Scott Sumner on Interest Rates

Intro. [Recording date: April 14, 2015.]Russ:We have a few topics I hope to get to today, but I want to start with one of your favorite themes, which I'll introduce with an observation of Nobel Laureate Robert Shiller's. In a recent interview he referred to what he called a puzzle, a puzzle of our time, and that puzzle is: Why is there so little investment, either public or private--but he mentioned private in particular--given how low interest rates are? Because we think low interest rates should stimulate investment, and yet investment seems to be very stagnant and very low. So that seems to be a puzzle in his eyes. But in your eyes, and I would add in mine, it isn't a puzzle. So, what mistake is he making?Guest:He's doing what I call 'reasoning from a price change.' And, let me start off with an analogy from just basic supply and demand--might make it easier to follow. So, suppose I told you that I had a crystal ball and I knew that oil prices next year were going to be much higher than this year. Could you predict what the implications would be for consumption, oil consumption, from that fact? Now, a lot of people I talk to think, oh, economics tells us that if prices are high, people consume less. But that's actuallynotthe prediction of the supply and demand model. It depends on what causes the price to rise. So, if oil prices are high because OPEC (Organization of the Petroleum Exporting Countries) cuts production, then, yes, people will consume less. However, if oil prices are high because demand shifts out, maybe the global economy is booming, then the higher prices will be accompanied byhigherconsumption. So it really depends on whether the supply or the demand curve shifts, before you interpret what the impact of a price change is in general. It's just a common fallacy you see in the news media all the time. Now, here, with Shiller's example, he was sort of assuming that the reason for the, say, low interest rates was maybe an easy-money policy by the Fed. And if that was the cause you might expect more investment to occur. But it's equally likely, and I would argue even more likely, that the cause of the low interest rates was a shift in thedemandschedule. That is, firms were engaging in less investment, and as a result there was less demand for credit, so interest rates are low and there's less investment occurring in the economy. And that's perfectly consistent with supply and demand. Now, even worse, in some cases when people reason from a price change, they are usually right because they've identified which curve shifts most often. In this case, though, he got it exactly wrong. Typically, during low interest rate periods, investment is low; and during high interest rate periods investment is high. And the reason for that is interest rates are strongly pro-cyclical. They gowiththe business cycle. So, typically, in a recession, interest rates are very low, and in a boom period interest rates are higher; and of course investment goes with the business cycle as well. So there's nothing surprising about low interest rates being accompanied by low levels of investment. It's what we usually observe in the economy.Russ:So, I want to come back to that--to this particular example of interest rates--but I want to go back to your original point first, which is about supply and demand. And so, I taught microeconomics for about 30 years, and I would always spend a number of classes--and there's quite a bit of material in my online resource on supply and demand, which we'll put a link up to, where I talk about different fallacies, mistakes that people make when using supply and demand. This is one of my favorites. It's to confuse a shiftalonga demand curve with a shift in the curve itself. This is a classic principles or intermediate price theory kind of problem. So the example I use with my students would be the following. I'm not going to answer it. You can answer it in the comments if you want. And Scott, you're not allowed to answer it, either, okay?Guest:Oh, okay.Russ:So here's the question. Suppose you see a new housing development that's being built near your neighborhood. Should that depress you? It seems like it should, because it's an increase in supply. It wouldseemthat it would be followed by a reduction in prices and that would mean thatyourhouse is going to be worth less than it would otherwise be worth because this new competition has come onto the market. So, you have this piece of information. The information is that--and by the way, what I just said, if you look at it in the transcript, part of that is going to be true and false, some of it is confusing, and some will be true some of the time. So I'm going to restate it now to make it a little more clear: If you see a new housing development going up and you are worried about the value of your own home, should this information that there's this new housing, should that make you happy or sad? And I think if you can answer that correctly you understand something I think subtle about supply and demand. I want to give one other example. I used to get called by people in the media--they don't call me anymore because they are smart--but they used to ask me what I thought about some recent result in the value of the dollar, a change in the value of the dollar. And they'd say, 'The dollar's rising', or 'The dollar is falling.' 'What's the implication for the economy?' And I would always say, 'I have no idea.' Which is not a good answer if you want to get quoted. They were looking for something dramatic. But I'd always say that if you don't know thecauseof the appreciation or depreciation of the currency, how would you have any idea of what the implications are for the U.S. economy? And this particular error of reasoning from a price change, for me, gets meconstantly--probably every day--in the media; somewhere people are opining about the change in the price of some currency. And to me, it's a perfect example of your mistake.Guest:Let me give your listeners a perfect example. In the late 1990s the dollar strengthened because there was more demand for U.S. assets because we had a high-tech boom. That was the bullish [?] for the economy. In late 2008 the dollar strengthened because monetary policy in the United States was too contractionary in my view, which is also controversial. But anyway,thatsort of strengthening, if it's due to tight money, is actually a bearish symbol for the economy. So, it completely depends why the currency is strengthening. Same thing weakening. Our currency can weaken because you are suffering economic collapse, or it can weaken due to an expansionary monetary policy like in Europe recently, which might be expected toboostgrowth in Europe. So, it's exactly right--it depends why the currency is changing. And that, and interest rates are the two most common examples of where even professional economists tend to reason from price changes.

