Why interest rates fell
The most cited reason why real interest rates have tumbled is the “global savings glut.” Bernanke gets credit for the term. Faster income growth in emerging markets— according to the IMF (2014) report— lifted savings, which the West wasn’t able to absorb quickly. A persistent abundance of capital reduced its price.
Saving alone, however, tells us nothing about the equilibrium interest rate. In the aggregate, saving must equal investment. It’s excess desired saving –or the shortfall of desired investment— what depresses the real interest rate.
For interest rates to fall, then, investment needed to fall as well, or at least rise less than desired saving. That’s presumptively what has happened since the 1970s in mature economies. The McKinsey Global Institute (2010) estimates that capital spending from 1980 through 2008 was $20 trillion less than if the investment rate had remained stable. Granted, investment in emerging countries soared, especially in China. But saving rates rose even more, so developing nations became net exporters of capital.
The lower demand for investment can be traced, in turn, to two other factors. Summers (2014) has recently argued that the entrepreneurial ventures of the 20th century (think Ford, British Petroleum, Airbus) required millions of dollars, whereas today’s startups need just a few thousands in seed capital. Also, investment demand has gone down because the relative price of capital goods has declined. A truckload of widgets buys more computers than ever before.
Another explanation is that the income distribution changed. The capital share of income has risen, and so has wage inequality among workers. For corporations, a bigger piece of the income pie has implied more saving, because businesses’ demand for capital has grown less than profits. Among households, the saving rate is much higher at the upper end of the income distribution. When the financial crisis hit borrowing-constrained households, the gap between desired saving and borrowing grew wider.
A shrinking labor force implies a falling natural interest rate as well. This point was famously made by Alvin Hansen (1939) in a speech where he laid out his secular stagnation hypothesis. He guessed the decline in population growth and “the failure of any really important innovations” would hold back growth and depress interest rates. The next 30 years proved Hansen spectacularly wrong—clearly on the innovation count—but the demographic concern seems relevant in the 21st century.
Man-made barriers can contain investment too. That’s an explanation favored by the “supply siders” in this debate, such as John B. Taylor and John Cochrane. Policy uncertainty, bad regulation, and distortions, they say, has discouraged investment.
Finally, besides a mismatch between intended saving and investment, a portfolio shift took place. The relative demand for safe assets increased, primarily by central banks and sovereign wealth funds in emerging countries. This shift further pushed down yields on liquid, “safe” assets, as the IMF (2014) has argued. On this count, then, declining interest rates reflect scarcity of “safe,” liquid assets. (Bernanke has mentioned this also.) Quantitative easing may have compressed term premiums as well since 2008, although it’s unclear how much.
Key views
- Real, long-term interest rates have been falling for 30 years across a number of countries.
- Several reasons are behind this secular decline. Among the most cited are: the global savings glut; a dearth of investment in mature economies; the changing distribution of income; a shrinking labor force; bad policy; and an increased preference for “safe” assets.
- It’s not clear which of these forces will continue to operate in the medium term, prolonging the decline of interest rates. Besides, offsetting factors might work to reverse the trend. The current account balance of China, the largest contributor to global excess saving, might shrink permanently. Economic growth in emerging markets might be lower in the future. Age-related spending will increase, and retirees will start drawing down their savings.
- My take is that long-term interest rates will increase between now and the next recession, driven by monetary policy. Beyond cyclical fluctuations, I think the real interest rate is not predictable.
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