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To Take Advantage of "Gift" Interest Rates, Let's Invest in Research

To Take Advantage of
 Eric Chaney
Senior Fellow - Economy

At market prices as of 14 October, the French Republic borrowed at negative or zero rates at all maturities up to 15 years. In other words, investors – ultimately, French and foreign savers – are willing to pay government bonds at a higher price than their face value.

Money may not be free, but it sure is not expensive!

Let's take an example. The French Treasury bond maturing in March 2024 has a coupon of 0% and therefore does not earn any interest. But in the current market conditions, one has to disburse €10,250 (idem) to own this bond, which will be redeemed only €10,000 in March 2024. If ever, in the meantime, the economy had sunk into deflation, this would be good news for savers, because their savings would essentially be preserved, but bad news for the Treasury, and therefore the taxpayer. On the contrary, even a low inflation rate like today's (0.9% in September) benefits the Treasury, whose tax base, all other things being equal, would increase at least as much as inflation, but who would still repay slightly less than it had borrowed. By the way, let's underline the term "repayment": negative rates do not mean free money!

It is likely, although not certain, that a full-fledged deflationary scenario would not happen for two reasons.

  • The major central banks (Federal Reserve, European Central Bank, People's Bank of China) are determined to do everything possible to prevent it.
  • The rise in protectionism initiated by the United States is intrinsically inflationary in the medium term.

The borrowing government therefore has good reasons to be pleased with the current situation, even if it is in no way the result of virtuous behavior on its part. French public debt is close to 100% of annual GDP and, despite ever-lower interest rates, has not declined since 2016. Virtue or not, the question remains: how to take advantage of this situation?

"Spenders" versus "conservatives"

Two starkly opposite points of views disagree on the topic.

  • Famed economist Olivier Blanchard launched the debate in his opening speech to the American Economic Association annual meeting in January 2019, pointing out that, when the risk-free interest rate (the public debt’s rate) is lower than the growth rate of the economy, public debt does not entail any additional budgetary costs in the future.
  • On the other hand, German Chancellor Angela Merkel is quoted saying: "If we are unable of getting out of debt when rates are low, how will we do it when they are high?”

These two points of views are respectable and their opposition – highly visible in the public debate – is largely due to diverging assumptions about the future. Olivier Blanchard and other economists, such as Larry Summers, believe that interest rates will remain very low for many years to come, due to a global structural excess of savings. Our German neighbors, who still remember the surge in interest rates during German reunification and again in 1994, are more cautious. They consider it unwise to assume that rates will remain this low for ever. History has repeatedly shown that, when interest rates rise, the most indebted agents, whether consumers, companies or even governments, find themselves in jeopardy, to the point of sometimes being at risk of default. Not taking advantage of low rates to reduce debt would therefore be a sign of great short-sightedness for the "conservative" camp. In the opposite camp, call them "spenders", they respond that not taking advantage of low rates to spend more is a sign of even more blinding short-sightedness as it perpetuates a cycle of low rates by extending the excess savings backdrop.

Exiting this dialogue of the deaf on top....

To get out of this dialogue of the deaf and find common ground, best to avoid the "increase or reduce debt" alternative and instead ask the question: is there a way for taking advantage of very low rates by borrowing to finance projects that are known, with reasonable certainty, to generate a long-term return on investment for the community that exceeds future interest rates? Borrowing to invest in such projects would ultimately lead to a reduction in public debt, since the return on investment would exceed its cost. But to convince the "conservative" side, the analysis must be based on a reasonable and cautious bet on future interest rates. To do this, the best there is to crunch historical data to evaluate an upper bound for future interest rates.

Let us consider German three-month interest rates since 1950, in real terms, meaning after deducting inflation. Their average since 1950, nearly 70 years, has been 2.2%, their standard deviation 2.3%, and, as can be seen below, their distribution approximately normal. It can therefore be considered there is a high probability that in the next 20 years, real interest rates will not exceed 6.8%, say 7% to round off.


Which investments have an expected social rate of return, in real terms, that exceeds 7% per year, or, if preferred, 9% per year, assuming that inflation returns to an average 2%? How many "traditional" infrastructure projects, such as real or digital communication networks, are lacking funds and likely to meet this test? One may assume that, where they exist and can be evaluated, such projects are already financed, either by private initiative, if their private return – a priori lower than the social return, since they do not take into account externalities – is sufficiently high, or by public initiative, including by the European Investment Bank.

