A new report from McKinsey Global has just about the most far reaching predictions we have seen in years. The report forecasts higher interest rates across the world. That’s real interest rates, by the way. If the predictions are right, and actually, we suspect they are, this will of course be bad, bad news for people and governments in debt. But what makes this report truly interesting is the explanation for why rates should rise. And its explanation provides reason to cheer indeed – perhaps the best reason for economic cheer in a very long time.

Before we delve into the guts of the McKinsey report, there are a couple of points you need to bear in mind.

Firstly, in a mature economy investment does not need to be that high. See it in terms of two farmers, a farmer that is well established and one that has only just set up. Our established farmer will probably have a decent combine harvester, all the necessary number of tractors, and lots of mod cons that help make the farm as productive as possible. Such a farm does not need much investment, normally requiring further input only to maintain equipment, or if a new wonder product comes out which will help improve productivity. This farm is analogous to a mature economy in which innovation, and not investment, leads to growth. The second farmer, on the other hand, has insufficient infrastructure, and every pound of investment leads to a significant rise in productivity.

It seems that when the Second World War ended, the developed areas of the world were all operating way below potential. All of the world’s economies had vast potential to increase productivity by investing in infrastructure, machinery and any other forms of capital you can think of. And so, for 25 years the global economy enjoyed a golden age. It was an age that ended in the mid 1970s.This column has argued before that inflation in the 1970s occurred because output growth slowed, but growth in demand didn’t. In Japan it was even worse, as she suffered from the triple blow of the bursting of a bubble in asset prices, an ageing population, and the ending of her period of technology catch up.

Secondly, economic theory says investment is funded by savings. So if saving is high and investment low, we get low interest rates. If investment is high and saving low, interest rates shoot up.

During the golden age of growth, disposable income per person in the developed world rose sharply. Your average household in the UK was much better off in 1973 than in 1950, and yet throughout this period, real interest rates were quite high. The fact that real rates were high was not a good thing per se, but the factor that caused them to be high was good. Or to put it another way, high real interest rates were a symptom of the fact we were becoming better off.

From the mid 1970s onwards, investment in the developed world slowed. McKinsey estimates that total global investment between 1980 and 2008 was round $20 trillion less than it would have been had total investment as a proportion of GDP stayed at the level seen during the 1950s and 1960s.

By the late 1990s and noughties, saving had risen too. Saving rates were high in Japan, and the money saved flooded into the US and Europe via the carry trade. And then as China started to save, in part as a reaction to the shoddy treatment handed out by the IMF to the Asian Tiger economies after their 1997 crisis, we saw the emergence of a global saving glut.

This saving glut fed the credit boom in the West.

It seems that during the period we also saw an increasingly uneven distribution of wealth, but the populace were placated largely because of the combination of cheap interest rates and ready supply of credit, which led to rising property prices and made people feel better off.

And then for the final act in this chapter came the credit crunch and the global economic crisis.

But maybe the global economic crisis was little more than the death-knell of that particular economic era.

And death-knell suggests a new era is beginning.

McKinsey Global put it this way: “Developing economies are embarking on one of the biggest building booms in history. Rapid urbanisation is increasing the demand for new roads, ports, water and power systems, schools, hospitals and other public infrastructures. Companies are building new plants and buying machinery, while workers are upgrading their housing. At the same time, ageing populations, and China’s efforts to boost domestic consumption, will constrain growth in global savings. The world may therefore be entering a new era in which the desire to invest exceeds the willingness to save, pushing real interest rates up.

Higher capital costs would benefit savers, and perhaps lead to more restrained borrowing than we saw during the bubble years. However, they would also constrain investment and ultimately slow global growth somewhat.”

In other words, investment across the world is set to explode. The report went on to say: “The world is now at the start of another potentially enormous wave of capital investment, this time driven primarily by emerging markets. We predict that 2020 global investment could reach levels not seen since the post-war rebuilding of Europe and Japan in the era of high growth in mature economies.”
McKinsey predicts that by 2030 global investment will be around $24 trillion, compared to $11 trillion today.

But as investment rises, suggests McKinsey, savings are set to fall.
Firstly they will fall as China’s consumers begin to save less and spend more. We have written about this many times, so we don’t need to go into more detail here today.

Secondly, suggests McKinsey, savings will fall as the ratio of retired to working population rises, meaning more money will be spent on healthcare, and less saved.

The result, says McKinsey, will be higher real interest rates, but at the same time the global economy may embark on another golden age of growth. One assumes that during this transition period, we will see default by a number of individuals, companies, banks and countries with high debts.

That leaves us with just one comment: the baby boomers.

Several times before, this column has argued that as the baby boomers approach retirement, saving rates will rise, creating deflationary pressure. Then, once the baby boomers have all retired, those savings will be eaten into, and inflationary pressures will be created.

The McKinsey report is fascinating indeed, and the report’s key assumption is surely right.

We suspect, however, that the baby boomer effect muddies the picture, and as yet it is not clear how the combination of ageing in the West will interact with an investment-led boom in the developing world.

For the McKinsey report, see:
Farewell to cheap capital? The implications of long-term shifts in global investment and saving

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