Scott Sumner on Interest Rates
Apr 20 2015

Scott Sumner, of Bentley University talks with EconTalk host Russ Roberts about interest rates. Sumner suggests that professional economists sometimes confuse cause and effect with respect to prices and quantities. Low interest rates need not encourage investment for example, if interest rates are low because of a decrease in demand. Sumner also talk about possible explanations for the historically low real rates of interest in today's economy along with other aspects of monetary policy, interest rates, and investment.

Allan Meltzer on Inflation
Allan Meltzer, of Carnegie Mellon University, talks with EconTalk host Russ Roberts about the current state of monetary policy and the potential for inflation. Meltzer explains why inflation hasn't happened yet, despite massive increases in reserves created by Fed policy....
Milton Friedman on Money
Russ Roberts talks with Milton Friedman about his research and views on inflation, the Federal Reserve, Alan Greenspan and Ben Bernanke, and what the future holds.
Explore audio transcript, further reading that will help you delve deeper into this week’s episode, and vigorous conversations in the form of our comments section below.


Carl Petersen
Apr 20 2015 at 8:12am

Saving is the path/journey and investment is the destination. There is now no return on walking the path because there is no inherent value in saving … the Saver is not rewarded until they accumulate capital and put it to productive and profitable use. That is why the Tomas P. and low savings convo is happening at the same time.

Apr 20 2015 at 8:30am

“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?”

Whether you should be sad or happy depends on the cause behind the increase in quantity of houses. If it is due to a shift to the right of the supply curve, it would decrease housing prices. However, if the increase in quantity is due to a shift to the right of the demand curve, it would increase housing price.

Levi Russell
Apr 20 2015 at 11:36am

Could it not be that both supply and demand are responsible for low rates? Easy monetary policy (as evidenced by the massive increase in the monetary base) and low demand for credit due to uncertainty and other issues would certainly explain low rates.

This plot of the money multiplier shows a decline on par with that of the Great Depression. So, we could have a Wicksell effect (increase in base money driving down interest rates) but no Fisher effect (inflation premium) because M2 relative to base money hasn’t risen and we aren’t seeing price inflation.

I’m certainly an amateur at the macro side of things, but I don’t see why this has to be a story of low demand for credit and tight money.

Per Kurowski
Apr 20 2015 at 12:04pm

You have ignored here that some of the rates you see are not real rates but subsidized rates.

Apr 20 2015 at 1:07pm

If people are bidding down the returns on safe assets, why is it not a good idea for the Fed to buy the most relatively undervalued assets rather than T-bills?

Apr 20 2015 at 1:59pm

Why no link to the interview in which Nobel laureate Robert Shiller is supposed to make an freshman-level econ mistake?

Of course, no one calls Russ for his opinion on what a strong dollar portends. Media organizations want commentary from an expert who is willing to use his knowledge of the current economic situation to help their readers/listeners understand why the dollar is strong and what that means for the future. Instead they get Russ, who acts ignorant of the reasons behind the strong dollar and throws his hands up and says “Who knows???? Absent other information, a price change doesn’t tell you anything.” The whole point of experts is they have other information.

Apr 20 2015 at 2:37pm

The advice “never reason from a price change” only applies in the macroeconomic sense, correct? In other words, I’m assuming it’s still reasonable for me to observe a drop in the price of, say, gasoline, and decide to drive more.

Apr 20 2015 at 2:48pm

I guess responding to a price change in that sense of my above comment isn’t “reasoning” but merely acting out my own personal demand curve.

My lack of economics is showing, I fear.

Levi Russell
Apr 20 2015 at 3:06pm


Sumner’s admonishment on reasoning from a price change has to do with inferring something about supply or demand when one observes a movement in a price. Someone might say “Well, the price of gas fell. That must mean there’s a new innovation in oil/gas production!” They could also say “Of course the price of oil fell, people are driving more efficient cars and driving less!” You have to know something about which side is driving the price, not just that the price changed.

You’re right that if the price falls, you are incentivized to drive more. If the price falls, it either means that the supply curve shifted rightward (more efficient gasoline production, for example) or demand shifted leftward (people in general value oil less than they did before). Either way, you have to give up less of other things to get the same amount of gasoline, so you could respond by buying more.

Apr 20 2015 at 4:05pm

On the topic of the Fed’s influence on the interest level, given your previous discussion on supply and demand, I was a little disappointed not to hear the following argument:

We do not know that the Fed happens to hit the equilibrium rate of interest just because we do not observe high levels of price inflation (or deflation).

It is perfectly possible that the natural rate of interest is way higher than the nominal one. The downward pressure due to expansionary monetary policy does create excess inflation in this case and brings it up to 0-1%, while we would see deflation otherwise.

