Facing The Long-Term Problem Of Low Interest Rates

Interest rates have been declining for several decades, both in the US economy and around the world. Why has this happened, what problems is it causing, and what monetary and fiscal policy responses might be appropriate? Elga Bartsch, Agnès Bénassy-Quéré, Giancarlo Corsetti, and Xavier Debrun tackle many of these issues in "It's All in the Mix: How Monetary and Fiscal Policies Can Work or Fail Together" (December 2020, Geneva Reports on the World Economy 23). 

As a starting point, here are a few examples of falling interest rates. The first figure shows the interest rate for borrowing money for a 30-year fixed-rate mortgage in the US.

This figure shows the "federal funds" interest rate, which is the interest rate targeted by the US Federal Reserve when it conducts monetary policy. 

As a third example, more theoretical but more conceptually accurate than the first two, consider the interest rate that economists call R*. As Bartsch, Bénassy-Quéré, Corsetti and Debrun explain:

R* is the real rate of interest that, averaged over the business cycle, balances the supply
and demand of loanable funds, while keeping aggregate demand in line with potential
output to prevent undue inflationary or deflationary pressure. Two key features of R* are
that it is (i) expressed in real terms (i.e., excluding inflation) and (ii) not subject to credit
risk. Hence R* is meant to capture the equilibrium (real) rate of return of a safe asset.

The R* interest rate is estimated, rather than observed directly. The authors report estimates showing a declining R* interest rate since 2000. 

Again, the R* interest rate is a real interest rate, stripping out any effects of inflation, and also a risk-free rate, stripping out risk of defaulting on loans. So what makes it decline? As usual for economists, the standard answer involves supply and demand: specifically, the global supply of savings has risen, and this higher supply of saving has not been matched by a concomitant rise in investment demand for saved funds. The authors write: 

More generally, however, an abnormally low R* is first and foremost a sign of economic malaise and imbalances ... Consensus explanations point to factors that simultaneously and inefficiently push global savings up and global investment down. Some of these factors are slow-moving and predictable. This is the case of accelerating population ageing in the West and in East Asia (China, Japan, South Korea). As individuals approach retirement age, higher wage income and the prospect of lower pension payments encourage them to save more to smooth their living standards over their remaining lifetime.


Yet, the issue is why these extra savings do not find their way into investment. After all, the effects of ageing on investment are not necessarily negative on balance. While the anticipation of shrinking markets in large economies is undoubtedly a drag on investment plans, a relative fall in the working-age population could be expected to raise the return on capital. In addition, a larger elderly population could entail reallocations of productive capacity, fostering innovation and, ultimately, investment as the aggregate consumption basket changes in favour of goods and services intended to alleviate the consequences of dependency. For instance, the return on investment in robotics, telemedicine and other innovative options to deal with dependency could be expected to rise. What prevents these arguably desirable developments from moving faster and on a greater scale?

Other slow-moving but less easily predictable factors include the significant rise in income inequality in many countries, the slowdown in trend productivity growth and an increase in market concentration. Greater income inequality is generally thought to raise aggregate saving as the income share of more affluent households – who tend to save relatively more – increases. Weaker productivity gains and greater market power could both contribute to lower private investment and boost corporate savings, resulting in sizable stock buybacks and purchases of low-risk financial assets, such as sovereign bonds from reserve currency issuers. And in fact, the corporate savings glut is an essential part of the story.

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