes, is likely to bring a significant drop in interest rates, which could provide temporary relief to the over-leveraged U.S. commercial real estate market, where today's credo is "survive until 2025." It is believed that if property owners can withstand another year of falling rents and rising financing costs, a sharp drop in interest rates in 2025 could stem the tide of red ink threatening to drown their businesses.

But even if inflation falls, interest rates are likely to remain higher in the next decade than they were in the decade following the 2008 financial crisis. This is due to various factors, including soaring debt, de-globalization, increased military spending, green transformation, populist demands for income redistribution, and sustained inflation. Even demographic changes, often cited as a justification for continuously low interest rates, may affect developed countries differently due to the increased costs of supporting a rapidly aging population.

While the world can certainly adjust to higher interest rates, the transition is still ongoing. The transition could be particularly challenging for European economies, as ultra-low interest rates have become the main glue that holds the eurozone together. "Our money" Bank of Europe policies seemed free when interest rates were near zero, but it is unclear whether the bloc can survive future crises if real interest rates remain high.

As I have previously argued, Japan will struggle with the transition from its "forever zero" interest rate policies because its government and financial system are used to treating debt as free. In the U.S., commercial real estate vulnerabilities, along with increased borrowing, could trigger a new wave of inflation. Moreover, while major emerging economies have been able to cope with high interest rates so far, they face enormous fiscal pressures.

In this new global environment, policymakers and economists, even those who used to belong to the "forever lower" camp, may be forced to reassess their beliefs in light of the current market reality. While expanding social programs or increasing military capabilities without large deficits is possible, it is not gratuitous. We will probably realize on our own skin that this was never the case.