Are high interest rates the new normal?

I've noticed a lot of arguments floating around that we are entering a new normal: structurally higher interest rates, permanently higher (& more volatile) inflation, geopolitical tensions driven by China's growth slowdown, etc. Funny, just 5 years ago, I could have sworn that the narrative was that the new normal is permanently low inflation, permanently low interest rates, and sluggish growth a-la-Japan. Things change quickly, eh?

Let's think about that for a second.

If interest rates do continue to stay structurally high, what does this mean for the economy in the long run?

For the past 40 years, governments and corporations have been refinancing debt with cheaper debt, year after year. It was so easy to incur new debt when interest rates were low or were on a secular downtrend.

This got exacerbated in the 2010s, between the crisis and COVID, when interest rates were at zero most of the time, the term premium even turned negative, central banks invented QE, markets were making all-time-highs almost every year, and we saw massive technological expansion - this usually happens when interest rates are low. Looking at 800 years of interest rate movements, periods of low rates tend to fund innovation. Societies benefit.

However, this time we are left with huge, unprecedented peacetime levels of both public and private sector debt. Much bigger than the last time we faced high interest rates, high inflation, and geopolitical tensions (specifically the 1970s). US debt-to-GDP is 4 times higher today than it was in the 1970s. Similar for many other countries, in Europe, and worldwide.

Interest payments for debt issued at 5% rates are taking a huge toll on the budget. Imagine if 10% of the budget each year is just interest on debts you took in the past. Well, we are now at 7.5% ($475bn of interest payments to $6.3tn budget). Projections are even worse in the years to come (see figures below), and the deficit is only getting larger ($1.7tn this year), meaning more debt needs to be issued to cover the windfall. Issued at 5% interest rates.

Furthermore, a big difference between now and then is much lower productivity today. This is why we had to accept a debt-driven model of economic growth, because we reached a productivity slowdown (Gordon's 2016 book The Rise and Fall of American Growth is a good read on this topic).

When you have an economic growth model driven by debt, you need low interest rates to keep fueling that growth. Or you need a massive productivity boost. That's what QE was for in the past decade, and again QE on steroids after COVID (central banks buying government bonds). It helped sustain the debt model, but it made the system structurally much much weaker. And basically dependent on central banks' and governments' explicit and implicit bailouts.

Permanently (say 10 years) high interest rates will break this cycle and the landing will be not hard, but a massive crash.

That being said, I see three possible scenarios arising from the current situation over the next half-decade:

1) Austerity, tax hikes, and a thousand cuts. Budgets cannot sustain this pressure, governments have to undergo large austerity and fiscal consolidation (again most likely via tax hikes rather than spending cuts). Same for corporations - except they will have to engage in cuts (personnel mostly). This alone creates a strong recessionary shock.

2) Kicking the can down the road scenario. Interest rates are back close to 0% (this only happens after a huge shock to the economy, a major recession), and the debt-fueled growth model is continued. Back to the familiar equilibrium.

3) Miraculous productivity boost. We make a technological breakthrough (new industrial revolution level) that increases marginal worker productivity which lowers the pressure of fiscal and monetary policy to keep greasing the system. This is something that happens slowly over time, and is not likely to pull us out quickly.

In conclusion, I don't think the structurally higher rates with more volatile inflation is the new normal, in a sense of it being a new equilibrium. The pressures are too high for it to persist. Rates will have to go back down one way or another.

P.S. This still doesn't make the empire dissolution theorists right. But that's another discussion.