Failure to address demand could blight recovery

Opinion: failure to answer question of demand was leading cause of financial crisis.

Former US treasury secretary Lawrence Summers has argued that the high-income economies seem to be worryingly unable to generate good growth in demand without extreme credit instability. Photograph: Alex Wong/Getty Images

Former US treasury secretary Lawrence Summers has argued that the high-income economies seem to be worryingly unable to generate good growth in demand without extreme credit instability. Photograph: Alex Wong/Getty Images


Why are real interest rates so low? And will they stay this low for long? If they do – as it seems they might – the implications will be profound: good for debtors, bad for creditors and, above all, worrying for the vigour of global demand.

The International Monetary Fund’s latest World Economic Outlook includes a fascinating chapter on global real interest rates. Here are its most significant findings.

First, globalisation has integrated finance. There used to be wide variation in real interest rates between different countries. That is no longer the case, since interest rates everywhere now respond to common influences.

Second, real interest rates – which are adjusted for inflation – have declined a long way since the 1980s. Ten-year rates are close to zero while short-term rates are negative. But the expected real return on equity (estimated from the dividend yield plus the expected growth of dividends) has not fallen by as much.

How is one to understand these developments? The real return on financial assets depends on various factors: how much people want to save and invest; what kind of assets savers prefer to hold; and changes in monetary policy. These are not independent of one another. Above all, central banks charged with hitting an inflation target must respond to shifts in demand by changing their monetary policies.

Changes in monetary policy
The IMF reckons that, in the 1980s and early 1990s, changes in monetary policy were the most powerful influence on real interest rates. In the late 1990s, fiscal tightening became the main force driving down real rates. Another important factor was the falling price of investment goods relative to consumption goods. Falling relative prices of information technology mean this is still true.

Since the late 1990s, however, much has changed. In emerging economies the savings rate has gone up, largely because incomes were rising. Investors began to favour assets deemed safe. Most importantly, recent financial crises have caused investment to collapse and private savings to jump in the affected economies.

The IMF argues that declining inflation risk has not contributed to the fall in long-term rates, since the “term spread” – the gap between short- and longer-term rates – has not fallen.

More important has been the effect of changes in national savings and investment. At the global level, savings must equal investment. So changes in the observed global savings rate will tell us nothing about whether there has been a growing “savings glut” – by which I mean an excess of desired savings over desired investment. Only a shift in the price – the real rate of interest – reveals that.

Strikingly, the 10-year real rate of interest was 4 per cent in the mid-1990s, 2 per cent in the 2000s, before the crisis, and close to zero thereafter. At least two factors lay behind this precipitous fall. Investment fell a long way in high-income economies but soared in emerging ones, especially China; yet the savings rates of emerging economies rose even more than their investment rates. Consequently, these economies became big net exporters of capital.

‘Safe’ assets
Emerging countries also largely nationalised this capital outflow. Their governments then tended to buy “safe” assets, especially to put in the foreign exchange reserves. This helps explain the portfolio move towards highly rated bonds.

The story, in brief, is that shifts in the balance between desired real savings and investment generated a large fall in real interest rates.

These were accompanied by changes in portfolio preferences towards safe assets and the collapse in the pre-2000 equity bubble. The shift in the distribution of income towards capital and highly paid employees in high-income countries also weakened demand.

The central banks then responded with aggressive monetary policies. These supported explosions of credit generally linked to house-price surges. Both imploded in the crisis. As economist Lawrence Summers has argued, the high-income economies seem to be worryingly unable to generate good growth in demand without extreme credit instability.

This is not a short-term story. The label “secular stagnation” looks apposite. The IMF agrees that real interest rates could remain low for a prolonged time. If governments persist with planned tightening of fiscal policies, this seems certain. If investment rates fell sharply in China, global real rates might need to fall still further. That is difficult while inflation is so low.

What might reverse this? The obvious possibility is a jump in investment in high-income countries driven by the relatively high expected returns on equity. The obstacles here are threefold.

One is that chief executives are not rewarded for investing for the long term; another is that investment goods are becoming cheaper all the time; and another is that, when the future is uncertain and the economy sluggish, companies rationally prefer to wait before they invest.

Another possibility is a big fall in savings in emerging economies. But this seems unlikely, at least without a collapse in oil prices. That leaves the option of sustained fiscal deficits in high-income countries, ideally to be invested in infrastructure. Housing-related credit booms are a far worse option. Redistribution towards the spenders seems quite inconceivable.

Real interest rates
If real interest rates do indeed remain low for a long time, creditors are going to find life difficult. But managing the post-crisis public finances should be far easier than the hysterics assume. A really big question in such a world is whether conventional inflation targets might be too low, because they do not give enough room for real interest rates to fall as far below zero as necessary.

The immediate question, however, is: how do we generate the demand that is needed to mop up potential global supply?

Failure to answer that need in a sensible way was a leading cause of the crisis. Continued failure will blight the recovery or, worse, cause another bout of financial and economic upheaval.

Do not imagine these challenges will soon vanish. They look like a semi-permanent condition. – (Copyright The Financial Times Limited 2014)

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