Friday, November 28, 2014

The Long Mystery of Low Interest Rates

CAMBRIDGE – As policymakers and investors continue to fret over the risks posed by today’s ultra-low global interest rates, academic economists continue to debate the underlying causes.  By now, everyone accepts some version of US Federal Reserve Chairman Ben Bernanke’s statement in 2005 that a “global savings glut” is at the root of the problem. But economists disagree on why we have the glut, how long it will last, and, most fundamentally, on whether it is a good thing.

Bernanke’s original speech emphasized several factors – some that decreased the demand for global savings, and some that increased supply. Either way, interest rates would have to fall in order for world bond markets to clear. He pointed to how the Asian financial crisis in the late 1990’s caused the region’s voracious investment demand to collapse, while simultaneously inducing Asian governments to stockpile liquid assets as a hedge against another crisis. Bernanke also pointed to increased retirement saving by aging populations in Germany and Japan, as well as to saving by oil-exporting countries, with their rapidly growing populations and concerns about oil revenues in the long term.

Monetary policy, incidentally, did not feature prominently in Bernanke’s diagnosis. Like most economists, he believes that if policymakers try to keep interest rates at artificially low levels for too long, eventually demand will soar and inflation will jump. So, if inflation is low and stable, central banks cannot be blamed for low long-term rates.

In fact, I strongly suspect that if one polled investors, monetary policy would be at the top of the list, not absent from it, as an explanation of low global long-term interest rates. The fact that so many investors hold this view ought to make one think twice before absolving monetary policy of all responsibility. Nevertheless, I share Bernanke’s instinct that, while central banks do set very short-term interest rates, they have virtually no influence over long-term real (inflation-adjusted) rates, other than a modest effect through portfolio management policies (for example, “quantitative easing”).

A lot has changed since 2005. We had the financial crisis, and some of the factors cited by Bernanke have substantially reversed. For example, Asian investment is booming again, led by China. And yet global interest rates are even lower now than they were then. Why?

There are several competing theories, most of them quite elegant, but none of them entirely satisfactory. One view holds that long-term growth risks have been on the rise, raising the premium on assets that are perceived to be relatively safe, and raising precautionary saving in general. (Of course, no one should think that any government bonds are completely safe, particularly from inflation and financial repression.) Certainly, the 2008 financial crisis should have been a wakeup call to proponents of the “Great Moderation” view that long-term volatility has fallen. Many studies suggest that it is becoming more difficult than ever to anchor expectations about long-term growth trends. Witness, for example, the active debate about whether technological progress is accelerating or decelerating. Shifting geopolitical power also breeds uncertainty.

Another class of academic theories follows Bernanke (and, even earlier, Michael Dooley, David  Folkerts-Landau, and Peter Garber) in attributing low long-term interest rates to the growing importance of emerging economies, but with the major emphasis on private savings rather than public savings. Because emerging economies have relatively weak asset markets, their citizens seek safe haven in advanced-country government bonds. A related theory is that emerging economies’ citizens find it difficult to diversify the huge risk inherent in their fast-growing but volatile environments, and feel particularly vulnerable as a result of weak social safety nets. So they save massively.

These explanations have some merit, but one should recognize that central banks and sovereign wealth funds, not private citizens, are the players most directly responsible for the big savings surpluses. It is a strain to think that governments have the same motivations as private citizens.

Besides, on closer inspection, the emerging-market explanation, though convenient, is not quite as compelling as it might seem. Emerging economies are growing much faster than the advanced countries, which neoclassical growth models suggest should push global interest rates up, not down.

Similarly, the integration of emerging-market countries into the global economy has brought with it a flood of labor. According to standard trade theory, a global labor glut ought to imply an increased rate of return on capital, which again pushes interest rates up, not down.

Surely, any explanation must include the global constriction of credit, especially for small and medium-size businesses. Tighter regulation of lending standards has shut out an important source of global investment demand, putting downward pressure on interest rates.

My best guess is that when global uncertainty fades and global growth picks up, global interest rates will start to rise, too. But predicting the timing of this transition is difficult. The puzzle of the global savings glut may live on for several years to come.