Russ:So, let's go back to interest rates. And I wish Robert Shiller were here. What you're suggesting--because he may have a defense. I can't imagine it. But that's a limitation of my imagination. But what you are effectively arguing is that the reason that interest rates are low is not because of an expansion of credit, but because of a contraction in, a reduction in demand. That is, ateveryinterest rate, people want to invest less than they did before. And therefore that desire to invest less, the demand curve shifts in, down and to the left, and the equilibrium interest rate falls. And the total amount of investmentfalls. And that's the end of the story, by the way. The other mistake that people make is they say, 'Oh, but if interest rates are low, that pushes out demand and interest rates go back up.'Guest:Yeah; and begin an endless circle.Russ:Yeah. Which is not the way it works. There's a new equilibrium interest rate, given the lesser desire that people have at every interest rate to invest. It takes a lower interest rate to clear the market than it did before. Why do you think there's a decrease in demand, and why are you content ruling out an expansion of credit? Because I think a lot of people--one thing maybe that Shiller would say is there's been ahugeexpansion of credit. And I guess another way to ask this question would be: Are you confident that investment is lower? Because that would be the sign that the equilibrium has moved down and to the left and not down and to the right.Guest:Yeah. And so, that's obviously kind of a complicated question. I think there's likely more than one factor today. But if we sort of take it back from a few years, it's pretty clear what was going on in 2008, 2009, and 2010. During that period, when interest rates fell sharply close to zero, it was really weakness in the economy. That was the main reason. So you had interest rates falling because nominal growth, nominal GDP [Gross Domestic Product] growth, was extremely low, even negative in 2009. And typically when that occurs and you have a deep recession with falling inflation, you get lower interest rates. The same thing happened in the 1930s, for instance. But that's not necessarily the explanation for today. And I think that what's going on is also reflecting sort of long run global forces having to do with savings/investment, which in my view are perhaps permanently or semi-permanently lowering the normal rate of interest in the economy. That is, the slowing population growth, the aging population, and so on, is leading to less investment. Meanwhile, you have the rise of Asia, which includes a lot of very high-saving countries. And so with these demographic changes, the savings-investment imbalance--and this is something that Ben Bernanke did talk about--is probably lowering the normal interest rate even when the economy is not severely depressed. And I would say today the economy is not actually all that depressed, although it depends how you measure and which variables you look at. But certainly not as depressed as it was 5 years ago. So the initial fall was the recession; but now I think we're also seeing the impact of longer-term forces. Idon'tthink it's due to what would be called an easy money policy, because if that were occurring we'd see rising inflation, and we just don't see that.Russ:Well, I'm going to try to get you to clarify some of that. You said it was complicated question and you gave, I would say, a semi-complicated answer. One of the lessons, as I was preparing for this interview, as I was thinking about the different things I wanted to ask you about is it is remarkable to me how complicated macroeconomics is, generally, in that there are many, many factors changing at once and we are all farmers--we are all picking cherries, we are all harvesters. We all pick cherries and we pick the things that seem plausible to us, the stories or narratives that seem to make sense to us; and we leave out everything else. And, you just made a list of a bunch of factors. I didn't think carefully when you were talking but I suspect they don't all go in the same direction. Some do and some don't. If we add all the factors we've mentioned so far. And then the question is: What are the magnitudes? So, to try to home in--which of course we can't measure those magnitudes in terms of the impact of each separate variable. But let's try to home in on some of these different factors. So, you said, interest rates were low in, say, 2008-2011 because the economy wasn't doing very well. Which means people are pessimistic about the future; they are not eager to invest; and that means people are not eager to borrow money. And therefore you don't get very much for your money when you try to lend it. That would be the argument. But then the economy bounced back. Quite a bit. As you said, you can debate how healthy it is right now. Why didn't interest rates go up? They haven't budged. They haven't budged. I guess it depends how you define interest rates. But the short term interest rate is still, by historical standards, very low. Why didn't they go back up?Guest:Yeah. So, it might help here to think about the way economists approach the question. We sort of partition it into a couple of different questions. One way we break it down is the distinction between the real and the nominal interest rate, where the nominal rate includes and inflation premium or adjustment. So, back in the 1970s when interest rates were very high, it was partly due to the high inflation that occurred.Russ:Those were highnominalrates.Guest:Nominal terms. Right.Russ:Mean, what we actually observe. And real is corrected for inflation. So, go ahead.Guest:Right. And so you can subtract out inflation from the nominal to get the real. Now, of course in recent years, inflation has been fairly low, so that's one of the reasons that nominal rates are lower than in earlier decades. But it's not the only reason. So the real interest rate has also fallen quite a bit. And that I think is the bigger puzzle. Because economists used to think real interest rates were fairly stable, at maybe around 2 or 3% on government bonds. And that's also fallen. So now when you look at the real interest rate, how do you explain that? And again, economists sort of partition it into two questions, a short run and a long run. They tend to think that in the short run the Fed has some ability to raise and lower real interest rates through monetary policy, but not as much flexibility as you might think, because there's costs of doing so. If you have an expansionary policy, you cantemporarilylower real interest rates, but at a cost of higher inflation. If you have a contractionary policy you canraiseinterest rates in the short run. But I would emphasize that these effects tend to be fairly short term, and the long-term effects eventually kick in, and you get it going the other way. So, in the 1960s we had an easy money policy. But after a while interest rates actually started rising because of the higher inflation. Now, a lot of people think we have a really easy money policy today. But I would argue that's kind of misleading, because we're not seeing any of the macroeconomic indicators that would support that contention. That is, we're not seeing inflation going up; we're not seeing any sort of overheating in the economy that we usually associate with monetary stimulus. So I think what's really going on is that monetary policy isn't as expansionary as it looks. It's more a defensive mechanism of the Fed injecting a lot of reserves into the banking system and the banks just sit on them because interest rates are 0%. But it's not having any stimulative effect. So I don't really think monetary policy is the factor that's holding down interest rates. If itwere, I think you'd be seeing higher inflation coming along, and we're just not seeing that. Nor are we seeing forecasts of higher inflation going forward. So, I'm just left with then, back to classical economics, supply and demand. We apply supply and demand to the credit markets through a savings and investment schedule: the more savings, the lower interest rates. More investment will raise interest rates. And we seem to be going to a global economy where there's a lot of savings going on and not as much investment as we're used to. And as a result those shifts in those schedules are pushing interest rates lower until they can find a new equilibrium.