Of course deflation is the big boogeyman in macro-economics and a lot of economists would argue that we should be glad for the disequilibrium in that case. But that’s another issue and I’d love to hear more about that discussion. It might also be one reason to explain the big spread between government bonds and returns in the stock market too.

amren miller
Apr 20 2015 at 4:06pm

Not to throw economists under the bus, but is there in fact a school of thought in the discipline that champions the ‘professional obfuscation of responsibility,’ as treetop implies? I may not be schooled in economics, but there does seem to be a certain type of economist who is ever-willing to throw their hands up in the air and say, “Who knows?” because of x,y,z factors. Of course, the other side of the coin is just as dangerous.

One more point, and I heard this in a video from Larry Summers a while back, so forgive me for the botched paraphrasing…….
“There MAY be a chronic mismatch between the desire for people to save and their willingness to have it turned into productive investment.”

I’m a little ignorant, but savings accounts are generally not treated by the average person as a money market in the traditional sense. This creates a lot of headaches for banks, does it not? Perhaps it is part of the reason for the disconnect in the real economy, which causes excessive intervention from the fed and drives down the interest rates that prudent savers could expect. For instance, the average person, who doesn’t know anything about economics, treats the savings account as just another checking account. This seems like a tremendous problem.

One more time, I am only an armchair economist, so maybe, just maybe, I have no idea what I’m talking about, but I thought it was interesting to bring that up.

Apr 20 2015 at 5:15pm


This is a Scott Sumner post in which he links to, and discusses, Robert Shiller’s argument:

Maybe Sumner is being too hard on one of Shiller’s throwaway thoughts, but Shiller does assume dollars left on the ground without providing his reasoning. Or worse, the reader may assume that low interest rates ARE his evidence for dollars left unpicked.

Brian Donohue
Apr 20 2015 at 5:57pm

Guarantees are very expensive today. Memories of the housing bust and stock market crash linger. Just as investors in the 1980s were rewarded for taking inflation risk, investors over the past six years have been rewarded for equity risk. The market has a good short-term memory.

Most people have little to no understanding of how the stock market works.

Warren Buffett understands investing, and he’s not moping around these days about lack of opportunity. From this year’s shareholder letter:

Our subsidiaries spent a record $15 billion on plant and equipment during 2014, well over twice their depreciation charges. About 90% of that money was spent in the United States. Though we will always invest abroad as well, the mother lode of opportunities runs through America. The treasures that have been uncovered up to now are dwarfed by those still untapped. Through dumb luck, Charlie and I were born in the United States, and we are forever grateful for the staggering advantages this accident of birth has given us.


Our investment results have been helped by a terrific tailwind. During the 1964-2014 period, the S&P 500 rose from 84 to 2,059, which, with reinvested dividends, generated the overall return of 11,196% shown on page 2. Concurrently, the purchasing power of the dollar declined a staggering 87%. That decrease means that it now takes $1 to buy what could be bought for 13¢ in 1965 (as measured by the Consumer Price Index).

There is an important message for investors in that disparate performance between stocks and dollars. Think back to our 2011 annual report, in which we defined investing as “the transfer to others of purchasing power now with the reasoned expectation of receiving more purchasing power – after taxes have been paid on nominal gains – in the future.”

The unconventional, but inescapable, conclusion to be drawn from the past fifty years is that it has been far safer to invest in a diversified collection of American businesses than to invest in securities – Treasuries, for example – whose values have been tied to American currency. That was also true in the preceding half-century, a period including the Great Depression and two world wars. Investors should heed this history. To one degree or another it is almost certain to be repeated during the next century.

Stock prices will always be far more volatile than cash-equivalent holdings. Over the long term, however, currency-denominated instruments are riskier investments – far riskier investments – than widely-diversified stock portfolios that are bought over time and that are owned in a manner invoking only token fees and commissions. That lesson has not customarily been taught in business schools, where volatility is almost universally used as a proxy for risk. Though this pedagogic assumption makes for easy teaching, it is dead wrong: Volatility is far from synonymous with risk. Popular formulas that equate the two terms lead students, investors and CEOs astray.

It is true, of course, that owning equities for a day or a week or a year is far riskier (in both nominal and purchasing-power terms) than leaving funds in cash-equivalents. That is relevant to certain investors – say, investment banks – whose viability can be threatened by declines in asset prices and which might be forced to sell securities during depressed markets. Additionally, any party that might have meaningful near-term needs for funds should keep appropriate sums in Treasuries or insured bank deposits.

For the great majority of investors, however, who can – and should – invest with a multi-decade horizon, quotational declines are unimportant. Their focus should remain fixed on attaining significant gains in purchasing power over their investing lifetime. For them, a diversified equity portfolio, bought over time, will prove far less risky than dollar-based securities.

