A Lack of Interest

Are we entering a long period of secular stagnation in which interest rates are low? We cannot foresee all the implications. 

This has not been an easy column to write, and it may not be an easy one to read. Part of the problem is that there is no agreement within the economics profession as how to interpret what is going on. I cannot recall any previous occasion in my lifetime when good economists were so puzzled.  Yet, what appears to be occurring is so fundamental, and may have such a huge impact on our lives, that readers deserve some sort of guidance.

The crucial fact we are trying to grapple with is that world interest rates are low. For the last six years base US interest rates have been near zero while key interest rates in Europe have turned negative. (New Zealand ones sit a little higher. That is because those who lend to us want a premium for exchange rate risk; but even ours have been falling to unusually low levels.)

A number of explanations have been put forward by a galaxy of the world's top economists including, Ben Bernake, Robert Gordon, Paul Krugman, Kenneth Rogoff and Larry Summers. (Yes, they are all Americans and all are broadly Keynesians - serious monetarists hardly appear nowadays, although populist pseudo-economists are inclined to warble on.)

Rather than go through each of their explanations (and tie readers into knots) I am going to offer – ever so tentatively –  my synthesis.

The effect of low interest rates should encourage investment in productive activities. (I'll talk about the impact on finance shortly.) That is not happening. It is possible that there is insufficient demand. But over recent years many measures have been taken to increase investment-inducing demand and they have had little effect. Six years is a long time – longer than from the beginning to the bottom of the Great Depression; you have to go back to the 1880s for a longer period of international stagnation.

The other possibility is that there are insufficient new investment opportunities. Of course there are some - think of the (art deco) cinemas constructed during the Great Depression. But there are not enough to generate a demand for savings to push up interest rates.

In his recently published The Rise and Fall of American Growth Robert Gordon argues that current technological innovations are not as significant as those of 100 years ago; that, for instance, electricity had a far more pervasive impact than computers.

I am a bit embarrassed to challenge such an eminent authority, and neither of us will be around when a comprehensive evaluation can be made. But the problem may not be so much the significance of the new technologies as that it is often difficult to make a profit from them. Your life is being transformed by the digital revolution, but many of the innovations' applications are not profitable. The media cannot work out how to make a profit from their news websites – while traditional media, such as newspapers, make losses. Twitter has not made a profit in ten years.

Suppose that Gordon - or my version of him - is right, then there will be much reduced opportunities to invest reasonably safely and interest rates will fall. The outcome will be the sort of world economy secular stagnation we are seeing. Certainly there remain some high risk investment opportunities with high putative returns but many will bomb out.

The point about the Gordon – or Gordon-plus – analysis is that we may not be experiencing a short-term stagnation. It may be that the world economy is going to remain in a slow growth stage of development for some time. Sure, there will be change, but returns on investments will be low.

This is a rather tentative projection, but it is worth exploring some of its outcomes. A curious one is that as rates of return fall, world wealth inequality may rise even though world income inequality falls. That is because the price of a financial asset rises when returns generally fall.

That induces more financial speculation, which is not underpinned by real economic activity to finance the speculators' consumption; ultimately it implodes. Remember 2008; we may repeat something like it in the not too distant future.

A particular example is housing. As interest rates fall, mortgage debt servicing becomes easier. So you can pay more for your house, the only restraint being the deposit. (That tends to lock out those currently renting - at least until their folks die and they inherit a share of their housing capital gains.) The rising house prices induce speculative investment for capital gains, although that cannot go on forever. I am not sure what happens in the long run.

For if the long-term secular stagnation theory is right, we are in uncertain territory, with outcomes we can only vaguely foresee, if at all.

Let me finish with one further example (thereby ignoring the implications for government spending. Retirees are grumbling that their incomes are being cut by the falling interest rates. So be it. The implication is they are going to have to consume some of their financial savings (so there will be less for their heirs). Systematically running down one's assets is called 'decumulation' (the opposite of accumulation). However exactly how to do it is unclear.

You won't get much guidance from financial advisers and their journalist counterparts, many of whom are likely to be stuck into a high interest mindset long after it becomes clear to everyone else that the world has changed.