Russ:Okay, I'm going to come back to this--I'm going to stop you there. I'm going to come back to the point about savings vs. investment, because I think that's an important point. But I just want to backtrack a bit and talk about real interest rates, because I think you said something that might have confused some listeners. You said, historically economists at least generally believed--and I think this is certainly true--that the real rate of interest, the productivity of the economy as a whole, is 2-3%. And then you said, well, government Treasury rates are in that area. But I think that's a little bit misleading. Because what you [?] really saying, the government sets an interest rate that will allow it to be in the market and effectively borrow. But it's responding to the overall, the more general rate in the economy as a whole, which is a measure of the productivity of the economy. So, when we say 2-3%, we usually believe that if you can put some money aside, there's usually something, an opportunity out there, that will let it grow at 2-3%, which would allow you to compensate your lender for the risk they took. And some things grow a lot faster than 2-3%; some things fail and be mistakes. But on average, the productivity of the economy is what allows there to be a positive interest rate. Right? Is that a good way to think about it?Guest:Yeah. I wouldn't say it necessarily has to be just productivity. It's also about just economic growth in general.Russ:Absolutely.Guest:So you can [?] like population growth. Australia typically has the highest population growth of the developed countries; and it's the highest interest rate of the developed countries. And, you know, a lot of people move to Australia; they have to borrow money to build homes there, to live there. And so that creates a demand for credit and supports a higher interest rate. If you think about the United States, for instance--just think about the housing market. We're producing so many fewer houses than we used to. And all those houses we were building prior to the Great Recession, and even going back into the 1990s and 1980s, someone had to save the money to lend to people for mortgages to buy those homes. Right? Now, if we're building far fewer houses, then there's much less need for savings to support that activity. But if people are trying to save just as much, saving just sort of floods into the credit markets and puts downward pressure on interest rates. So that would be maybe one concrete example I could give you of the forces pushing interest rates lower--there's just a lot less housing construction going on.Russ:And that, again, we're talking about real interest rates, correcting after inflation--and we should be careful--expectedinflation. If I'm going to lend you $1000 or lend you $100, and I expect to get back $103, and I'm pretty sure you are going to pay me back. So I ask for $103. If inflation is going to be positive over that year before you pay me back, I wantmorethan $103. Because otherwise I end up with less money in my pocket in terms of its purchasing power than when I started. So that's why nominal interest rates are affected byexpectedinflation. Of course, we don't really know what expected inflation is. We haveactualinflation, and we often use that to adjust nominal interest rates and call the result a 'real interest rate'. But it's not quite kosher. Right? There's a little slip there.Guest:Yeah. Let me just clarify one point. When you said, you want to get a certain amount back to compensate you for inflation and to earn a real rate of return and so on, the question of what youwantand the question of what you are willing to accept are two radically different things, and what we've discovered[?] recently--Russ:Yes. And what you have to accept. Yeah.Guest:So if people are trying to save a lot and there's not a lot of investment activity going on in the developed world, and all this savings floods into the market, you could easily get interest rates going below 0% as long as people are willing to accept that rather than the alternative. So they may be so anxious to save that they'll accept those low interest rates because they simply don't see any good alternatives. Now, economists also used to believe that nominal rates could not fall below 0% because everybody could hold cash as an alternative.Russ:The alternative is to put it in your mattress.Guest:Right. And you can always get a zero rate of return on cash, risk free. But now we've even foundthatisn't quite right. Interest rates have gone slightly negative in Europe. And itseemslike the explanation is that people don't really like to hoard lots of cash, hold huge amounts of cash. So, institutions in Europe that need to park a billion dollars somewhere, they would rather take a slightly negative interest rate than to try to accumulate that much cash somewhere. And so that's been a little bit of a surprise for us to see the rates go slightly negative. Now, we still believe they can't go very far negative, because at some point, people would switch over to just holding currency and putting it in safety deposit boxes. But we do see quite a willingness to tolerate low interest rates, especially in Europe and Japan today.Russ:Yeah. I had a great uncle who, when he traveled would carry money in grocery bags. I did not find that appealing. As a young person, I remember looking at that thinking, 'That's nuts.' And similarly, if you have $1000, you are willing to pay to have somebody hold onto them in safety rather than leaving them in your house where somebody might stumble upon it and take it away from you. So we generally are willing to paysomesort of premium for the security of a bank's system, the banking system. Whereas the mattress is not risk-free. It's got the risk of theft. And that's definitely part of it.Guest:Right. And so just to sort of summarize all of this, if we break down the mystery of low interest rates into two parts, the nominal and the real, we can say that one part of it is easy to explain. We understand that inflation is a lot lower. Expected inflation is very low. We understand how this has been accomplished through better monetary policy since the 1970s. And because we've got low inflation, we can expect lower nominal rates. The real mystery, as you indicated, is with the real interest rate. That's also lower than normal. And that doesn't seem to be as easy to explain. And that's where I suggest these global forces of savings, investment putting downward pressure. But there's alternative explanations. Ben Bernanke has a new article where he refers to a decline in the risk premium. So people are willing to accept lower rates than they used to on, like, 10-year Treasury bonds because they view them as beingsaferthan in the 1970s. In the 1970s they had to worry a lot about inflation risk. And also, they are the one safe asset in a world that is full of other types of risk, like stock market and housing market fluctuations. So, if you own Treasury bonds, when everything else is going down, like in 2008 and 2009, Treasury bonds arerisingin value. So that makes them very attractive as a way of hedging risk. And so for all these reasons, people seem to be willing to accept lower rates of return on Treasury bonds than in the past. As they say, in the 1970s, they were viewed as a veryriskyinvestment to make, because of the high inflation, high interest rates, and so on.

