Martin Wolf in yesterday’s Financial Times discusses the reasons for low interest rates and suggests some interesting scenarios for the years ahead. I agree with most of what he says but I have doubts about the role that he assigns to central banks.
Let me start with the arguments with which I agree 100%. The logic of the Bank for International Settlements that low interest rates are the outcome of central banks managing to keep interest rates artificially low for decades is “wildly impossible”. And the main reasons are that we have no economic model (or evidence) that suggests that central banks are able to manipulate real interest rates for decades and we do not either have any model (or evidence) that supports the idea that a central bank policy of low interest rates will not generate substantial inflation.
As Martin Wolf argues, any explanation for low interest rates has to start with some version of the savings glut hypothesis. Economic, demographic and social changes have expanded the desire to save among a significant portion of the world economy and this has kept interest rates low. This is an explanation that is consistent with any economic model that has an intertemporal dimension built into it and there is plenty of evidence that supports it.
What is the role of monetary policy in this story? Martin Wolf believes that because of the increase in desire to save in the world, central banks
“in seeking to deliver the monetary conditions needed for equilibrium between savings and investment at high levels of activity, the central bank has to encourage credit growth”
Here is where I am not sure I follow Martin’s argument. Why do central banks have to encourage credit growth? The fact that there is a savings glut that puts lower pressure on interest rates already means that somewhere in the world there will be an increase in credit/borrowing. There is no need for central banks to encourage credit. We can talk about whether central banks could have discouraged it, whether they had the tools and whether it was within their mandate, but there is no need to have central banks driving the process of credit growth to make the story consistent with what we have observed.
What makes the description of the dynamics of interest rates and financial flows that result from a savings glut difficult is the fact that we need to understand heterogeneity among economic agents (individuals, companies, governments). And this heterogeneity, combined with a regulatory framework that is limited, can drive dynamics that are unhealthy, excessive and lead to bubbles and financial crisis.
If there is a savings glut and interest rates are coming down this is a signal for someone to borrow more. Some of that borrowing will for sure be reflected in increase leverage because it will take the form of house purchases and creation of mortgages. Within some countries (e.g. China) we might observe that while the country as a whole saves, the private sector increases its internal debt exposure and leverage because of the exchange rate policies, government demand for foreign safe assets and capital controls that are part of their financial environment. There are plenty of stories like these that are triggered by a significant change in the economic scenario (lower interest rates) that might result in the financial imbalances that lead to crisis. The same way new technologies can create bubbles and financial instability (as in the 90s), the savings glut generated new and possibly excessive behavior as economic agents adapted (and not always well) to the new equilibrium.
Martin Wolf finishes with some thoughts on what come next. This is a difficult exercise as it requires a good understanding of economic trends across all regions in the world. There are some short-term forces that are playing against the savings glut hypothesis: oil producers countries are quickly reducing their saving, in some cases turning them into borrowers. But this is more than compensated by the Euro area that has become a large saver after the borrowers (Greece, Spain,…) have brought their current account deficits to zero while the savers (Germany, Netherlands) have not changed their behavior. So interest rates are likely to stay low and the saving surplus of some countries will have to be absorbed somewhere else (although it is not clear that the surpluses will be larger than in the past). Yes, this means a “credit boom” somewhere else but this should not always be a recipe for imbalances.
What the world is missing is investment demand. The real tragedy is that investment in physical capital has been weak at the time when financial conditions have been so favorable. Why is that? Jason Furman (and early the IMF) argues that the best explanation is that this the outcome of a a low growth environment that does not create the necessary demand to foster investment. And this starts sounding like a story of confidence and possibly self-fulfilling crises and multiple equibria. But that is another difficult topic in economics so we will leave that for a future post.