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    1. CommentedMichael Harrington

      Under the central banks' ZIRP the time value of money is zero, the risk premium is zero, and the inflation premium is zero. The existential signal of zero interest rates is that there is no tomorrow. So why lend money? Only for capital preservation against catastrophe. These are the symptoms of a very, very sick world economy still floating on a credit bubble.

    2. CommentedTom Whelan

      The savings glut hypothesis seems as deeply wrong as it is widely accepted. Central banks around the world are supplying the largest current consumers of credit – governments and banks – with no cost substitutes for private savings. In a world is starved for capital, interest on savings is low for much the same reason that food prices drop and remain low while relief agencies supply free food to relieve a famine. There is no food surplus. Free food displaces the normal food market, drives down food prices by increasing non-market supplies, depresses local farm income, and reduces locally grown food supplies going forward, often prolonging the famine. Even when the cause of the famine is over, farmers can't sell food as long as their customers can still get food for free. Relief agencies learned the hard way that relieving an acute famine by passing out free food produces chronic famine by preventing the recovery of healthy local farm economies.

      In much the same way that free food supplied in a food shortage reduces the price of food, the Fed’s policy of supplying free money to banks drives down the price for private savings. Deposits are loans savers make to banks. In the current policy environment, banks do not need to pay interest to private savers to attract deposits as long as Mr. Bubble Bernanke and other central bankers will lend money to the banks for nothing.

      But wait, there’s more. Every month, Mr. Bubble is buying taxpayer backed debt – treasuries and Fannie and Freddie bonds – in amounts roughly equal to the US government’s monthly deficit. In debt markets, unlike goods markets, more buyers for debt put downward pressure on the price of savings. The Fed is printing money to buy bonds so Uncle Sam cqn pay his bills, which means Uncle Sam does not have to offer higher interest to attract buyers for his bonds.

      Savers won’t find buyers, at any price, for their savings as long as Mr. Bubble continues to supply money to savers’ primary customers for free.

    3. CommentedC. Jayant Praharaj

      Short-term nominal interest rates are low due to aggressive monetary policy acting in the same direction in many major economies, increased risk-averseness among those who demand loans, increased risk-averseness about investment in the short run among businesses and possibly increased risk-averseness among private savers. For the rich economies, since inflation is low, short-term real interest rates and short-term nominal interest rates are not that different. So, the real and the nominal short-term interest rates should have the same determining factors as those mentioned above.

      Long-term real interest rates can be expected to be low for rich economies and several emerging economies due to diminishing returns and stalled productivity increases. The determination of long-term nominal interest rates requires expectations about long-term inflation trends. This requires forming expectations about economic recoveries and also about central bank commitments about employment and inflation in the long run. The long-term real interest rates can be expected to strongly modulate long-term nominal interest rates.

      Rich country interest rates and emerging country interest rates ( real and nominal ) are most probably determined by very different factors. There still are serious barriers to capital and labor flow between rich and emerging countries, so the determinants of the interest rates can be very different.

      Emerging economies may be growing faster than rich countries, but the growth rates of China, India and Brazil ( three of the biggest emerging economies ) have slowed significantly. China is transitioning fast up the product and services ladder and has already experienced a lot of capital accumulation. Productivity increase in China also may have slowed down like in the rich countries. This means China has probably begun experiencing the kinds of diminishing returns that rich countries have been facing for a while. While investment in China may be booming, diminishing returns will probably begin to play a larger role in the Chinese economy, similar to rich economies. India has its own problems in the areas of capital and productivity and spillover effects from the slowdown in rich countries.

      The extent to which capital can take advantage of a global labor glut through outsourcing or capital movement or labor movement has serious limits. Labor cannot move very freely between nations. Emerging countries and rich countries still specialize in very different segments and this puts limitations on the movement of capital and on outsourcing. So, there are serious limits to the extent to which a supposed labor glut affects returns to capital globally.

    4. CommentedKermit Johnson

      Is analysis of interest rates any different than analysis of pork bellies? I've asked this many times, and maybe here I can get an answer why it might be different.

      Interest rates are simply the cost of using money. When a buyer and a seller come together and agree, the price of using the money is set. Low interest rates are merely a sign that supply greatly exceeds qualified demand. So, for rates to rise, either the supply of money must come down, or the qualified demand for it must go up. Isn't the question then, what will make either happen?