Russ:So, your answer right now, which I'm going to challenge--your answer is that there's a lot of savings, which is pushing down rates. And there's also the possibility--which I don't agree with either--I have a problem with both these parts of the answer. One part of the answer is that there's a lot of global savings. And the second part of the answer is there isn't a lot of optimism about the future--you didn't literally say this, but that's part of the reason potentially that the demand schedule for investment might be shifted in: it's that population growth is down, opportunities in the future don't look as good as they used to. So, here's the problem I have with it. There are two problems with it. First of all, if the savings glut--so-called 'savings glut', I hate that phrase; I don't think you like it either--but the enormous amount of savings going on around the world looking for a return, if that was the reason that nominal interest rates were low, we'd expect there to be enormous amounts ofinvestinggoing on as we slide down the demand schedule. As the credit pours into the market, the opportunities to use money pour into the market, that should result in lower nominal interest rates, and lots of investing. We don't see it--I don't think that's the case. I don't think the quantity of investing is up at all. Again, I didn't look into it--Guest:Yeah; you are right on that. Let me--it's always a little hard to explain these things verbally because I always think in terms of graphs.Russ:Draw away, maestro. We can all see it.Guest:But if your listeners picture like a supply and demand diagram but make the supply curve a savings schedule and make the demand curve the investment--so, when interest rates go down there's more demand for credit for investment purposes. So it's like a demand curve. Now, what's really going on in my view is both of these schedules are shifting. And the net effect is we are probably ending up with a little bit less investment and savings than before, but at much lower interest rates. Now, how could that occur? Well, if you draw it on a piece of paper and if you shift that savings line to the right a little but, but shift the investment line to the left by a larger amount, both of those shifts will put downward pressure on interest rates. But the net effect is--Russ:The net effect onquantity. The amount of investing.Guest:On quantity. You still have to go to an equilibrium point where the savings and investment schedules cross each other. And so this is what I think causes confusions when you just describe the process in words. If I say a 'savings glut,' it sounds to most listeners like, oh, there's more savings than there is investment. No: in equilibrium actually savings will equal investment, as economists define these terms. But what has to happen is interest rates have to fall so low in order for that equilibrium to occur. Okay? Just like, in a supply and demand diagram, if there's a huge oil discovery, supply will shift to the right; but you don't have more oil than you are consuming. What will happen is the price will fall low enough until people willusethat extra oil.Russ:Movingdownthat demand curve, if that did not shift.Guest:Moving down that demand curve. Now, inthiscase, I think the bigger effect is a shift in the investment schedule inward. Notice that the first country to hit low interest rates was Japan. They are kind of the opposite of Australia. They are a 0-population growth country. Very little demand for new housing and so on; in fact, falling population. And they were the first to hit the 0-interest rate situation. And I think it's partly because there is just not a lot of good investment opportunities in a country whose population is falling fairly rapidly. So, if you think of the investment schedule as shifting to the left, you move downalongthat savings curve--there's actually less quantity of savings and there's less actual investment occurring as well. But I think the savings schedule has also moved a little bit to the right. The net effect may still be for there to be less savings than investment, but the high propensity to save in Asia, which is a rising part of the global economy, I think is an issue here; and it probably was one factor undergirding the U.S. housing boom during the early 2000s. A lot of funds flowed into the U.S. market and financed mortgages and so on. And people even then, before the recession, were talking about the unusually low interest rates, given that the economy was booming. Remember--I think it was Greenspan who talked about a savings glut--or 'conundrum.' That's right--conundrum of low interest rates. And that was even before the Great Recession. So I think we've seen this process beginning to play out over a number of years, but since the Recession it's become much more noticeable.Russ:I'm pretty sure there's a three-letter word that we have not spoken much about at all, which is the Fed (Federal Reserve). And wearegoing to come to the Fed. But I think a lot of people tend to want to blame the Fed or honor the Fed for changes in interest rates. We're going to come to that, but I'm just telling listeners--I also want to warn listeners, when you said a minute ago that at lower interest rates you get more investment, you were talking about movingalong a fixed demand curve. So, you weren't making the fallacy of reasoning from a price change, which you had decried earlier. But as an economist, you just tend to assume it's given when you say that: you were talking about a fixed curve, and everything else held constant.