[outer quotation marks changed to indented quote. Please use indents for long quotes so readers can more easily distinguish what you are quoting from what you yourself have to say.–Econlib Ed.]

Michael Byrnes
Apr 20 2015 at 7:08pm

danan wrote:

“It is perfectly possible that the natural rate of interest is way higher than the nominal one. The downward pressure due to expansionary monetary policy does create excess inflation in this case and brings it up to 0-1%, while we would see deflation otherwise.”

This isn’t really how it would work, though. If the Fed pushes its interest rate “too low” and keeps it too low, then inflation will rise, and keep rising, until the Fed gives up. Keeping the rate too low is not a road towards elevated, but stable, inflation; it’s a road to hyperinflation. We can infer from the stability of the inflation rate (and the economy as a whole) over the past ~5 years that the Fed isn’t holding rates too low.

“Of course deflation is the big boogeyman in macro-economics and a lot of economists would argue that we should be glad for the disequilibrium in that case. But that’s another issue and I’d love to hear more about that discussion.”

Scott has some old posts at his blog ( on this topic. His argument in brief:

Never reason from a price change. Whether deflation is good or bad depends on its cause. Deflation is good if prices are falling for “real” reasons (productivity gains, positive supply shocks). Deflation is bad if prices are falling for nominal reasons (ie excessively tight monetary policy). Here’s one:

Michael Byrnes
Apr 20 2015 at 7:37pm

This was a great podcast, particularly the second half of the podcast with the discussion of secular stagnation. No answers there, only more questions, but it was a great discussion.

In particular, this point from Scott was remarkable:

“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 the opposite claim–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. ”

I was aware of both of these arguments, but the apparent conflict between them never occurred to me.

The discussion about the changing capital structure, and land, and rents, and zoning was also interesting. Matt Rognlie’s Brookings paper touched on some of this from a different angle – how about having him on as a future guest?

Michael Chaput
Apr 20 2015 at 9:17pm

Great podcast about interest rates. I have a question, why wasn’t government spending addressed? How can the government’s seemingly endless capacity to borrow, not have a massive impact on the market for rates?

Dr. Duru
Apr 21 2015 at 2:00am

Governor Stevens from the Reserve Bank of Australia happened to take a stab at answering your low rate, low investment question in a speech today in NY:

I think you will find the last paragraph refreshing in admitting not to know the final answer…

A striking feature of the global economy, according to World Bank and OECD data, is the low rate of capital investment spending by businesses. In fact, the rate of investment to GDP seems to have had a downward trend for a long time.

One potential explanation is that there is a dearth of profitable investment opportunities. But another feature that catches one’s eye is that, post-crisis, the earnings yield on listed companies seems to have remained where it has historically been for a long time, even as the return on safe assets has collapsed to be close to zero (Graph 2). This seems to imply that the equity risk premium observed ex post has risen even as the risk-free rate has fallen and by about an offsetting amount. Perhaps this is partly explained by more sense of risk attached to future earnings, and/or a lower expected growth rate of future earnings.

Or it might be explained simply by stickiness in the sorts of ‘hurdle rates’ that decision makers expect investments to clear. I cannot speak about US corporates, but this would seem to be consistent with the observation that we tend to hear from Australian liaison contacts that the hurdle rates of return that boards of directors apply to investment propositions have not shifted, despite the exceptionally low returns available on low-risk assets.

The possibility that, de facto, the risk premium being required by those who make decisions about real capital investment has risen by the same amount that the riskless rates affected by central banks have fallen may help to explain why we observe a pick-up in financial risk-taking, but considerably less effect, so far, on ‘real economy’ risk-taking.

Whether this is best seen as a temporary increase in risk aversion, a genuine dearth of investment opportunities, evidence of monetary policy ‘pushing on a string’, a portent of secular stagnation, or just unusually long lags in the effects of policy, will probably be debated for some time yet. I don’t pretend to know what that debate may conclude.

[quotation marks changed to indented quote. Please use indents for long quotes so readers can more easily distinguish what you are quoting from what you yourself have to say.–Econlib Ed.]

Matěj Cepl
Apr 21 2015 at 3:39am

I work in the high-tech sector (not in the Silicon Valley so I see them
just from the distance), and I just cannot consolidate my empirical
observations with the explanations provided in the podcast. If
I understand well, then you blame IP protection and monopoly power of
the present market participants for the lack of competition?

I just don’t see either of these forces working at all. Concerning IP
protection, it is just generally viewed as what it is, i.e., protection
money paid to the protection racket in return for nothing (protection
racket being older participants in the market like Microsoft, or
complete gangsters called “patent trolls”). However, I don’t see much
anybody skipping their effort in order to avoid this. It is just
a nuisance of life not much more.

