Inequality, Interest Rates, Aging, and the Role of Central Banks

The Overshoot

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Inequality, Interest Rates, Aging, and the Role of Central Banks<br>Bad things lead to more bad things. But (some) bad things can be fixed.

Matthew C. Klein<br>Aug 31, 2021

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Here are three facts about the recent history of the world:<br>Income has become more concentrated within societies. Both the shares of household income going to the top 1% and corporate profit shares have increased dramatically since the 1970s.

Inflation-adjusted interest rates are much lower now across much of the world than they were in the early 1980s. That’s contributed to a surge in asset values relative to incomes—and likely means that future investment returns will be much lower than in the past.

The human population has aged rapidly, with the global median age rising by about ten years since the early 1980s. The share of the population aged 65 and older in the high-income countries and China, which together account for the vast majority of global economic output, has already jumped from less than 7% in the 1970s to 13% today—and the United Nations projects that share will rise to 25% by 2060.

New research suggests that these facts are directly connected: the drop in interest rates has been caused by changes in population structure and by shifts in the distribution of income. 1 Lower expected returns on investment are just another consequence of deeper forces holding back economic dynamism.<br>Share<br>Two recent papers provide complementary explanations of the mechanisms at work. Adrien Auclert, Hannes Malmberg, Frédéric Martenet, and Matthew Rognlie focused on the demographic angle, while Atif Mian, Ludwig Straub, and Amir Sufi focused on income inequality.2 Before digging into their specific arguments, a brief refresher on the basics.<br>What are interest rates, anyway?

For most of history, humanity faced a harsh tradeoff: we could produce goods and services that could be enjoyed today, or we could invest in the production of capital goods and research that would hopefully support higher living standards in the future. But we couldn’t do both. Until relatively recently, simply securing enough food to prevent starvation was a major challenge.<br>That constraint isn’t nearly as binding now as it was when we lived as subsistence farmers. In fact, our big problem for the past few decades has been a glut of capacity that we’ve refused to put to work. We’ve been living below our means and have been actively discouraging new investment. Nevertheless, we still retain many of the social institutions that we invented to endure the long era of scarcity.<br>One of those social institutions is “interest”: a reward that society pays to those who voluntarily sacrifice spending power today in exchange for the promise of more spending power later. That sacrifice frees up resources so that others can spend more than they earn now. In exchange, the borrowers agree to either spend less later (if they are borrowing to buy consumer goods and services) or to produce more later (if they are borrowing to invest in expanding society’s productive capacity). Whether this is good or bad—and therefore deserving of reward or punishment—depends on each society’s circumstances. 3

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In theory, interest rates are supposed to encourage or discourage spending according to each society’s needs at different points in time. If there is too much demand for goods and services relative to current production, high interest rates can potentially help by making it more expensive to borrow and by raising the rewards for those who abstain from spending.4<br>But if nobody is consuming or investing, then it’s pointless to get people to spend even less. Thus inflation-adjusted interest rates tend to be higher when the economy is growing rapidly and lower (or negative) during downturns and periods of slow growth. From this perspective, the relentless decline in interest rates is a signal of serious social problems.<br>The search for “neutral”

In most economies, baseline interest rates are “set” by central banks. Private investors and traders then set the borrowing costs for businesses, households, and governments on top of those baselines according to duration, credit risk, and other factors.5<br>Central banks can impose any level of (local currency) borrowing costs on the economy that they want, which is why some say that “interest rates are a policy variable.” But central banks generally avoid exercising that power arbitrarily—and for good reason. Interest rates that are too high or too low relative to what makes sense can lead to undesirable consequences ranging from mass unemployment to currency collapse.6 That’s why most central banks instead try to meet the economy and financial system where it is.<br>However, central bankers have an incredibly hard time estimating the “neutral” level of interest rates because there are so many countervailing forces at play. Here are just a few...