Russ:I take the point about Japan. I want to come to the United States and I want to raise a puzzle to that story that you just told. Which is the following. We both talked about how historically interest rates have been about 3%--real. And usually people say 2% of that--1% has been population growth. So, as you point out, if your economy is pretty stagnant but you have population growth, you can have positive interest rates because there's more stuff going on. More activity. You can expand your business just because there are more people. But 2% of the 3 is growth--is productivity and technology and other things that are changing. So, underneath all of this conversation so far we've ignored an issue that has gotten a lot of attention lately, which is--and we've talked about it here on EconTalk a number of times--which is, so-called 'secular stagnation.' It's a bad phrase, by the way. 'Secular' sometimes means non-religious. But here it means over time. Which is confusing. All it means, really, is there's not much growth going on. We have a stagnant economy, supposedly. So, here's my problem with that story. I look at a part of the country, California, that I visit in the summer, and there's just thisunbelievable explosionof creativity there. And it's not just hypothetical. People aredoingstuff: engineering things, a lot of it's software obviously. But there's a lot of enormous opportunities for investment and a lot of wealthy people in the form of venture investing, making bets on putting, taking risk, and investing in these firms. People are constantly--no one is sitting around saying, 'Well, there's no point in thinking about the future because population growth is low in America.' People are not--they don't think that way. They don't--it's going like gangbusters. And there's a lot of investment going on in that part of the economy--the so-called high-tech sector in Silicon Valley. How do you reconcile thatfactwith this story that you hear from other economists that, 'Well, it's not going to be like it used to be when we had a lot of growth. It's going to be sluggish. We've thought of all the good ideas for a while.' This is a theme--Tyler Cowen is somewhat associated with this. So is Robert Gordon at Northwestern. Other people have said, 'The glory days of the 1960s and even some of the 1970s and 1980s, they're over. We just have to get used to this sluggish economy.' And I look at Silicon Valley and I think, what the heck are they talking about? Is it everything else that is negative and that's the only place where there is positive growth? Because that place is going crazy.Guest:Right. And I've puzzled about this. I don't have any great answers but I'll speculate a little bit on it anyway. One thing that I've noticed is that even though rates of return on government bonds are extremely low, it sort of seems like rates of return on riskier forms of capital are still pretty good. So, investors in the stock market who have invested in these high-tech companies have been doing well. Of course that doesn't mean that ex ante, before the fact, theyknewthey were going to earn high rates of return. But anyway, they've done pretty well. And then you've got the situation where government bonds are paying almost nothing as an interest rate. So, investors are earning a pretty good rate of return on these higher risk investments like high-tech companies. And I'm wondering[?], what's different from, say, the 1960s? If you think of the old economy that produced steel and cars and home appliances and things like that, if one company was making large profits making, say, refrigerators, lots of companies would start up essentially copying what they were doing, making refrigerators and hiring workers and putting together capital, make factories and so on. So, the very highly competitive economy in that sense. A lot of the companies we see now in Silicon Valley that make large profits, it's not obvious how outside competitors would jump in and copy e-Bay or Facebook or Google. You know what I mean? Because a lot of these companies are basically based on certain sorts of intellectual property, and this is protected by patents and copyrights and so on. So, what you seem to have is two parts to the economy--the thriving part of high-tech firms in places like Silicon Valley, but then a lot of the rest of the economy seems to be fairly sluggish and doesn't seem to able to participate in that real high-charged growth that you are talking about in places like California. And it doesn't seem like those firms use enough capital to put much upward pressure on interest rates. Another thing that's interesting about these new firms is they often have relatively small amounts of capital, physical capital, and a relatively small number of employees. So, in stock market capitalization they are very, very large; they are having a big effect on the high-tech sector. But they don't really require the enormous quantities of capital that the older economy used to need to manufacture basic items. So it is seems like the difference in the nature of the new economy may be one reason why growth in one area isn't sort of spilling over to the macro variables in the way you might expect and has occurred in earlier decades. But that's just speculation on my part.Russ:That's interesting, though; and I think that it forces you to think about how important these things are. One of the things that it also forces you to remember, which I meant to bring up earlier as my Austrian side, is that--we're talking abouttheinterest rate as if there is a single rate. And of course, there's not. There's short term rates and long term rates; there's different kinds of risk associated with different kinds of savings and investment. And you make an excellent point, that what's really different now compared to, say, 10 years ago or even 20, 30 years ago--there's two things that are different. One is, as you pointed out, inflation is lower. So there's no inflation premium right now built into the nominal interest rate because people aren't worried about it. But the second factor is that it's therisk-freerate that's low. It's the government bonds--I don't know the equivalent; there isn't an equivalent corporate bond--but it's that that's low. And so, as you point out, if you invest in certain types of sectors of the economy or even if you just hold the S&P 500 (Standard and Poor's 500), you've made alotof money over the last few years by putting money aside. A huge amount of money. The returns areextremelyhigh. What's low is the short-term risk-free rate. And maybe we shouldn't be so worried or interested in that. Maybe we're spending too much time thinking and puzzling over that, and we should spend--although, having said that, I'm not sure that the stock market returns are very comforting either. But the overall economy is growing. Parts of it are growing faster than others. And maybe it's not such an important or puzzling phenomenon that risk-free rates are low.Guest:Yeah, and I could add one other thing. Someone could point out that the stock market returns may not be expected to continue at this rate, and that's certainly plausible. But we also have other indicators like the rate of corporate profits is pretty good. And people have been commenting recently on how a greater and greater share of corporate net worth is sort of in the intangible area--things that are not visible. Like it used to be more of the value of a corporation was in the value of its actual physical buildings and factories and so on. But it's more and more in the intangible area today. And that also feeds into this idea that it may be related to intellectual property protections: it may be hard to compete away those earnings. And so even though you do observe existing firms making pretty good profits, at the margin, new firms entering may not be able to expect to earn nearly as high a return and therefore you are not getting the investment that you normally would have expected when the corporate sector is doing so well.