Concerning monopoly power, you cannot be more wrong in my opinion.
Entrance costs are less and less and still decreasing. These days
building a new service “in the cloud” (for example on the Amazon AWS,
Rackspace, Microsoft Azure, Google Cloud Platform) enables anybody for
quite low entry-cost to build a service in the size unimaginable just
couple of years ago (see for example Netflix shifting from the mail
service to the streaming over the Internet).

Concerning the current participants in the market, I see their positions
quite more volatile than for example General Motors of 1950s. Age of
Facebook users rises pretty high, so it is less and less appealing to
the advertisers, most youngsters moved to Instagram or and now even
somewhere else. Twitter is still waiting on the jury to return and
I don’t hold my breath for the result. I can easily imagine that if
they don’t change their model dramatically in the next couple of years,
both Facebook and Twitter will be gone in five years. Sure, they will
change something, but it really doesn’t look like The Big Three in the
1950s just producing cars and cars and more cars and being rather
certain that they will do so for the next ten years at least.

Also, yours (as most) analysis of the Silicon Valley is founded on the
mistake of confusing Facebook et al. customers … users are just
products to be sold, customers are ad agencies and the competition for
their money seems to be quite alive.

Ali K
Apr 21 2015 at 5:53am

I had to come here to post just because of the many inaccuracies. Here is this big one. You need to get Steve Keen on the show.

Lending/Money for investing comes from savings
This is the argument that Ben Bernanke makes that there is an excess glut in savers. WRONG.

There is NO link between savers and lenders. The money necessary for lenders is created out of thin air.

The standard story about how banks create money, and how reserves work, is the “Money Multiplier Model”

This alleged system, known as Fractional Reserve Banking, is seen as “fraud” by Austrian economists, and by many in the public.

To Neoclassical economists, it’s just the way banking works: bank lending is controlled by the Fed…

And to anyone who’s done empirical research, it’s a myth.

The short answer is “endogenous money”: bank lending creates deposits, so the decisions of banks to provide loans determine the level of money, and reserves are largely irrelevant.

Mike Maloney had a great rant on the topic.

On a very simple level, their central banks (1) take the dollars we send them and create an equivalent amount of their local currency, (2) give the freshly printed local currency to the business owner who sold the goods to the U.S. consumer originally, (3) use the dollars and prevent their currency from strengthening, or (4) loan the dollars back to the United States, with interest. This allows the United States to borrow seemingly endless amounts of currency, and it allows these nations to maintain their exchange rates relative to the U.S. dollar—which keeps their unemployment low and their economies growing quickly.

The result? The U.S. debt-binge has been propped up by artificially low interest rates.

[link html fixed so as to be visible to the public. Please read how to use the Link button.–Econlib Ed.]

Shayne Cook
Apr 21 2015 at 9:30am

Brian Donahue:

DITTO! Ditto squared, as a matter of fact. I hope everyone here reads your comment, several times if required. Well done.

Shayne Cook
Apr 21 2015 at 10:12am

Russ and Scott:

I was taught (in economics courses, and elsewhere) that interest rate has three distinct components:

1.) Basic Rent Premium.
Generally, small, known and fixed around 1%
This is a loss-of-use premium – if you are using my money for a period of time, I obviously can’t be using it as well. Hence, I’ll charge you a rent premium for my loss of use.

2.) Inflation Premium
(Generally variable, based on known and expected inflation)

3.) Risk Premium
Highly variable, and supposedly based on the calculated risk that either or both principal and interest will never be repaid.

Inasmuch as the Rent Premium can always be presumed fixed at about 1%, and that the Inflation Premium can generally be well estimated, the real variance in all interest rates can be assumed to be exclusively Risk Premium.

Stated another way, every interest rate reflects the supply and demand for Risk (capital), and current risk tolerance – both on the part of demanders and suppliers. If you apply the perspective of thinking of interest rates – any and all interest rates – in terms of supply/demand of Risk rather than “money”, you may be able to better understand/explain some of the more puzzling unknowns of the current environment.

And by the way, Shiller is a “housing guy”. He’s correct that Investment in new homes construction remains below historical average. But it is wrong to conclude or state that business sector Investment also remains depressed.

(I)nvestment – non-residential fixed was well above 12% of NGDP in both 2013 and 2014. The average for that category over the 1980 to 2006 period was just over 11% of NGDP. Business sector investment in new plant and equipment is doing quite well, and has been growing robustly for over 3 years.
(Source: – Table 1.1.5, NGDP historical data)

Noah Carl
Apr 21 2015 at 10:20am

Excellent podcast.

Levi Russell
Apr 21 2015 at 11:01am

Michael Byrnes,

You said
“This isn’t really how it would work, though. If the Fed pushes its interest rate “too low” and keeps it too low, then inflation will rise, and keep rising, until the Fed gives up.”

