Shifting Trends Point to Dip in U.S. Interest Rates

A. GARY SHILLING is president of A. Gary Shilling & Co., economic consultants and asset managers. His firm publishes Insight, a monthly newsletter covering the business outlook and investment strategy

Will U.S. interest rates rise or fall in the 1990s?

Looking at the international scene, one might think that rates could rise. In the 1980s, the United States was a huge net borrower on world capital markets. This was because the deterioration of America's merchandise trade balance produced during the decade a massive $767-billion current account deficit--the amount that our imports in goods and services exceeded our exports. The U.S. government was a major contributor to this excess of domestic spending over national income, with net borrowing of $1.564 trillion during the period.

Japan and West Germany, with high savings rates and large current account surpluses, supplied much of the capital. In the 1980s, about 30% of national income was saved in Japan and 20% to 25% in West Germany, compared to less than 15% in the United States.

Now, however, the momentous political changes in Eastern Europe will soak up much of West Germany's savings. The additional private investment that will go into East Germany, plus extra borrowing by the West German government to pay for pensions, unemployment benefits and infrastructure, will absorb a big slice of West Germany's excess savings. Those savings have hitherto been exported via the current account surplus, which reached $72 billion in 1989.

The rest of Eastern Europe, which unlike East Germany lacks a West German government guarantee to reassure investors, will be able to attract and absorb capital very slowly in relation to its needs. Nevertheless, the region will soak up significant amounts of capital that would have gone to other uses--such as financing the U.S. trade and budget deficits.

Meanwhile, over the next five to 10 years, the changing demographics of the Japanese population will reduce the excess of savings over investment that drives the country's current account surplus. Between now and the year 2000, the proportion of retirees in the Japanese population will jump from 12% to an estimated 17% (comparative figures for the United States are 12.7% rising to 12.9%).

The demographic shift will significantly reduce the savings rate in Japan. As people move from their last--usually highest-earning--years of their working lives into retirement, their income levels fall substantially. They have less surplus income to save and, as a consequence, their savings rate drops. In fact, many may have to begin drawing down savings accumulated during their working lives.

Japan may also become a more consumer-oriented society, as Western patterns of consumption are adopted and obstacles to consumption--particularly those that tend to discourage spending on imports, such as complex and inefficient wholesaling and retailing networks--are removed. This trend may already have begun. The proportion of disposable income saved by Japanese households has fallen steadily to about 15% in 1988 from almost 25% in 1976.

Meanwhile, the United States will be under pressure to spend on such neglected areas as the infrastructure, environment and education, not to mention the $500-billion savings and loan bailout.

Does this mean that the United States will be left in the lurch, as the excess savings of the world's two biggest creditors dries up? Will higher interest rates result from the competition for the world's diminished supply of surplus capital?

Probably not. More likely, increasing domestic and government thrift will allow the United States to meet its needs without increasing taxes, while also allowing the federal government's budget deficit to continue to shrink. This will happen in part because the nation's demographics are about to shift in favor of saving.

As the baby boom generation--those born between 1946 and 1964--ages, the proportion of U.S. households headed by persons between 25 and 54 is rising dramatically. By 1995, 62% of households will be headed by someone between those ages, compared to 58% in 1985 and 56% in 1975.

Contrary to the view of many economists, the aging of the baby boomers will not be the major factor in an increase in the savings rate. Savings rates are much more highly correlated with income than with age. As international competition forces U.S. businesses to cut costs, middle-income jobs will be in short supply. As middle-income households are squeezed, greater income inequality will result. My research shows that households in the $60,000-and-over range (in 1985 dollars), which had 35% of the nation's personal income in 1985, will control 50% of it in 1995. The effect of this shift will be to increase the savings rate--since upper-income households typically save up to four times the national average.

The shift in income distribution in favor of high-earning, high-saving households, the aging of the U.S. population and the end of the housing boom should prompt the U.S. household savings rate to rise from its 1987 low of 3.3% to more than 10% by 1995.

The end of the Cold War will also allow the United States to reduce defense spending in real terms. At the same time, the United States will have a huge Social Security surplus--somewhere between $80 billion and $160 billion by the mid-1990s. This net inflow of funds to the federal government's coffers will reduce its net borrowing requirements accordingly.

The idea that inflation or a scarcity of capital will keep U.S. interest rates high will therefore prove unfounded. Serious inflation is over, and higher U.S. savings will head off capital shortages. The combination will allow interest rates to fall in the 1990s.

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