Russ:Well, I'm not sure. Let me push back on part of that because that's the part that caught my ear and I didn't agree with it. So, here's the part I like. The part I agree with you with is if you could make a slightly better washing machine or slightly better car, the way that we normally saw progress in most of the 20th century was through technology, the application of technology to manufacturing. A lot of those gains--those maybehavebeen taken advantage of already. And the future possible improvements there are relatively small. And so is the profitability. You make a market return, if you make a good car or a good washing machine, but it's hard to make a killing. And if you did, it would probably be copied fairly quickly. Now, let's talk about the non-traditional, the so-called new economy. Yes, there's Google and Facebook and all these iconic firms that make huge amounts of money. And they are protected by intellectual property rights. But there'ssomuch possibility here for entry. You are not going to enter and grow into a firm that employs 250,000 people like a large manufacturer, or 500,000, or even a million people. You are going to be small. But you are going to have a lot of capital. It's going to be human capital. It's not tangible; it can't be measured. But your productivity of your company allows you to get into the market and earn money has really created people coming up with a novel way to use a smartphone or something related to the web. And it seems to me that that potential right now is enormous. It's not like it's hard to enter at all. Teenagers are doing it. And they do it well.Guest:Some people are good at it.Russ:Yeah. Not all of them.Guest:Let me put it this way: I sort of agree--I agree with you on one level, but I would say a couple of things. The amount of capital that they are using in this process is often quite a bit less. Let's say that we've got two people that observe Google's enormous profitability. One of them is the CEO (Chief Executive Officer) of U.S. Steel, and the other is a student at Stanford. Which of those two is going to say, 'Oh, we should set up a new division sort of like Google so we can get in on those profits?' The CEO of U.S. Steel is probably going to be very fatalistic, like, 'Well, yeah, they are making a lot of money but I have no idea how they did it, so even if I borrow a lot of money and set up a big research center in Silicon Valley, what expectation do I have that I'll make as much as Google?' On the other hand, the student at Stanford might have some ideas that he or she could play out in a startup firm. But that sort of investment often doesn't require that much capital. So I think what is happening, it's happening in a segment of our economy--the people with those skills, the creativity skills necessary to create those new firms--they're doing very well and they are pushing a lot of innovation, but it's not really having quite the macroeconomic impact that the broader industrial booms had in the earlier parts of the 20th century, that really brought the whole economy into the process, I think. If that makes any sense.Russ:Yeah, it does. But again, there's a part that's not as persuasive as it might sound. So, in the old days, if I wanted to--you're making the point that if I wanted to start a factory in Red River to make cars, I need ahugeamount of money. But if I'm going to be tinkering in my bedroom with an App that I came up with, I don't need any capital. So that would argue that the demand forcapitalcould be relatively low even though there's a lot of investment going on. The problem with that is that, in the old days--again, the old days--we're talking about it like it's the last 500 years. Really we're talking about 1945-1965, maybe. Sort of the post-War, steady, normal, somewhat staid economic picture of the post-War era which was healthy until about maybe 1960-something and then we started to get inflation and then we started to get, we get the Malaise of the late 1970s and then we get the recovery of the 1980s and 1990s, etc. Relatively small period of U.S. economic history before the Internet. But in that period, it wasn't like somebody said, 'I'm going to start a car company. I'm going to need a lot of money.' Most people couldn't start a car company. It was very hard to enter those markets. It's true that there was some competition across manufacturing companies. But the way you entered, it was mainly through--I guess, there was some expansion, due to population growth and income growth by the way. So there was an increased demand for cars. But it wasn't like we saw an explosion of entrants. Because they couldn't enter. It was too expensive. And they weren't trustworthy. There were basically very few--zero, maybe one and it was a niche car in the late half of the 20th century that had traditional manufacturing--I'm thinking of maybe, what, the McLaren or whatever it's called--I can't remember the name of it. So it's not obvious to me, the fact that economic activity was more "capital intensive"--and I would call it brick-and mortar capital intensive. Most of the capital expansion, I would assume, in the 1950s, 1960s, 1970s, and even 1980s was things like--somebody builds a grocery store on the corner; CVS, Walgreen's suddenly comes up with this idea that they can make a national pharmacy brand; Starbucks comes along, they are building on every corner. They are notgiantcapital projects, right? Now it's true that they are larger than creating an App on an iPhone. But again, if I'm making an App--a serious App, not just a little fooling-around thing--you've got to hire people. People are expensive. I have to borrow money from those venture--not borrow money; I have to give up an ownership stake. Those Venture Capital firms, they invest a lot of money. It's not a small amount of money. So it's not obvious to me that this claim that because the new economy doesn't hire as many people, doesn't invest as much in brick-and-mortar--there's so much more of it. It's not obvious that that doesn't overcome some of the differences in the physical economy in the old, traditional ways.Guest:Yeah. I would say, though--on the question of entry, even though maybe it was hard for an average person to, say, enter the auto industry, I do think the old manufacturing economy was closer to what economists call perfect competition. For instance, the products they sold, the price tended to be fairly closely related to the cost of production. So there was enough competition among the firms that were alreadyinthose industries, like, say, automobile industry. So that if a car sold for $20,000 it might cost $16,000 or $18,000 to make. Something like that. In the high-tech economy you have many, many goods for which they sell at a certain price and the cost of manufacturing is almost zero. Then normally when that is the case you would have just tremendous competition. Firms would jump in at the chance. But in a lot of cases, there's intellectual property protection. So, one firm has a patent on a certain type of software or something, or there's something like, say, network effects where one company is dominant because everybody wants to be using the service that others are using. That's sort of the Facebook effect, the e-Bay effect, and things like that. So, I think there's something different about the high-tech economy. I'm not sure exactly which of these characteristics is crucial for what we are talking about, but I don't think it's really quite the same as the old economy in terms of competitiveness, if you will.Russ:Oh, I agree. I think it's probably more Schumpeterian. If you go back and read, which I haven't in a while,Capitalism, Socialism and Democracy, in the capitalism part of that book, the first section, he probably has some deep and very relevant things to today's economy, where he talks about--basically he says, the goal is not to beat everybody else. The goal is to be a monopolist. And hope you can sustain that long enough to make some money. And you are right--in a way, you can sustain it longer today than you could in the past. Possibly. And again, I don't know if that's anything to worry about. But again, I just don't know if that has anything to do with interest rates. I think these are really deep and important and interesting things, and there are no answers, no obvious answer that's right about whether these differences are important. But it's not obvious to me that real interest rates should be lower in a virtual economy that has more virtual firms and more software development than it has hardware development. That's all.

