Why Interest Rates Are So Inconceivably Low?

In a recent article in the Washington Post professor Larry Summers has argued that the fact that the U.S. 10- and 30-year interest rates reached all-time lows of 1.32 percent and 2.10 percent on July 6th this year, as well as the record-low 10-year interest rates in Germany, France, Switzerland and Australia reflect a heightened recognition of the importance of the “Secular Stagnation” risks. He wrote:

There is a growing sense that the world is demand-short — that the real interest rates necessary to equate investment and saving at full employment are very low and often may be unattainable given the bounds on nominal interest rate reductions. The result is very low long-term real rates, sluggish growth expectations, concerns about the ability even over the fairly long term to get inflation to average 2 percent, and a sense that the Fed and the world’s major central banks will not be able to normalize financial conditions in the foreseeable future.

Thus, theoretically speaking, according to professor Summers the configurations of the supply and demand functions for investment funds now suggest a very low real interest rate  (most probably implying a negative rate at the full-employment level) which is unattainable due to the close-to-zero lower bound nominal rate. This argument as previously laid out by him and his co-authors Eggertsson and Mehrotra in Secular Stagnation in the Open Economy (NBER Working Paper No. 22172, April 2016) is based on Alvin Hansen’s idea of secular stagnation suggesting that:

the industrial world is plagued by an increasing propensity to save and a declining propensity to invest. The result is a declining equilibrium real interest rate, a tendency for lower bounds on interest rates to constrain their ability to find equilibrium levels, and a consequent persistence of inadequate demand leading to slow growth, sub-target inflation, and excessive non-employment.

Believing that the sluggish growth and low inflationary expectations are consequences of these low long-term real interest rates, Summers expresses concern that:

policymakers still have not made sufficiently radical adjustments in their worldview to reflect this new reality of a world where generating adequate nominal GDP growth is likely to be the primary macroeconomic policy challenge for the next decade.

But why there is an increase in global propensity to save? Are the interest rates providing relevant signals about the global saving propensity at the current sluggish economic environment? Moreover, what is the rationality for this bizarre economic agents' inter-temporal choice in such uncertain times? We note that Professor Summers' argument is grounded on the Swedish economist Knut Wicksell's thory of "Natural Interest Rate". Substituting the term "neutral rate" for the Wicksellian "natural rate" concept, he writes:

Secular stagnation occurs when neutral real interest rates are sufficiently low that they cannot be achieved through conventional central-bank policies. At that point, desired levels of saving exceed desired levels of investment, leading to shortfalls in demand and stunted growth.

We note that the Wicksellian theory is a general equilibrium theory in which the financial rate of interest that borrowers actually pay must be equalized to the natural rate of interest that is determined by the marginal return on the fully employed real capital. If the financial rate is below the natural rate the demand for investment will rise as businesses can borrow at the lower financial rates and invest the funds into high-returning projects. However, the information signals that a Wicksellian paradigm could emit are not meant for a disequilibrium environment in which the real capital is underutilized and businesses are postponing investment in irreversible fixed capital and opt for waiting.

When due to the prevailing uncertainty businesses refrain from investment and when in their capacity planning they resort to utilizing contingent labour and capital instead of moving towards their long term minimum average cost capacity the Wicksellian equilibrium theory would be an inappropriate analytical framework.  In fact, the concept of the natural rate of interest in a disequilibrium environment would be an oxymoron. The low and negative interest rates, are the prices savers are willing to pay to have access to a relatively less risky liquidity in these uncertain times. The factors influencing such inter-temporal preference is derived from a risk aversion motive.

As we have argued in the past, the economic agents are concerned about the precarious state of the global finance, the banking frailties, the high levels of various global debts, and a fast spread of political uncertainty. The sluggish growth and lack of demand are the consequences of a very disorderly structural adjustment in a perilous financial environment in which the old rules of the game have been abandoned and no new rules have yet been established.

The low interest rate thus is an indication of market assessment of the growth rate of potential output. As the following chart from Quartz show we have been in this situation also in the depression of 1930's.

This blog has referred in the past:

 “ to the suggestions of the prominent Swedish economist Gustav Cassel who in Brussels conference had recommended a re-balancing of the world flow of funds based on Purchasing Power Parity. A Cassel type of PPP adjustment does not necessarily require a gold-standard regime. A return to a Purchasing Price Parity can be grounded on a composite index of industrial materials. This process would create a realistic correspondence between the nominal world of finance and the real world of goods and services. A global annual GDP of 75 trillion dollars does not need to be lubricated by 600 trillion dollars of toxic assets."

We have also emphasized a need for restructuring of global debt and a need for a new global Marshall-type plan.  We also reminded the readers that:

in the eve of the London conference of 1933, the British Prime Minister Ramsay Macdonald, who understood the significance of the need for a global restructuring to establish a global financial balance, opined that the conference might possibly save democracy from the world’s economic challenges.”