The steady decline of real interest rates is certainly a puzzle, but there are a host of factors. First, we do not actually observe the true economic real interest rate; that would require a utility-based price index that is extremely difficult to construct in a world of rapid change in both the kinds of goods we consume and the way we consume them. My guess is that the true real interest rate is higher, and perhaps this bias is larger than usual. Correspondingly, true economic inflation is probably considerably lower than even the low measured values that central banks are struggling to raise.
Read the whole thing. It is part of an interesting symposium on secular stagnation. Pointer from Mark Thoma.
Rogoff also supports the hypothesis of financial crowding out.
Whether by accident or design, banking and financial market regulation has hugely favoured low-risk borrowers (governments and cash-heavy corporates), knocking out other potential borrowers who might have competed up rates. Many of those who can borrow face higher collateral requirements. The elevated credit surface is partly due to inherent riskiness and slow growth in the post-Crisis economy, but policy has also played a large role. Many governments, particularly in Europe, have rammed down the throats of pension funds, banks, and insurance companies. Financial repression of this type not only effectively taxes middle-income savers and pensioners (who receive low rates of return on their savings) but also potential borrowers (especially middle-class consumers and small businesses), which these institutions might have financed to a greater extent if they were not required to be so overweight in government debt.
I have an explanation for secular stagnation and low interest rates as being caused by stagnating labor productivity in what you call ‘The New Commanding Heights (NCH)’ sectors. (Health Care, Education, Government, etc.) Let me explain.
First, I can hear an objection, “Stagnating productivity? But aren’t certain people complaining about what they claim is a maldistribution of the gains of rising productivity?” I’m with Tyler Cowen – the labor productivity data is bunk for NCH sectors of non-outsourceable services paid for largely by third-parties such as the government.
Lets recall the Great Centralization story I told in an earlier comment. If you look at how many people are employed in which sectors, you’ll see that what happened to agriculture and commodity production – which used to employ the bulk of the whole labor force everywhere – is now happening to manufacturing too (a situation which is amplified in developed countries by globalization, outsourcing, and the Great Factor Price Equalization), and also anything that is replaceable by automation or the zero-marginal-cost-scalable internet (e.g. travel agents vs. kayak, brick-and-mortar-retail vs. amazon).
The fraction of the population in developed countries which is employed in the production, transformation, and distribution of tradable tangibles or internet-replaceable services has been shrinking for a few decades and continues to implode. Don’t take my word for it, do what I’ve done and look at the employment numbers.
Everybody displaced from these sectors has to adjust and find some other thing to do to earn the next best income they can. So the question is, what is the nature of the kinds of things that are left for people to do? Where have they been going, and thus where are they likely to continue to go?
The answer is “non-outsourceable, non-automatable services” that are somehow – probably through regulation – insulated from global competition. That is, NCH sectors.
Now, what is the nature of the trend of labor productivity in these sectors, and thus the driver for economic growth in the developed economy as a whole?
The answer is “pretty flat”. A surgeon is not doing many more surgeries today than his counterpart was doing 50 years ago. His surgeries may be better, but the evidence is that the growth in marginal QALY’s per dollar spent on physician activity (i.e. not just drugs) hit the domain of diminishing marginal returns a long time ago. A teacher is not teaching many more students than they did in the past. An hour massage still takes an hour. Judges aren’t deciding four times the number of cases per week as their predecessors, etc. Planes aren’t any faster than they were fifty years ago, so how many more places can a salesman or CEO or diplomat go in a week? Telecommuting and conferencing never lived up the hype, and what’s left are human activities servicing, coordination, or interacting with other humans in close proximity.
You see the problem? Humans can only interact with each other at fixed human speeds. They can’t get more productive at those kinds of activities or services, but this is increasingly the only work left for them to do. Economic growth per capita depends on people producing things at an ever-accelerating pace, but that’s impossible if the things they are producing can’t be sped up, or, as in the massage example, consisting of ‘human time’ itself.
These workers can’t satisfy the Solow story and get augmented by extra capital or technology to increase their productivity. They are probably already saturated with all the human and technological capital they can profitably exploit.
And so what you get is a new (permanent?) labor productivity stagnation.
The next question is why does this lead to low interest rates. Three reasons.
One is just population growth rates. Hard to get much growth and satisfy all those pension obligations when, collectively, people didn’t have enough kids, and so the number of workers is flat or declining in a lot of countries.
The second reason is that since more people are doing work in which labor productivity cannot increase very much, the overall amount of services produced in the economy cannot grow very much (especially in real, per-capita terms), and so neither can consumption or aggregate demand.
You might say that manufacturing could still grow fast, but it can only grow as fast as the most constraining bottleneck, so that’s not true if it hits some fundamental challenges in trying to cheaply overcome natural scarcities in key resources, such as energy. I think the evidence points in the direction of ‘hard to overcome bottleneck’.
The third reason is something that becomes clear if you think about this from an entrepreneur employer perspective. Why do entrepreneurs borrow capital, or, in other words, where does the future-production-focused demand for capital come from that would support higher real rates of interest?
Let’s think about what the answer was back to when farming occupied most of the labor force, which was the Solow Narrative. I own some farmland and employ fifty laborers with shovels. But I only have to employ five of them if I could get a tractor, and if the prices, wages, and interest rates work out right, then I’ll try to borrow some money, contribute to the overall demand for capital, equip my laborers with more capital-per-capita, increase their labor productivity, and after the economy recalculates and the displaced workers get jobs in industrial manufacturing, the new equilibrium is a richer country with more aggregate everything produced and thus consumer per person. So rates are high.
And this can happen again – and did in fact happen again – for industrial manufacturing. But now what happens when the entire tangibles sector (and automatable and outsourceable services sectors) take up a smaller and smaller portion of the labor force?
There’s nothing an entrepreneurial employer can buy to augment his workers to increase their labor productivity. They’re no equipment or anything for him to invest in. There’s no point: labor productivity in NCH sectors cannot be increased.
This follows inexorably from the logic of labor market equilibrium, because, over time, people will be displaced out of those areas rising in labor productivity relative to the mean, and thus disproportionately be employed in those sectors that are relatively stagnant.
The secret to secular stagnation and low rates is thus economy-wide Baumol disease.
In other words, the great industrial era project of several centuries has finally advanced to the point where the output in those sectors has become so amazingly efficient and productive that we’ve painted ourselves in a labor-market corner. Most people are now doing things in which the real market value of their output stopped accelerating a long time ago. And it’s just going to get worse.
Outstanding comment. Hats off to you.
I don’t find explanation #1 by Rogoff to be convincing. If anything, I would guess that real interest rates are understated because measures of inflation focus on consumer goods. If you include some element of assets in the measure, then inflation would be higher, and thus real rates lower. In other words, asset price inflation has generally been much higher than consumer price inflation, and it isn’t clear to me why measures of inflation should be only consumer focused.
I find explanation #2 by Rogoff to be the most likely cause of low interest rates. First, the onset of low interest rates seems to have been prevalent as the world moved forward from the 2008/2009 financial crisis, and this period has also been one of heavy central bank intervention (i.e., crowding out). Second, it is my understanding that certain countries have had a heavy financial repression bent, (e.g., China) and these countries share of GDP has grown over the past decade. Consequently, those countries that have institutionalized the practice of “crowding out” may be comprising a larger part of the global mix. I also wonder whether the recent political consolidation….ah I mean corruption crackdown in China has caused some outflow of investment dollars from that country, which in turn has had the effect of accelerating the export of “crowding out” effects from China to the ROW. Just speculation on that last point.