Guest:Well, to change the topic slightly, I would also go back to the notion that--my view, which is a little bit different from many others, is that interest rates mostly reflect market forces over any sort of reasonable period of time. So, on a day-to-day basis, the Fed may be setting interest rates. But over any longer period of time they basically have to be reflecting market forces. If they weren't, you'd get an explosion of hyper-inflation or -deflation. The economy would become highly unstable. And since we're not seeing that, we have to assume that the place where the Fed seems to be setting interest rates must be relatively close to an equilibrium interest rate. Otherwise we would be seeing some signs of strong disequilibrium in the market. Which we're just not seeing, in the macroeconomy. So, something is causing it that is, in my view not what would be considered artificial. And a lot of the people I debate on this say, well, interest rates are just being held artificially at this level and this isn't the correct level. But this is the level where the market has them. And no one's been able to convince me that the Fed is a magician that can make interest rates be vastly different from their equilibrium level and hold them there for many, many years without any sort of inflation or deflation side-effects cropping up.Russ:Which is unfortunate, because I like to blame the Fed. As many people do. One of the things that disturbs me about the current world--and this is irrational, I suppose--but it bothers me that my children are growing up in a time when the return to setting money aside for the future is close to zero. So, when you say to them, 'You could save some money and don't have to buy everything with the money you have,' their response, which is correct, is, 'Well, what's the point?' They look at their savings accounts, they are getting pennies. Pennies. And it's a fool's game.Guest:Let's think about how strange that observation is. You're absolutely right. But just to drive home the point of how strange that is, this worry the people have, you and many others, is occurring at exactly the same time that Thomas Piketty has become famous making exactly theoppositeclaim--that the capitalists are doing better and better and the workers are doing worse and worse. So, Piketty's claim is the returns to the savers are too high and they are worsening wealth inequality in the global economy. And that gets back to this dichotomy we drew between thesafeassets--like Treasury Bonds that have very low rates of return, or bank accounts--and these riskier assets, like corporate stocks or real estate. Rents are very high and landlords are doing well. And that's a little bit of a mystery, how these things are co-existing. And why aren't the people that are investing in the safe assets, why aren't they moving their money into these stocks or real estate investment trusts [REITs] or things that offer higher rates of return?Russ:One answer is it's hard to do when you are 15 years old.Guest:Yeah.Russ:So, my son--Guest:That example, yeah. But there's also a lot of fairly affluent people that have money in accounts that have relatively low rates of return.Russ:Well, let me put myself in that class for a moment and restate your question in a different way. We talked earlier that the stock market has done very well. You pointed out--it may not be sustainable. I'm kind of anxious that it may not be sustainable. I have a lot of my wealth tied up in the S&P 500 and various assets like it. But that's probably the biggest one. And I'm pretty confident that it's not going to continue to look that bright. So, I'm thinking, I should reduce the share of my savings that's in the stock market. But of course the question then is: And put it in what? Put it in a Treasury at a few percent that might get eaten up by inflation? I can protect it against inflation: there's Treasury and inflation protected securities. But they don't pay very well right now. It's interesting to me how there's nothing in between--is the way I would describe it. There's the risk-free--which pays close to zero. Just a little better than your mattress. Then you have the risk-y, which is very unclear what's going to happen. It's not going to be a steady 8% or 10% or 6% up over the next ten years. It's going to have some wild possible swings. So that to me is what's weird--and unpleasant--about the current environment.Guest:Yeah. Well, I guess all I can tell you is you can obviously spread your risk by doing some of each in some proportion. And that gives you sort of an intermediate level of risk, and intermediate level of return, from one extreme or the other. But getting back to Piketty, it is interesting that he talks about the return to capital overall as being so high. And that just seems to--it seems strange that we're having both of these conversations at the same time: a conversation about capitalists doing so much better than workers, and then this conversation about people that save earning such low rates of return on their savings. Obviously, I think you've identified what the crux of the problem is: that there's different types of investments. But nevertheless I do find it kind of interesting.Russ:Well, actually,youidentified it. And you also made the distinguishing point, which I think is very[?] relevant, and other people are starting to notice this also, which is that a lot of this is being driven by housing. So, in the corporate investment world--stocks, bonds, etc.--there's a lot of risk. And there's been--there's a lot of unpredictability about it, going forward. Rates--it's been a great stretch for the last couple of years, but most people are pessimistic, not so optimistic that the future is going to be anything close to that rosy. Similarly, if you bought a house in 1995 in the right place, by 2005, 2007, you had made ahugereturn. But if you bought it in 2007 or 2008, you haven't done so well. It's not so attractive. And if I could do one thing to change--I don't know how to phrase this. The idea that your house is where you should be parking your wealth, to me strikes me as a very bad idea, for that idea to be widely held.Guest:Yeah. But I'd like to point out something else about housing that's interesting. So, there's this perception that housing is really overbuilt in the United States during the housing boom.Russ:Yep.Guest:And that's certainly true in some locations. But the data doesn't really tend to support that. Rents have been rising, actually fairly rapidly in recent decades. So, faster than people's incomes in many cases. And people that invest in rental apartments I think have done very, very well in recent years. And one of the reasons for that is there are a lot of restrictions on building now, so building since 2008 has been at very, very low levels. And yet the population continues to grow. So, people are going more and more into rental units; they are having difficulties getting mortgages. And so that part of the real estate sector, rental units, is doing very well. And rents are rising. And in many of the most prosperous parts of the country you can actually argue that there's toolittlehousing because of regulations that make it difficult to build. And so that pushes up prices and rents in those areas. So, again, we have a market that's kind of complex; and I think the story that people focused on a few years ago was the overbuilding in certain locations. But nation-wide, you can argue that we aren't building enough housing, and as a result, the costs are going up. Which means the returns to landlords in New York City and California and so on are actually very high right now.Russ:And homeowners generally. Right?Guest:Yeah. Well, they get an implicit rent on it. And they may profit if the price of their home goes up in those areas.Russ:Yeah. Which they have dramatically, many of them

