Long-term low interest rates and the orientation of budget policy

In the advanced economies, interest rates on risk-free assets are at historically low levels, and even negative in some countries. This trend is due in part to low inflation, particularly since the onset of the global financial crisis in 2008. However, even after deducting inflation, real interest rates are very low. The structural causes of low rates (demographics, rising inequality) suggest that risk-free rates will not be normalized in the short term. According to our simulations, using the iAGS model, a long-term scenario of low rates could free up a substantial fiscal space of 2 percentage points of GDP in Ireland and up to 10 points in Italy, provided that rates remain low for a decade.How useful this fiscal space could actually be depends to a large extent on the analysis of the economic situation. If low rates are the result of a permanent change in supply conditions (Gordon-type secular stagnation), then the room for manœuvre is only superficial, and actually masks a long-term weakening of potential growth. On the other hand, if long-term low interest rates are the result of Summers-type secular stagnation – that is, a shift in the savings rate and the ex ante investment rate of private players – then the mobilization of the public deficit for changing the macroeconomic balance between savings and investment will help economies out of an equilibrium of underemployment of the production factors.