... by investing in projects with very high social returns

One area where long-term returns are well above the 9% threshold, but that cannot be evaluated with methods used for traditional investment projects, remains: fundamental and applied research. The essential difference between the performance of research and, for example, road infrastructure that allows the opening up of a region – a project with a higher social return than its financial return because of the positive externalities thus created – is depreciation. Quite the contrary with scientific discoveries: return on investment increases when technological innovations make use of it. Archimedes' principle has not aged one bit and we still use it!

Tartaglia and Galois, two creators of immense wealth

Let us use two examples to illustrate. Niccolò Fontana, an obscure 16th century mathematician better known as Tartaglia, due to a sabre wound during the massacre of the Brescia inhabitants by King Louis XII’s soldiers, invented imaginary numbers to solve the 3rd degree equation. Evariste Galois, killed in 1832 at the age of 21, had previously solved the enigma of the 5th degree equation, by demonstrating there were no solutions that could be expressed with algebraic formulas. To do so, he had to develop a new conceptual framework: group theory. This is very abstract research and one wonders what good it has in everyday life. And yet, none of the technologies invented since the 19th century would exist without the power of the tools offered by complex numbers and group theory. The social return on these two inventions is immeasurable and continues to increase year after year.

Of course, basic discoveries generating extraordinary and growing social returns, such as those of Tartaglia, Newton, Euler, Galois, Pasteur, Einstein, Planck, Heisenberg, Crick and Watson, are rare. Although no one has ventured to estimate them, it is accepted that their statistical distribution is "heavy-tailed" (see What's so special about Science, by William Press, Science, 15 Nov. 2013), one way of saying that their rarity is by far compensated by their high social return. Borrowing to finance fundamental and applied research is thus the most profitable long-term investment you could think of. In practice, only states can afford to do so, because the horizon for return on investment is sometimes much farther than what is conceivable for a private investor. In fact, the short-term electoral horizons are one explanation for why governments are typically reluctant to significantly increase research budgets, while in parallel, the Chinese state is increasing them massively.

The social return on R&D is at least 20%

Let us move away from the abstract world of fundamental discoveries to consider the social return of research and development (R&D) in general. A report prepared by Frontier Economics in 2014 for the UK Department for Business, Innovation and Skills concludes that the median social return of R&D in the United Kingdom, across all funding sources, ranges between 40 and 75%. Even assuming a depreciation rate of 10 to 20%, these figures remain very high. For R&D financed by public funds, which is far less subject to depreciation – within R&D, the depreciation rate of basic research is zero, if not negative – social return would approximately be 20%, which still exceeds by far the threshold of 9% indicated earlier to reach a consensus between "spenders" and "conservatives".

Why don't governments invest more in research?

Given it is fiscally virtuous to borrow for financing R&D, why don’t we do it, or at least do it more? Beyond the reluctance to spend today for a certainly high social return, yet uncertain time horizon, three other reasons emerge.

  • On the one hand, spending on research can only generate high social returns if public funds are allocated efficiently, based on objective, such as the research team’s excellence, rather than political criteria.
  • On the other hand, every country in the Eurozone is either constrained by the Union's budgetary rules or, as is the case for Germany, by its own budgetary rules.
  • Finally, national policymakers often have limited interest in public research because it produces outcomes that are by nature public goods: a new mathematical theorem or a new superconductor at room temperature can be used by everyone in the world, business or governments alike.

Exclude research expenditure from the calculation of excessive deficits, under governance conditions

While the first challenge is a well-known governance issue, and the second is more political and institutional in nature, these two are in fact closely linked. How can these be overcome? Considering the Eurozone only, the only solution is to review the criteria used by the European Commission for evaluating excessive deficits. Borrowing, therefore increasing current public debt, to invest in projects whose social return – i.e., let us emphasize, taking into account positive effects beyond the investment itself including positive externalities – is far superior to a cautious assessment of the upper bound on future interest rates, ultimately leading to public debt reduction, all other things being equal. It would therefore be perfectly justified for investments in research to be excluded from excessive deficit calculations, on the one condition, however, that the allocation of these investments is based on scientific rather than political criteria, even if disguised under the word "strategic".