Russ:You raise a great point, which is the restriction on supply part of this story. It depresses me greatly when people say things like, 'We need to build some low-income housing in such-and-such a city' or 'We need to have more opportunities for the middle class to have comfortable places to live.' Well, in New York--in any city--take the cities--I'll take the three where I have some acquaintance with. New York City, Washington, D.C., and California. These are three places where it's very expensive to live, if you are a young person starting out in your life and you'd like to either own a house or you'd like to just rent an apartment. And the question is: Why? Because it wasn't always--people said things like, 'Well, California has great weather.' Well, they had great weather in 1960, too. New York City is a great city; it was a great city in 1960; it had some issues, yes. But why is it that as these places have grown in their attractiveness, themixof housing has, I suspect, moved greatly toward the high end? And that, I think, is due to regulation. And it's a terrible result. Capitalism gets blamed. Markets get blamed. I don't know--'Markets don't produce low income housing, middle income housing. It only produces high end.' Well, there's a reason for that. There's a reason that that's so profitable.Guest:I think that a lot of people on the Left don't realize how much of some of the issues that they worry about is actually driven by regulation. One is inequality. And I'm working on an article on that topic right now. But also this investment question we are looking at may be part of it as well. It's just a lot harder to get approval for all sorts of building projects. One is housing as we've been talking about. But even things that people on the Left tend to favor--government projects, like high-speed rail. And in Massachusetts they fought endlessly to build a windfarm off the coast. Well, these days, these get tied up in the courts forever. And it's very hard to get a project actually built. A major, like, infrastructure-like project, that sort. So, because of the increasing complexity of regulation and land restrictions, environment rules, and so on, that's--it's just harder for us to have the sort of economy we had in the 1960s where we just build highways and housing developments all across the country. Whenever there was a demand for it in a certain location. And there are costs of that. One is there is less investment in the economy. I would argue it worsens inequality in a number of ways as well. It's hurting renters right now, relative to homeowners. But that's something I think people on the Left don't fully recognize when they think about the effects of regulation. They don't think about the connection with inequality. Another instance is that a regulation often makes it harder for smaller firms. There's sort of a fixed cost of complying with all these complex government regulations that come along. And as those regulations more and more burdensome, they are easier for bigger firms to deal with. And studies show that there is more inequality at large firms than at small firms. For instance. So, that's another way in which regulation can be increasing inequality.

Russ:That's a nice story. I'm sympathetic to it, of course. I just don't know if it's true. You have to think about what evidence would allow you to--I've heard the claim made before, and it'splausible, that regulations have gotten more complex, more burdensome. But I think the challenge is quantifying that in a way that's credible. So, here's an example. I was just in Israel for two weeks. Israel is--they have security issues, of course. But on the domestic side, the thing people are most worried about is the price of food and housing. There have been protests in the street. Netanyahu almost lost this last election because of his failure to do anything about it. And he's made lots of pledges: he's going to fix it. But the reason that there's a food and housing crisis in Israel is pretty straightforward. There's a lot of barriers to importing food and to creating retailing in food. So food is really expensive. There are cartels, literally, in some parts of the food supply, that keep the price higher and growing. And that's easily fixed--if you wanted to. But politically, it may be very difficult. And with housing, the government owns a lot of the housing, a lot of the land, in Israel. And to the extent that it doesn't, it makes it hard to use it privately. So, recently I was talking to a guy--he's building a house. He said it's going to take 3 and a half years. When I told that story to somebody, they laughed. They said, 'Oh, hethinksit's going to take 3 and a half years.' Now, when it takes maybe half a decade to build a house, something--you are pretty confident that renting prices are going to be pretty high in a growing economy. Which is your point. And one way to quantify that would be to see how muchlongerit takes to build a house in Israel today than, say, 10, 20 years ago. I don't know if it's changed. It may have gotten a little bit shorter. But in the face of growing demand it may be offset by that. And it's similar in the United States. When we talk about regulation and real estate, which is enormous in major urban areas, I'd like to know, I'd like to see some measures. How long does it take? How many bureaucracies do you have to go through? We're still much better than Israel. But I'd say we're probably in the ballpark. Maybe it's not the 3-and-1/2-year thing to build a house. But I assume if you want to start a real estate development in New York, it's a major political investment. And, as you say, that rewards high-end, large firms. And of course if you are going to have to incur a large fixed cost, you are probably going to have to intend to build on the higher end. So I assume it's part of the problem. But it's a story. I'd like to see some evidence.Guest:Yeah. There's actually quite a bit of evidence that the cost is large. One piece is that in places like Los Angeles, if you have, say, a 10,000-square-foot piece of land that is zoned for two units rather than one unit, it's worth vastly more money in the marketplace. So that gives you a pretty good estimate of what that particular zoning rule--if itisonly zoned for one unit, it tells you that zoning rules is costing quite a bit of money, in the hundreds of thousands, let's say. Yeah. And by the way, another area where regulation increases inequality is some of the increased copyright protections. So, copyright laws have gotten stricter and stricter. Part of this is under lobbying pressure from companies like Disney, so they can, you know, protect Mickey Mouse for a hundred years. And so, you know, consumers pay more for Mickey Mouse toys, and Disney makes more money. And that's due to regulation. It's something people don't think about often when they are using the term 'regulation,' but it is an artificial barrier to entry to new firms. Copyright used to be just 14 years, and it's been extended much, much longer with recent legislation.Russ:Yeah, I think that's a mistake. But I don't think, again, that that's--it's probably hampered, somewhat, innovation, but again, I see lots of innovation going on. I think the bigger challenge is this issue we're talking about, which is real estate and the cost of renting or the return to homeowners who already own homes, and their ability to use the political process to protect those investments seems to me to be a really big problem that doesn't get enough attention.Guest:I agree.