Lagging economic growth, savings glut mean low interest rates are here to stay

Nov 16, 2018

Credit Dr. Chris Erickson

Commentary: Donald Trump complains about high interest rates, directing his ire at the Federal Reserve. The Donald is wrong. Interest rates are not high but remain at historical lows. But this raises another question, which is why have interest rates been so low for so long? Is it head winds from the Great Recession or is something else going on?

The data is pretty clear. Starting about 1875 through the end of World War II, inflation-adjusted real interest rates were stable at about 2 percent, then rose to 2.5 percent by about 1980. Interest rates have been in a tailspin since. The world wide average as we speak is about .5 percent. This is a global phenomenon, with rates falling in nearly every developed country, from the United States to Japan.

Many have argued, including me, that recent low interest rates are a consequence of worldwide attempts by central banks to stimulate the economy in an attempt to fight the Great Recession. But the evidence no longer supports this view.

First, the interest rate decline started well before the Great Recession, back in the 1980s. Second, the Great Recession is well into the rear-view mirror, yet interest rates remain low. This is unlike previous financial crisis, when rates have quickly rebounded to previous levels.

The fundamental cause of falling interest rates is a decline in economic growth among developed countries, not the Great Recession. Because of slow economic growth, business demand for loans is weak.

Businesses borrow to fund investment. If the business expects the investment to pay a return of, say, 5 percent, then the business is willing to pay up to 5 percent to fund that investment. When economic growth rates fall, the return on investment is less, so business are less willing to pay high interest rates. Circa 1980, business prospects were good. Business expected economic growth and were willing to pay high rates. Not so now as the economy is stagnating.

The causes of the global slowdown are controversial, but most observes point to unfavorable demographic trends. Aging baby boomers are past their prime. Meanwhile, millennials are still a decade away from their maximum earning potential. Thus, there is a relative dearth of high productivity middle aged workers, meaning an overall less productive work force.

Then there is the slowdown in innovation. This cause of this is somewhat mysterious. Some point to the decline in federally funded R&D. If you look at the high-tech companies of today, nearly all of them have their basis in either DoD or NIH funded research. That research, as a percentage of GDP has declined.

The global slowdown is not the only cause of falling interest rates. The world is also experiencing a global savings glut. China and India are notorious for their high savings rates. As these countries incomes rise, the result has been a massive increase in savings. Asians want to invest this savings somewhere safe, that is, in developed countries. Developed countries are being inundated with gushing ocean of liquidity, pushing down short-term interest rates.

If you buy my argument about long term decline in interest rates, then Trump’s concern about the Fed raising rates too much too fast has some legitimacy. Increasing rates to pre-Great Recession levels would trigger a recession. The Fed seems aware of this and the modest rate hikes currently expected are meant move Fed policy from stimulative to neutral, which is where it should be for now.

Christopher A. Erickson, Ph.D., is a professor of economics at NMSU. He has taught money and banking for more 35 years. The opinions expressed are not be shared by the regents and administration of NMSU. Chris can be reached at