Why interest rates have stayed so high is the great unanswered question of economics this year. A better question is why interest rates stayed so low for so long.
The conventional explanations for prolonged high interest rates have merit. The government does not have much credibility when it promises to fight inflation, because for 15 years officials have delivered abundant promises and inadequate action. Whenever inflation began to abate in past recessions, the government lost its nerve and switched to stimulation policies to alleviate unemployment.
The Reagan administration has tried to close this credibility gap. Much to the surprise of its critics and supporters, the administration has been very effective in cutting government spending to reduce demand-induced inflation. The administration also has given the Federal Reserve a free hand to pursue an anti-inflation policy. Despite this good start, the financial markets remain doubtful of the government's ability to follow through on its pledge to cut inflation when the going gets rough.
The second conventional explanation for high interest rates is the current mix of fiscal and monetary policies. Fiscal policy, notably the recent tax cut, is attempting to stimulate real growth, while monetary policy is intended to slow inflation. Driving the economy by stepping hard on both the fiscal accelerator and the monetary brake leads down a long road of high interest rates.
Heavy reliance on monetary policy creates major strains in the credit markets. The Fed is not supplying enough credit to finance recent rates of inflation, so some borrowers will be left out. Since the federal government is one borrower that will get its money, the remaining supply of credit is rationed among private borrowers. High interest rates are the rationing device that eventually discourages enough borrowers to equate the limited supply of credit with demand.
Both the credibility problem and the impact of monetary policy are well-known to economists, most of whom do not regard those explanations as adequate to explain why interest rates have stayed so high so long. Despite their constant forecasts that interest rates are about to decline, these rates have stayed high and gone higher.
Precisely what constitutes a high rate of interest is worth examining. A generation ago, investors believed that a 3 percent coupon on a 30-year bond was a high rate of interest. With the benefit of hindsight, that belief was extraordinarily dangerous to the financial health of those investors.
Inflation revolutionized investors' perceptions of what a high rate of interest comprises. For the last 30 years, lenders, particularly long-term lenders, have seen the real value of their assets destroyed by inflation. The investors who bought those 3 percent bonds have seen double-digit inflation dwarf the value of their single-digit coupons, and have seen plunging bond prices demolish the real value of their holdings.
From a lender's perspective, interest rates have been far too low for the last generation. The recent rise in interest rates, far from being inexplicable, is only beginning to provide them a modest real rate of return.
Lenders come in two classes -- taxable and tax-exempt -- and they have very different ideas about what constitutes a real rate of return. To taxable investors, today's interest rates barely allow them to break even. If an investor with a marginal tax rate of 50 percent earns 18 percent -- the highest rate available in money-market funds -- he or she still takes home only 9 percent. Since inflation is running at about 9 percent as well, the taxable investor enjoys no real return. If state taxes are considered or inflation accelerates, the taxable investor emerges as a loser in real terms.
While the taxable investors are still struggling to break even, tax-exempt ones such as pension funds are enjoying positive real returns for the first time in a generation. Interest rates of up to 18 percent are far above the inflation rate, and the real returns are extraordinary by almost any standard.
Since lenders are a combination of taxable and tax-exempt, their real returns are, too. When the high real returns to tax-exempt lenders are combined with the break-even real returns to taxable lenders, the net result is moderate real returns overall.
From a lender's perspective, there is no mystery why interest rates are at current levels in light of the moderate real returns they provide. The real mystery is why interest rates stayed so low for so many years.
Borrowers understandably view the situation differently. After having a generation to become accustomed to negative real rates of interest, they regard today's rates as a shock that imperils their living standards and ability to repay their debts.
The threat to borrowers' ability to repay suggests that interest rates may stay high for the oldest of reasons -- fear of default. Calculations of real rates of return quickly become irrelevant when there is a major risk that lenders will not get their money back. Unfortunately for lenders, the same rise in interest rates that increases their real returns also increases the risk that their loans will not be repaid.
High interest rates are a two-edged sword that raises the financial burden on borrowers while reducing their ability to carry that burden. The increase in the financial burden is obvious, since it rises in direct proportion to the interest rate. When the prime rate goes from 10 percent to 20 percent, the borrowers' annual interest payments double.
The other edge of the sword is the reduction in real incomes that accompanies a recession caused by high interest rates. Borrowers who were able to pay their debts in a strong economy might not be able to pay them if they become unemployed during a recession.
When a borrower gets in trouble, that trouble generally comes in battalions, not in ones and twos. Poland is an unfortunate example of where everything is going wrong at once. Its $27 billion in variable-rate debt was a heavy burden at lower interest rates and is a crushing burden at current ones. Its ability to earn hard currency through exports to Western economies is declining along with the recessions now gripping those economies. The political chaos inside the country will reduce real national income by more than 10 percent this year, according to Polish government forecasts. Even without the specter of Soviet military action, Poland's creditors have good reason to be depressed about the prospects of getting their money back.
Concern about the prospect of credit defaults does not extend much beyond Poland. A good yardstick of lender concern is the yield spread between high- and low-quality bonds, which currently is at only a moderate level. Lenders are concerned but not really scared, as they were in 1974.
The lack of real fear over credit defaults today, far from being reassuring, may mean that the worst is yet to come. Interest rates usually hit their peaks when three events take place: a serious recession comes into full bloom, the Fed has kept credit tight long enough to cause serious bankruptcies, and lenders become frightened enough to demand large interest-rate premiums to accommodate low-quality borrowers. None of these events has occurred yet in this cycle, which suggests that the peak in interest rates may not have occurred yet, either.