Then you said
“Keeping the rate too low is not a road towards elevated, but stable, inflation; it’s a road to hyperinflation. We can infer from the stability of the inflation rate (and the economy as a whole) over the past ~5 years that the Fed isn’t holding rates too low.”

The second doesn’t follow from the first. It’s certainly plausible that an increasing rate of productivity growth could offset continued low rates. Besides… why can’t it be that demand is low and supply is high in credit markets? That would certainly explain low rates better than the “supply is tight but demand is low” explanation.

Scott Sumner
Apr 21 2015 at 12:21pm

Levi, In my view the monetary base is not a good indicator of the stance of monetary policy. I like NGDP growth better, as it seems more reliable. In my view rates would be low even if the base was much lower.

Per, Perhaps, but even free market rates are quite low.

Floccina, I have little faith in the Fed’s ability to spot undervalued assets.

treetop57, Here it is:

Ian, See Levi’s reply.

Danan, That exact issue is discussed in my new Econlog post.

amren, The short term nature of savings accounts can contribute to financial distress, when the banks have lent the money long term, as you imply.

Michael Byrnes, Yes, Matt would be a good choice for a guest.

Michael Chaput, That’s part of the mystery, and points to the low level of investment relative to the desire to save.

Dr. Duru, Interesting comments.

Scott Sumner
Apr 21 2015 at 12:33pm

Matej, This is one of those areas where words get in the way. You are using “competition” to mean something like “struggle to succeed.” I agree that there is plenty of that in Silicon Valley. I mean something more like “drives prices down to the marginal cost of production.” The prices of new drugs, new software, New Apple phones, etc, is much higher than the marginal cost of production.

My overall appraisal of Silicon Valley is very positive, except for the patent troll issue that you refer to, and some excessive copyright and patent protection in general.

Ali, Actually, saving is exactly equal to investment, by definition.

Shayne, I’m not sure you can assume the rent premium is stable.

Ali K
Apr 21 2015 at 1:47pm

Hi Scott,

Thank you for responding. I agree, as per definition and Keynes’s General Theory, (I – S ) = (T – G).

But is saving exactly equal REALLY to investment in empiric evidence?

What about investments from new money created? New money that did not exist in the system? My understanding of how the banks work, is that demand for loans by household/business are a source of new money creation.

I am not an economists (just a lay person trying to understand), so I’ll leave it to an economists to a more rigorous proof/discussion:

Endogenous Money and Effective Demand

Love to hear your thoughts/analysis on why Steve Keen’s analysis is wrong.

Best Wishes,

john penfold
Apr 21 2015 at 2:11pm

Another great conversation, thanks.

Secular stagnation is the way the world was for most of human history, with flashes of flourishing here and there. It’s why the third world is third world until it isn’t. I think the answer is in Mancur Olsen and when those encrusted rent seeking stagnant places finally start to come apart, if they avoid being invaded, we get a new organic explosion in all the nooks and crannies that open up with radical change, like what happens after a forest fire; it’s the same organic process. When you considered housing you recognized the dead hand of regulation and other economic rent seeking interests, but it’s pervasive, deep and everywhere. Hard to measure to be sure but lets do some Fernando DeSoto experiments. Try starting various businesses legally in a variety of locations and keep book on the time and costs. The effort might provide insights on where to try to collect data.

Shayne Cook
Apr 21 2015 at 2:45pm


“Shayne, I’m not sure you can assume the rent premium is stable.”

Perhaps I can explain why the Rent Premium is always stable, predictable and low (about 1%) …

It’s the result of competitive forces, and they are enormous. A lender can “tack on” reasonable assumed rate for Inflation Premium and Risk Premium. But no lender can charge a higher Rent Premium for any given combination of Inflation and Risk premiums. Competing potential lenders would “out bid” them on that basis.

Knut Skaarberg
Apr 21 2015 at 2:49pm

Russ, what are Your thoughts on Lord Adair Turner’s critisism of the classical macroeconomic models?

“Adair Turner: Textbook description of banking is completely mythological”:

I seem to remember your view that the CPI is highly subjective. Given the changes in calculations, could it be that the CPI is comparable with what we had in the 70s? Some seem to think so.

“Inflation Actually Near 10% Using Older Measure”:

Brendan riske
Apr 21 2015 at 5:26pm

Scott, you butchered this. Too blinded to see that this is federal reserve policy. The easy money policy is driving this. The inflation that you expect to see is not being captured in our current calculations. The feds easy money has vastly inflated finacial assets. Now regular people are feeling it’s effects in Healthcare and housing. Go out into the real economy and see for yourself.
And you never really explained negative rates. Interest rates cannot possibly be negative naturally! You said it yourself, the first place to see negative rates was japan. Why? It was the first place to ease!
As for your attack on piketty, your dead wrong returns to financial assets, which are owned by the wealthy primarily, are super high. Why? Easy money driving their price up through carry trades! Look at what easy money does to fiancial markets and tell me that it isnt driving asset values up. Savings rates, which average people get, are incredibly low. That leads to income inequality!

