Paul Krugman: “The era of low interest rates will continue”

Let’s recall the context: the low interest rates that prevailed just before the pandemic were the result of a downward trend that had been going on for three decades. A useful concept here, over a century old and due to the work of the Swedish economist Knut Wicksell, is the so-called “natural rate of interest”. Wicksell defined it either as the rate which matches saving and investment, or as that which guarantees price stability. These definitions are actually consistent with each other: an interest rate that is too low, so that investment spending exceeds the supply of savings, will lead to an inflationary overheating of the economy. And the fact that we haven’t seen any in the context of a three-decade decline shows that the decline was not artificial.

And that the natural rate of interest must have decreased during this period. Why could that rate have dropped? The most likely culprit is the fall in investment demand, caused by the combination of demographic stagnation and technological stagnation. However, since the 1990s, these two engines of investment have lost much of their momentum.

The number of Americans in their prime years, which had been rising rapidly for decades, has leveled off. An even sharper demographic slowdown in other rich countries. Europe’s working-age population has been declining since 2010, and it has declined at a fairly rapid rate in Japan.

Technological change is more difficult to identify, but it is difficult to escape the impression that major innovations are becoming increasingly rare. When was the last time you got excited about the latest iPhone? And on the other hand, estimates of total factor productivity, a measure intended to assess the overall technological level of the economy, have been rising slowly since the mid-2000s.

The jump in inflation is probably temporary

Is there therefore any reason to expect demographics or technology to be more favorable to investment in, say, 2024 than they were in 2019? I don’t see any. It is true that there have recently been many technological advances in green energy, and it is possible that an energy transition will contribute to investment in the years to come. But aside from that, the same factors that kept interest rates low before the pandemic still seem to be in place. What about inflation? Another useful old principle is the Fisher effect, according to which a rise in expected inflation should normally lead to an increase of the same magnitude in interest rates. However, the jump in inflation over the past 18 months is probably temporary. Because if we take the height, the situation presents itself as follows: during the crisis linked to the pandemic, governments have abundantly helped households in order to guarantee their income in the face of economic confinements. Consumer purchasing power remained high despite a temporary reduction in productive capacity, which pushed up prices – and caused central banks to raise rates to bring inflation down. Everything indicates that the financial markets expect inflation to return to pre-pandemic levels.

To sum up, then, the low interest rates were not artificial; she was natural. And it’s hard to see any factor that could push the natural rate up once the current inflationary spurt passes.

All in all, the era of low interest rates is probably not over.