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.”

Will the Global Economy Survive the Brexit

  Pavel Constantin,  Romania, June 22, 2016 Caglecartoons.com,

UK's vote to become the first country to leave the EU, has the potential to start a motion that could unravel the post-war global financial structure and with it a deep plunging of the global growth. To be clear, the Brexit itself is not the culprit as we have argued before the global financial system has been in an extremely perilous situation over the past decade.

It is unfortunate that Brexit has happened in such  uncertain times when the US political situation is in such a precarious state  with the two highly  divisive presidential candidates; of whom one   is so out of touch with the global economic fundamentals that he constantly adds to the prevailing uncertainty by his uniformed and misguided policy statements and the other’s “extremely careless” use of a private email address and server has been mischievously exploited to render her as a completely ineffective leader, should she win the election. Meanwhile, the US economy is slowing down and a significantly higher dollar, partially reflecting the increased global risk, is exacerbating the global economic disorder.

In Asia, both China and Japan's economic and political situations leave a lot to be desired. A tepid global demand is intensifying the adverse impact of Brexit on Chinese exports at the time when the rise of dollar, vis-à-vis Europe’s currencies, may force China to react yet again by allowing a more rapid depreciation of its renminbi, which is scheduled to be included in the IMF’s basket of currencies making up the Special Drawing Right (SDR) effective October 1, 2016.  The country’s growth, after averaging almost 10 percent between 2006 and 2014, slowed to 6.8 percent in 2015 and it may slow to about 5.8 percent this year.   The  promised economic restructuring and the consolidation of inefficient state enterprises with chronic oversupply now appear of remote possibility, while the probabilities of political and social unrest should not be underestimated.

Japan’s economic malaise is also worsening and Abenomics appears dead after the Brexit.  A frightening fiscal debt level, a stagnant economy and an ineffective monetary policy with a damaging negative interest rate must now deal with the consequences of an appreciating yen against several currencies which will reduce its exports,   weigh heavily on its industrial sector’s earnings and undermine the country’s domestic investment prospects.

Of course, the brunt of the Brexit mishap will be felt mainly in Europe, and particularly in the UK where British pound has plunged to hit a record low of $1.28 since June 1985. The pound also fell to a near three-year low against the euro at €1.17. On the stock market, shares in domestic companies, such as supermarkets, housebuilders and banks, took the biggest hit on July 6^th after the Bank of England unveiled a four-point plan to cope with the Brexit crisis. With the economy dependent on his ability to act quickly, decisively and with full access to information, governor Carney provided a timely reassurance that “The bank can be expected to take whatever action is needed to promote monetary and financial stability, and as a consequence, support the real economy.” This was a reminiscent of the 2012 Mario Draghi’s pledge to do “whatever it takes” to save the euro, which has only been successful as far as it has postponed the day of reckoning for euro.   The bank of England has eased special capital requirements for banks, providing an estimated extra £150bn for lending, which would not be nearly enough to prevent the risk of a global contagion.

Of course, the answer to Brexit cannot be monetary policy.  The limits of central banking in Japan, Eurozone, and the US have already been observed. The answer to Brexit is not even in the hands of Europeans ( the UK included). The world global financial disorder requires an urgent restructuring to get rid of the global toxic debts, establishment of a purchasing-power-parity-based exchange rate system, and a Marshall-type plan to invest on global digital infrastructure, renewable energy, and eradication of poverty and diseases. Unfortunately, the world is faced with lack of credible and visionary leaders to push for such an agenda.