Apr 21 2015 at 5:31pm

The difference between the real and nominal interest rates results from an information gap. Sumner is saying that the current inflation rate is the real inflation rate. That begs the question, Why is it still low? The answer is, an information gap, but on the side of the economy. The economy isn’t really doing as well as is being advertised.

As evidence: “Unemployment is almost back to normal, but the economy isn’t.”
“…looked at how low the unemployment rate is versus how low we think it could go, how high the participation rate is versus how high we think it could go, and how many people can only find part-time jobs. That first part tells us how much further unemployment itself could fall, the second how many discouraged workers could come back, and the last how many people would work more if they could. In other words, it shows us the gap between how many full-time jobs we have and how many full-time jobs we need. The result, as you can see above, is that instead of being a million full-time jobs short, like the unemployment rate says we are, we’re about 3.5 million short.”

Thanks for the podcast Russ.

A new housing development is always bad if you want to live beyond the ‘burbs. Your property value may be increasing, however. Quality of life vs. property value. I’m a quality of life guy.

Yogi Berra:
“Nobody goes there anymore; it’s always too crowded.”

Keith H
Apr 22 2015 at 8:18am

@Ali K

Spot on about Russ letting Scott get away with the savings generate loans fallacy!

Russ – I think you even had a podcast explaining this not to long ago, that our banking loan system (home, auto, business, etc) is NOT based on the amount of savings held in a bank – they are not constrained by that factor, and in fact those savings are counted as liabilities.

John Strong
Apr 22 2015 at 9:48am

This podcast was SO helpful. Thanks for explaining “reasoning from a price change” to us layfolk.

Levi Russell
Apr 22 2015 at 12:39pm


So if you’re using NGDP to determine the easiness of policy, how are you controlling for velocity? If I’m not mistaken, you’re still relying on MV=PY. Are you assuming V is fixed?

Michael Byrnes
Apr 22 2015 at 2:07pm

NGDP targeting is not based on any assumption of fixed V. Rather, it is based on the idea that the goal of monetary policy should be to stabilize MV (and thus PY) along a prespecified growth path.

Original monetarism depended on stable V. (Think of Milton Friedman’s recommendation that the Fed should target a fixed growth rate of M). If M is fixed (or growing at a constant rate), then changes in V mean changes in NGDP. Hence original monetarism only works if V is stable.

NGDP targeting improves upon traditional monetarism by accounting for changes in V.

Apr 22 2015 at 3:50pm

As aside Russ mentioned the fact that housing wealth may explain a lot of the inequality that Mr. Piketty is so concerned about. Looking at the Zillow Home Value Index ( from 1996-2015 demonstrates pretty dramatic differences in equity gains depending on geographic location. And given the fact that housing is typically levered 5:1 (or more) these differing amounts of appreciation lead to dramatic changes in wealth.

As a little exercise I decided to see what would happen to a few hypothetical young California workers who were given a 150K bonus in 1996. The condition of the bonus was that recipient would have to buy the median priced home in their community with 20% down and the remainder of the bonus invested in the S&P with dividends reinvested.

Here is what happens to the value of that 150K bonus over those 20 year in various California cities:

1) Palo Alto: $2.5 Million
2) Bakersfield: $850,000
3) Malibu: $2.5 Million
4) Rialto: $923,000
5) Mountain View: $1.7 Million
6) Pomona $959,000

The differences are more stark when accounting for the implied rent one receives in one area (i.e. Malibu) vs another (i.e. Bakersfield) over the 20 years.

Great podcast once again, Russ.

Apr 23 2015 at 8:46am

“Never reason from a price change” deserves its own acronym, NRFAPC, like Friedman’s TANSTAAFL (originated by Robert Heinlein, I believe), and it may be just as important. Credit Sumner for his relentless–yet good-humoured– insistence on sticking to logic and first principles. Like TANSTAAFL, NRFPC is one of those truths that many people who should know better, don’t. NRFPC and you’ll be smarter. Even than some prize-winning economists.

Shawn Barnhart
Apr 23 2015 at 11:09am

An interesting discussion even for the dilettante whose only economics background is EconTalk.

I was surprised to hear arguments on the relative difficulty in competition in high tech due to IP. Microsoft didn’t get its start as an especially novel technology company, either, much of what they “innovated” was bought or copied from someone else originally and “embrace, extend, and extinguish” was a common label applied to Microsoft’s method of undermining pre-existing standards and technologies — couple support for a standard which you then make non-standard on your widely available platform and then you eliminate the ability of your competitors to use the standards or technologies to compete.

