Ken Rogoff writes a very interesting article on the mystery of low interest rates. He starts by going back to 2005 when Ben Bernanke blamed the “Global Savings Glut” for the unusually low (by historical standards) real interest rates in the world economy. His comment was a reaction to the conventional assumption that interest rates are determined by central banks. As Ken Rogoff correctly argues,
“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”)”
Interest rates should be seen as the price that clears a market where the supply of funds (saving) meets the demand for funds (investment). A shift in the global supply of funds through a combination of the aftermath of the Asian crisis, the reaction of oil-producing countries as the oil price was increasing as well as the increasing savings from Germany and Japan (a result of low growth and contained domestic spending) led to falling interest rates in the period 1998-2005.
What has happened after 2005? Interest rates stabilized for a few years but then during and after the financial crisis we have seen a further decrease in the real interest rates to levels close to zero or negative. Ken Rogoff argues that this is more of a mystery, that the behavior we have seen in saving and investment during these years cannot justify a further decline in interest rates. I am not sure this is the case. A slowdown is likely to reduce interest rates. Yes, China’s investment stayed strong but so did its savings. And in advanced economies we witnessed a collapse of private investment as well as a large increase in private savings (partly compensated in the early years by government spending but not so much since austerity has kicked in). So we have all the conditions to see a further decrease in interest rates during the period 2008-2013.
In particular, what has happened to saving in emerging markets since 2005? Rogoff argues that
“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.”
I am not sure I share Rogoff’s views. Central banks or sovereign wealth funds cannot save, they can at most be managing the savings that either the private sector or the government have generated. Let’s take an extreme example: a country with a current account surplus where private citizens are not allowed to invest in foreign assets. In this environment, private savings will always show up in the form of an increase in foreign reserves at the central bank as private citizens redeem the foreign currencies that they earned from exports at the central bank in exchange for the local currency. The central bank is not saving, it is simply the destination of all foreign earned income (and not spent). This story fits well with the accumulation of foreign reserves in China and other emerging markets that we have witnessed in recent years. A similar story holds for sovereign wealth funds, they are simply the vehicle through which savings (private or public) are channeled into foreign assets.
There are other factors that have possibly influenced real interest rates in recent years: from the flight the quality as a result of the crisis, or the potential influence on portfolio allocations of quantitative easing, but it seems to me that an explanation as simple as demand and supply shifts represented by savings and investment in global financial markets still can produce a reasonable story that explains most of the evolution of interest rates since 1998.