    5. CommentedHans Listz

      i don't think of it as a "mystery" but "counter factual" given the extraordinary amount of debt that exists. "nothing succeeds like excess" while not a good explanation is certainly a GREAT starting point. here's how i explain it "generally." first the dollar is the world's reserve currency...still. with the Great Speculation fast becoming the Great Speculative Blowoff i think folks in the large industrial, mining and extraction industries are looking for a safe haven asset class now that the laws of supply (too much) and demand (way too little) are coming back with a vengeance. Treasuries fit that bill. I also think "the capitalists" (for lack of a better term) are suddenly being forced to take an interest in final demand...PRICING as it were...and the "composition of the New American Consumer." What they are discovering is UGLY but conforms well with other speculative blow offs in the past (the 20's, the 60's, the 80's, the 90's, the 2000's) yet more reason to bid Treasuries. Obviously the Fed "has your front AND your back" here...can't be what the Government itself is buying. And finally you have catastrophes in Japan, Europe and the Middle East that simply put are not going to be solved anytime soon. these were magnets for Global Capital but now that capital is fleeing predominantly for the USA. this productive capital will continue to drive up productivity, continue to drive innovation, continue to drive down cost...and ultimately drive down far and how dramatically remains to be seen. I think Europe will show the way to a MAJOR let us hope "not like that."

    6. CommentedDouglas Carr

      There's no mystery. The reason long-term rates are low is that investors expect short-term rates to continue to be low. As of today, with the 3 month at 0.07%, investors expect short rates to average 0.32% from 1-2 years out, 1.25% from 3-5 years out and 3.19% from 10-30 years out. The primary reason they expect rates to be so low is that rates have been low. Historical rates are the most important influence on expected rates. With inflation running above yields, it's a good question whether the expectations will be proven out, but that's what they are today.

      This is detailed in my papers on expectations at and on inflation at

    7. CommentedStamatis Kavvadias

      Not much insight into the possible reasons of the “global savings glut” in this article.
      Tim Chambers, below, puts it in a very convincing way, for me, though focused to a US local context.

      Could it be that 147 companies (indirectly) control the world economy, as the Swiss Technology Institute (ETH) of Zurich says ( Is it possible that these companies hold back their investments in derivatives, causing the crisis, and the resulting global lack of corporate confidence in such instruments causes the, so called, "savings glut”?
      The study says the 147 companies control 40% of the wealth of a network of 1318 companies, which control 80%(!!!) of world economy. These 1318 companies could easily account for the "savings glut”, even without taking into account the resulting reduction in company growth competition.

      Seeking the causes in the real economy, seems very misled to me...

        CommentedStamatis Kavvadias

        Of course, sovereigns and central banks pretend to be puzzled and to resent this "rational behavior" of the markets. Yet, there is no move to restrict the use of derivatives, and the cost is directed to non-"hedged" social investment, through austerity.
        The real economy sinks, except in sovereigns where tax on dividends can be avoided, and the banking sector enjoys immunity.

    8. CommentedMichael Holt

      I think it would be helpful to analyze this in an historical perspective. In doing so, an Andex chart referencing other key developments would be helpful. This will make it easier to see the impact of various developments on both the supply side and the demand side, and both internationally and domestically.

      In sum, there are many factors that have contributed to lower interest rates over time. Some of the developments can be described as changes in natural market forces, and others can be described as market distorting forces stemming from increasing levels of intervention on the part of governments and central banks and the growth of non-bank banks and even the new types of financial instruments in use today.

      The end result is a puzzling set of circumstances that has so far prompted more and larger policy responses on the part of governments and central banks around the world, leading to a condition that former PIMCO economist Paul MacCauley described as "stable disequilibrium." Until policy fatigue sets in leading to complacency, the rest of the world looks on with confusion, and essentially seeks answers to three questions:

      1. What is happening?
      2. What does it mean?
      3. What should I do about it?

      Much attention has been given to questions one and three, but question two remains largely unanswered which, in the meantime, makes attempts to answer question three somewhat meaningless.

      Normally, when there is no clear answer to the question "what should be done about this?" the answer is to leave it to the markets to sort through all of the intricate decisions that must be made in real time within all the nooks and crannies of the global economy.

