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OPINION

Why interest rates have fallen

Why interest rates have fallen
December 1, 2015
Why interest rates have fallen

Story one is that companies are still reluctant to invest. The share of business investment in GDP, at 9.8 per cent in the second quarter, is still below its pre-recession levels and far below the 13 per cent-plus ratio we saw in the late 90s. Rather than invest, companies are building up cash: their bank deposits have risen 12.7 per cent in the last 12 months.

Story two is that business investment is picking up. It's 38 per cent higher than it was at the trough of the recession, and its share of GDP is now back above pre-recession levels.

Both stories are correct. Story one refers to the cash that companies invest; story two to the volume of investment, the quantity of investment goods they buy.

The two are consistent because the relative prices of investment goods have fallen: in the last 20 years they've dropped by 8.4 per cent while other prices (as measured by the GDP deflator) have risen 57 per cent. This means that a given amount of cash buys more capital goods than it once did. This means that spending in cash terms seems low while the volume of spending seems high.

This paradox is only possible because demand for investment goods is price-inelastic: companies do not buy many more when prices fall. There are many reasons why this is the case. There are limits to how far capital can replace workers: for example, supermarkets have introduced self-service tills, but still need a member of staff to help customers use them. Low animal spirits and/or weak aggregate demand means companies fear they'll be unable to see extra output. They might be loath to invest for fear that further falls in capital goods prices will allow companies that invest later to undercut them. Or maybe companies just can't think of what to do with new software.

Whatever the reason the implications are enormous, as the Bank of England's Gregory Thwaites has shown.

If a fall in relative capital goods prices does not cause a one-for-one rise in the volume of investment, then cash spending on investment falls relative to GDP - as has happened. This, though, means that investment makes less demand upon the flow of new savings. The laws of supply and demand thus tell us that real interest rates will fall. Again, this is just what has happened since the mid-1990s.

But, of course, falling real interest rates have effects. One is to increase financial fragility as banks and investors search for yield elsewhere. Another - not unrelated - is to increase house prices as mortgage costs fall. In this sense, says Mr Thwaites, lower capital goods prices help to transfer real resources to the old who own houses from the young, who must pay a fortune to buy or rent.

There's more, as Nicola Borri and Pietro Reichlin of Rome's Luiss University, have shown. If people are spending more on housing they have less to spend in more dynamic sectors of the economy. This will tend to depress aggregate growth because of simple maths: the weight in the economy of a relatively stagnant sector rises. In this sense, secular stagnation can be self-perpetuating: low interest rates, in raising house prices, lead to slower growth. This might help explain why interest rates are still low, even though the relative price of capital goods has stopped falling in the last two years.

There are, perhaps, wider points to this story. The fall in capital goods prices is due in large part to the IT revolution: it's one manifestation of Moore's law. Pretty much nobody, however, predicted it would have these effects. This warns us that technical progress has unexpected consequences.

Also, I suspect that few of you pay much attention to the relative price of capital goods. And yet it might lie behind some of the most important economic developments of recent years. This reminds us that our economic fortunes, for good or ill, can be shaped by facts of which we are barely aware.