Germany and France ought to better coordinate their research efforts

In France, research efforts are clearly insufficient. Aggregating private and public R&D, expenditure only reached 2.2% of GDP in 2016 (Source: OECD), compared to 2.9% in Germany, where Chancellor Merkel has set a new target of 3.5% of GDP in the wake of Japan’s example, where the threshold is 4% of GDP. Even if France must significantly ramp up its efforts in both public and corporate research, our two countries nevertheless have converging visions for the need to encourage world-class research and doing so by ensuring the governance of public funds’ allocation is based on scientific quality. It would be sensible to pool resources dedicated to world class research with the establishment of a common governance mechanism. Thus, at an equivalent level of resources, public funds would be allocated more efficiently, on a larger research platform with increased competition. And, if an agreement could be reached on excluding research expenditure from excessive deficit calculations in the Eurozone, the resources thus pooled could be significantly increased. Within the same logic, why not initiate immediately a close coordination between the French Agence nationale de la recherche (ANR) and the Deutsche Forschungsgemeinschaft (DFG), starting by pooling resources, and opening up the possibility of eventually merging the two bodies, for rationalizing the management and governance of research funding in the common area.

The European Research Council, Europe's best investment

To further raise our ambitions, it should be noted that the European Union has an institution that remarkably fulfils the governance criteria outlined above: the European Research Council (ERC). A photo that went viral on social media networks over the last few days illustrates the degree of excellence achieved by the ERC: Sir Peter Ratcliffe smiling as he learned that he had earned the 2019 Nobel Prize in Physiology or Medicine, while he was dutifully filling the form for a research grant from the ERC! Sir Peter is the seventh ERC-funded scientist to receive a Nobel award.

The ERC has acquired such a reputation thanks to uncompromising scientific governance: project funding is granted only on the basis of its scientific quality. It is not based on the research laboratories’ nationalities, nor their congruence with the economic objectives of the Union and member states. For a researcher, obtaining ERC funding is proof that she is world-class. Today, the ERC has a budget of €13 billion as part of Horizon 2020, allowing the distribution of just under €2 billion funding per year to researchers in the countries that participate to this fund, namely the EU and a number of associated countries, from Israel to Turkey, including Norway and Switzerland.

Given the ERC’s tremendous success, the ridiculous amount of its annual budget is confusing: a mere 0.012% of the European Union's GDP. If Europe wants to play its part in the race to innovation, the main source of future wealth and for which scientific research is at the very core, this cannot be satisfactory. To significantly increase the ERC's budget, two channels are possible.

Significantly increasing the ERC's budget, or providing it with capital

  1. Within the EU budget, distinguish research funding under a unique heading, allow member states’ funding not to be included in excessive deficit calculations, and increase the ERC budget by a very significant factor, i.e. at least triple if not multiplying by five. Even in the latter case, the ERC's annual budget would still only represent 0.06% of the Union’s GDP.
  2. Provide the ERC with capital whose financial income would contribute to the institution's annual budget, and therefore no longer be part of the EU budget. To finance the current budget, a capital of around €100 billion would be required, with an expected financial return on investment of 2%. A fivefold increase in the ERC's budget would require a capital of €500 billion. The additional debt (3.1% of EU GDP in the case of a capital of 500 billion) would not change the net wealth of member states, since they would be shareholders, instead of financiers, of the ERC. Thus, the institution could be recasted as the "European Research Fund" (ERF) with a potential of financing up to an annual €10 billion for European scientific projects of excellence.

It is conceivable that participating states could borrow jointly by issuing long-term, or even very long-term, 50 years, "research" bonds, and that this debt would be excluded from the excessive deficit calculations. Akin to the bonds issued by the European Investment Bank (EIB), these assets would be added to the pool of "safe and liquid" assets, since these are jointly guaranteed by participating states, which the ECB has been calling for to strengthen the Eurozone’s financial stability. The management of this capital could be entrusted to the EIB, which has strong expertise in this field. It should be noted in passing that, for reasons of sound exchange rate risk management, most of the ERC's capital would be invested in Eurozone financial assets, thus facilitating the financing of its economy.


Since the Greek antiquity, Europe has had an extraordinary scientific tradition. Most of the dramatic increase in its standard of living can be attributed to it such the decline in infant mortality or the increase in longevity. It has also contributed to much of Europe’s international influence. While the United States is still far ahead in most scientific fields, and China is banking on research and innovation to ‘get rich before it gets old’, is Europe resigning itself to being left behind? Today, not investing massively in research when you can borrow at negative rates, would be the confession of that, in my opinion.

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