Greg Mankiw wrote in the NYT about the puzzle of persistently low interest rates. Interest rates have been lower than ever before in history and they have been very low for decades so low interest rates seems to be the new normal. But why? Mankiw gives several plausible theories, but he misses an important one. He writes:
Several hypotheses might explain the decline in the natural rate of interest:
- As income inequality has risen over the past few decades, resources have shifted from poorer households to richer ones. To the extent that the rich have higher propensities to save, more money flows into capital markets to fund investment.
Mankiw is theorizing that inequality has increased the supply of savings, but it could also increase the demand for savings (borrowing) as poor people increasingly want to borrow. I haven’t seen evidence one way or the other for this.
- The Chinese economy has grown rapidly in recent years, and China has a high saving rate. As this vast pool of savings flows into capital markets, interest rates around the world fall.
This was a major influence back from 2004-2010, but China’s external lending has been quite modest since then, so it cannot explain why interest rates are even lower now than they were during the peak of Chinese lending.
- Events like the financial crisis of 2008 and the current pandemic are vivid reminders of how uncertain life is and may have increased people’s aversion to risk. Their increased precautionary saving and especially their greater demand for safe assets drive down interest rates.
There is no evidence for this. Plus, interest rates were already getting low before the crisis of 2008 and the value of risky assets like stocks has soared since the financial crisis and even the pandemic and this increased appetite for risky assets contradicts the theory.
- Since the 1970s, average economic growth has slowed, perhaps because of a slower technological advance. A decline in growth reduces the demand for new capital investment, pushing down interest rates.
The timing is all off for this theory. Growth has been low since the 1970s, but interest rates were particularly high during the 1980s. In theory lower productivity growth should reduce interest rates, so this should be part of the story even though the big-picture timing is off for the correlation.
- Old technologies, such as railroads and auto factories, required large capital investments. New technologies, like those developed in Silicon Valley, may be less capital-intensive. Reduced demand for capital lowers interest rates.
- Some economists, most notably the New York University professor Thomas Philippon, have suggested that the economy is less competitive than it once was. Businesses with increasing market power not only raise their prices but also invest less. Again, reduced demand for capital puts downward pressure on interest rates.
These last two theories are both very plausible, but difficult to measure and test. The last theory is supported by the fact that the stock market has soared and corporate power has been growing. Another piece of supporting evidence for the last theory is this:
Whereas in the early 1980s most of global investment was funded by household saving, nowadays nearly two-thirds of global investment is funded by corporate saving. This shift in the sectoral composition of saving was not accompanied by changes in the sectoral composition of investment.
The dramatic decline in interest rates reduces the incentive to save and should reduce net household saving and increase net household borrowing, so as corporations save more, that will also cause households to save less (and borrow more) by driving down the interest rate.
The theory that Mankiw completely missed is demographic change. As life expectancy increases, that increases household savings rates because people expect to have longer periods in retirement and a longer retirement increases the need for more savings. Meanwhile, it is young households that primarily borrow money for education and house purchases and as population growth has slowed, the percent of the population in that high-borrowing age demographic has shrunken. Finally, a nation with high population growth needs to invest more in expanding roads and infrastructure and school buildings and factories to meet rising demand. As population growth has slowed, investment has also slowed and less borrowing is needed to pay for it. Retired people simply don’t need as many goods and have more time for consuming services and the latter is typically a lot less capital-intensive than manufacturing (which Mankiw characterized as “railroads and auto factories”).