Scott Sumner does rightly later attributed the Network Effect which I think is a much greater contributor in computer technology, especially for companies like Facebook. Nothing about Facebook’s “technology” is particularly novel or exceptional — passing messages on the Internet is as old as the Internet itself — think email, and for the cognoscenti “USENET” might ring a bell.

Facebook’s innovation was making communities using message passing for “ordinary” people but even that innovation wasn’t all that different from what happened with CompuServe or AOL in their heyday. Facebook was primarily in the right place (a widely available computer network many people were familiar with using) and the right time (the advent of smartphone technology). It stays big because it has so many users and this network effect has kept Google’s Google+ service from gaining any traction despite some appealing technologies and Google’s massive backing.

Even addressing the IP area specifically, technologies come and go so fast that your IP isn’t really all that valuable more than in the short term. It may suppress immediate competitors, but with shifts in technology your competition isn’t trying to copy your design, they have completely replaced it with something better. You’re not losing business to competition for your product, your entire market has vanished.

The other thing I thought wasn’t really well addressed was the supposed paradox between Pinketty’s claim of excess return to capital and the low return to savers. I think some of what’s happening there is that saving is hard for many people in an era of declining middle class incomes — you have to accumulate enough cash to even be able to invest it in markets that return a rate of investment worth investing into. Plus banks really are more interested in charging fees to retail customers for use of their saving, checking and banking services than they are in paying them for access to their money, especially when so little of their retail base has enough extra cash to save.

Apr 24 2015 at 8:54am

Russ and Scott,
I was yelling “Network effects” in my car at multiple points in the conversation. It is very hard to enter a market with a product that increases its value according to the number of users. Part of the reason that Google is great is because people use Google and algorithms can learn from the users. Facebook has around a billion users. I like Facebook because everyone has Facebook, so even those who aren’t active users, like myself, it’s convenient to easily keep in contact with family and friends. I don’t believe these companies will ever become monopolies, mostly because even with the enhanced network effects they can only take one so far. Still, these network effects create enormous barriers to entry, even for the Stanford genius with VC funding. These barriers are a primary driver of high profit margins.
Also, I think when you look at the market you should also be looking at P/E and forward P/E ratios. P/E ratios are high (compared to historical averages) and forward P/E ratios aren’t any better. When looking at the market I don’t see any attractive options, even with an appetite for risk. When the stock market booms because P/E ratios rise, that can simply mean more people are piling in because they don’t like their other options. Further, the real risk-free rate in much of the developed world has flipped negative. It’s unprecedented territory and nobody really has a good idea of where we are going. When Scott recommended a mix of risky and risk-free investments, the right mix for most of us should be a mix of stocks and non-perishable goods, toilet paper, etc., instead of including the risk-free bonds that yield a negative real return.
One last item, if the Fed expands the money supply and the incremental money supply piles into financial assets and drives up prices and valuations, how could that be taken into account with a NGDP model? Talk to VC and PE funds and they’ll say they haven’t seen similar valuations since at least 1999 or 2006, depending on the industry. On the public side the P/E ratios have increased. Risk-free has fallen to negative real. Nearly insolvent governments have somewhat healthy interest rates compared to similar situations in the past. Previously “under the radar” financial products like sub-prime auto loan rates have fallen. It gets one starting to think that we found where all the central banks’ money went.

Levi Russell
Apr 24 2015 at 3:09pm


Then his definition of “loose monetary policy” is just different. If he says NGDP indicates the looseness of policy then he’s talking about two components: M, which is directly dependent on policy and V which has a lot less to do with policy and more to do with how people react to it.

So yeah, you can just invent a new definition for loose policy, I guess. The very fact of inventing it doesn’t make you right.

Michael Byrnes
Apr 24 2015 at 4:44pm

@Levi Russell:

Not really. Clearly Scott is not the first macroeconomist to define the stance of monetary policy in this way:

The only aspect of Friedman’s 1970 framework that does not fit entirely with the current conventional wisdom is the monetarists’ use of money growth as the primary indicator or measure of the stance of monetary policy. Clearly, monetary policy works in the first instance by affecting the supply of bank reserves and the monetary base. However, in the financially complex world we live in, money growth rates can be substantially affected by a range of factors unrelated to monetary policy per se, including such things as mortgage refinancing activity (in the short run) and the pace of financial innovation (in the long run). Hence, it would not be safe to conclude (for example) that the recent decline in M2 is indicative of a tight-money policy by the Fed.