      But, sadly, the result of many of the developments over time is that markets are now largely broken, and where the sources of market failures can be identified, identifying solutions doesn't necessarily follow given, for example, the divergent interests of those responsible and a general unwillingness to endure more than a modicum of pain. So, the number and magnitude of policy responses grows, further distorting the natural market forces of supply and demand in order to sustain a stable disequilibrium for at least a little longer.

      Clearly the direction of these developments is not sustainable but until either: (1) who knows what; or (2) sufficiently powerful market based solutions can be identified and agreed upon by all those who will be affected differently by such solutions, this is the path that policymakers have chosen to take, and for now at least, the rest of us have largely been willing to seek ways of getting around this in order to maximize our own well being and let someone else worry about someone else's grandchildren.

    9. CommentedTim Keese

      You are looking primarily at the supply side.

      What about the demand for funds? It seems to me that the struggling major economies and high unemployment are the best and simplest explanations for the low interest rates.

      That seems so obvious to me that I wonder why you don't even mention them.

      Might it be Krugmanphobia?

    10. CommentedProcyon Mukherjee

      There was a small error in my comment, Corporate America has an excess savings over investment of $1.5 Trillion.

    11. CommentedProcyon Mukherjee

      I have a different view to explain the savings glut as of now, one need not go a distance to emerging markets to understand the nuances of global savings glut. Corporate America is one of the highest savers and it has a savings of close to $1.5 Trillion, most of it privately held and invested in a mix of products, from fixed income to the more rewarding ones. This savings glut could have been mellowed had there been investment avenues (fixed investments) in the businesses Corporate America operates in, as going by the earnings per unit of capital invested, the rate of return is higher than what one would otherwise have been able to muster through the current investments that are outside the ambit of their current business arena. The obvious reason is lack of demand and the capacity overhang which is already so huge in the businesses where they operate. I do not see how the monetary transmission alone could change this savings glut to move from those stashed in assets that are non-core to the business to shift to the ones that are core.

    12. CommentedMichael Holt

      To what extent are low interest rates explained by the dramatic growth of interest rate swaps which allow investors to protect themselves from the risk of higher interest rates?

    13. CommentedTim Chambers

      Simple. Low wages plus increasing productivity and low corporate tax rates causes capital to accumulate but stifles demand, reducing capacity utilization, thereby reducing investment.

      Lots of capitalist surpluses with no place to go. Increasing taxes and investment in public goods would increase employment, raise demand and result in a virtuous cycle.

    14. CommentedHerbert Walter

      Far from there being an Asian savings glut, the point is that (outside China) Asian retirement systems are more insurance-based than in the west and therefore more closely conform to actuarial principles rather than political discretion and make-belief. This is our problem, not theirs.

    15. CommentedG. A. Pakela

      How can you say that quantitative easing has only a modest effect on long-term interest rates? The Fed as accomodated most of the budget deficit and it has been using its tools in an effort to lower long-term interest rates as a matter of policy. Are you saying that its efforts are ineffective, and if so why is the Fed taking on this risk if private savings would not only mop of the debt but bid interest rates to historical lows?

    16. Commentedarnim holzer

      Thanks so much for the note. We have been discussing this issue for so long that I think we have gotten stuck in the ruts of all the prior arguments. I would propose that the combination of poor demographics, protectionist and mercantilist policies can only explain a part of the problem. I think more likely is a temporary (which can be a decade long and in the scheme of history this is short) lull in the recognition of innovation and disruptive productivity improvement. Historically as changes in productivity are recognized, investing and spending is dramatically changed. Employees get more confident and start to spend on better hope and companies start to invest to meet demand. Simple, I know, but the impact of this cycle is what leads to upward pressure on rates. It doesn't matter where the workers are just that they get hope and ability to spend. As the developing markets mature and allow their workers to consume and earn the benefits of their productivity improvement we should see a break to this cycle of low rates. In the developed ageing world productivity improvement will still have impact through better equity returns and disposable income. In the developing world we should see the long awaited consumption movement that will bring higher rates.

    17. Commentedpieter jongejan

      Rising debt rates result in lower real interest rates and lower real interest rates result in lower profit rates and lower investment ratios. Lower investment ratios result in lower economic growth and even higher debt ratios. Low real interest rates and stagnating economic growth are here to stay due to the cheap money policies of central banks. Tyler Cowen should rewrite his ebook about low economic growth.