All my friends know the low rider. The low rider is a little higher. Low rider drives a little slower. Low rider is a real goer. Low rider knows every street, yeah, low rider is the one to meet, yeah. Low rider don’t use no gas now. Low rider don’t drive too fast. The lyrics to the 1975 song by the band War describe the cool impact of the Mexican-American hot rod culture of the early 1970’s. It can also describe interest rates in most of the developed world over the past few years. In fact, interest rates on the benchmark 10-year Treasury Note have been generally falling since 1981, and are now lower than at any time since the late 1950s. In real, or inflation adjusted terms, long-term interest rates are basically at zero percent right now. How can this be? Why would people be loaning the Federal government money and not expect at least some return?
Listening to the media or reading the popular press might suggest that the Federal Reserve is setting interest rates at low levels in order to help stimulate the economy, and while it is true that the Fed has set interbank interest rates at near zero, the Central Bank has little control over long term interest rates like the rate on the 10-year note. These rates are set by the same supply and demand mechanisms that set all prices in a free-market economy. If there is little demand for loans and a lot of money chasing that demand, interest rates will fall. On the other hand, if there is a lot of demand for money and few resources available, then the opposite would be true. In short interest rates are the price for money.
Since interest rates are set by the market, what is it about the supply of money and the demand for money that are forcing rates into negative territory? Many mainstream economists have looked at the demand side for money and have suggested that the economy has changed. Factors like an aging population, falling prices for capital goods (machinery and equipment) and a shift from a manufacturing to an information economy have seriously reduced the demand for capital. But this explanation does not reflect much understanding of markets. As former Fed Chairman Ben Bernanke suggested in a recent Brookings Institution blog post, demand is flexible and at negative real interest rates almost any investment is profitable. Think of it in personal terms, if someone is paying you to use their money for the long term, you can purchase nearly anything knowing that you would never have to pay the money back. And businesses across the country are taking advantage of inexpensive money, issuing low-cost bonds and using the proceeds to buy back equities. In other words, the low cost of money is being used not to create new productive assets but to buoy the stock market.
Bernanke goes on to suggest that it is the supply side of the money market that is forcing down interest rates, and this is because there is what he calls a global savings glut. Bernanke suggests that major exporting countries, namely China and the big oil exporters, have been hoarding capital and that this is forcing up the supply of money and forcing down interest rates. There is some truth to this, particularly in the case of US money markets, but not due to a savings glut, but rather the lack of investment opportunities and rule of law in many major economies. Investors in countries ranging from Russia, to the Middle Eastern oil producers, to Venezuela and Argentina are all funneling their cash to US markets and investments. In an economy where the government can summarily appropriate one’s savings, an investment with a guaranteed return of -1 or -2 percent looks good.
With huge amounts of capital flowing into US money markets forcing down interest rates, why then is demand not responding? As was mentioned before, it is. But the nature of the demand is not particularly productive. While former Chairman Bernanke is correct in pointing out that with low or negative interest rates even marginal investment opportunities would be profitable, he did not mention that with virtually free money, purchasing nearly any existing capital asset also becomes less expensive. So rather than going through the trouble of dealing with regulations, boards of directors or persnickety customers, businesses are pushing up their earnings per share by simply reducing the number of shares on the market. Rather than investing in new businesses, foreign investors are simply parking cash in expensive apartments, or in impressionist paintings. This is why art auction prices are at record levels and New York City apartments are selling for unimaginable amounts.
It’s easy to change the pattern and put all of this pent up savings to work creating jobs, increasing output and buoying tax revenues. Simply make is more profitable to invest in work rather than in stuff. This can be done by reducing regulatory burdens, or corporate tax rates, or the societal risks involved in starting and operating a business. The problem with the American economy is not over saving and is not a lack of demand, it simply don’t use no gas now. It don’t drive too fast.