The imperfect reliability of money growth as an indicator of monetary policy is unfortunate, because we don’t really have anything satisfactory to replace it. As emphasized by Friedman (in his eleventh proposition) and by Allan Meltzer, nominal interest rates are not good indicators of the stance of policy, as a high nominal interest rate can indicate either monetary tightness or ease, depending on the state of inflation expectations. Indeed, confusing low nominal interest rates with monetary ease was the source of major problems in the 1930s, and it has perhaps been a problem in Japan in recent years as well. The real short-term interest rate, another candidate measure of policy stance, is also imperfect, because it mixes monetary and real influences, such as the rate of productivity growth. In addition, the value of specific policy indicators can be affected by the nature of the operating regime employed by the central bank, as shown for example in empirical work of mine with Ilian Mihov.

Do contemporary monetary policymakers provide the nominal stability recommended by Friedman? The answer to this question is not entirely straightforward. As I discussed earlier, for reasons of financial innovation and institutional change, the rate of money growth does not seem to be an adequate measure of the stance of monetary policy, and hence a stable monetary background for the economy cannot necessarily be identified with stable money growth. Nor are there other instruments of monetary policy whose behavior can be used unambiguously to judge this issue, as I have already noted. In particular, the fact that the Federal Reserve and other central banks actively manipulate their instrument interest rates is not necessarily inconsistent with their providing a stable monetary background, as that manipulation might be necessary to offset shocks that would otherwise endanger nominal stability.

Ultimately, it appears, one can check to see if an economy has a stable monetary background only by looking at macroeconomic indicators such as nominal GDP growth and inflation.

It makes no real sense to define monetary stability any other way.

Levi Russell
Apr 25 2015 at 5:13pm

But some have focused on monetary aggregates. It’s somewhat confusing to the non-specialist because when you talk about, say, EPA policy, people’s response to the policy doesn’t determine how extreme that policy is.

If market monetarists want to look at it that way, fine, but it seems as though you could miss real-world issues by ignoring monetary aggregates and by taking a mechanistic interpretation of the Fisher equation. Scott seems to completely deny/ignore the reality of Wicksell effects because he’s so committed to MV=PQ.

Apr 25 2015 at 6:01pm

Another great discussion.

Special thanks to Scott for reading and replying to some of the posts.


Reasoning from a price change – The Fed rate changes lead the market rate changes. There is no doubt that the Fed is driving interest rates down, not the market. Scott’s theory is fine in an unmanipulated market, but this is not the reality that we live in.

On the other hand, the Fed has clearly stated that it believes that by lowering the interest rate it will encourage lending and growth. So are they reasoning from their own price change without understanding supply and demand?

Interest rates – They also have specifically said that they are trying to force investors into higher risk securities and investments. Is it possible that investors are making a reasonable game theory decision in that “the only way to win is not to play” (apologies to War Games…)?

The fact that interest rates are still low after so long may mean that the effectiveness of Fed rate changes are longer lasting than discussed. I really think that much of the world has been fooled into thinking that the Fed has control over the long run. They do not. I understand that believing that the world is foolish is a poor basis for economic theory, but just look at 2007.

Now, if you are a lender at a bank and the same 9 out of 10 credit scored borrower comes in when interest rates are 6% and you have to make your own judgement about risk and growth vs that same borrower coming in and you are at a 2% rate and the Fed is continuing to say that the economy is so bad that they can’t raise rates – in which situation is the loan more probably made? In addition, the Fed is paying you 0.25% to NOT loan out the money.

One more point. Of the new money created, corporations have soaked up $2-3T over the last few years buying back stock. That has added to the increases in stock prices and reduced the amount of money available to lend for growth oriented opportunities.

Silicon Valley – Networking critical mass is of course very important. But so is a culture of reward for risk. Even with federal and CA taxes, it is still possible to make great amounts of money in SV with the right ideas and hard work. Incentives matter.

Income inequality – Again, I think that this is an artificial metric. It is measured pre-tax and pre-redistribution. Therefore, further redistribution ideas to reduce inequality will not work. Instead of working to an artificial metric, work to the highest order metric – raising the median standard of living. Free markets are the best way to do this.

Piketty – Per my comment in the other thread, the Cantillon Effect may explain how the rich are gaining so much more in relation to the median. As before, I have little use for Piketty.

Regulation – As far as landlords seeking more restrictive zoning, other rent seeking and regulatory capture, regulations are certainly stifling the economy. Which is why the left is never serious about income inequality, as they invent most of the regulations (although the right is far from perfect) that increase it – and lower the median standard of living.

Final thoughts – QE and lowered interest rates failed to do anything for the economy of Japan, regardless of their population issues. Europe has the same population issues and QE will do nothing for them. The US has a small native population growth and a boom in illegal immigrant population growth. Those illegals will take a long time to assimilate and produce net positive effects for the economy, possibly even a generation or two. Despite population effects, QE will not work in the US either.

I continue to believe that QE exists to reduce the interest payments of the federal government (at a direct cost to savers). We are running $300-400B lower deficits now than if we had market rates. That’s maybe $2-3T less national debt (and tax on savers).

When the world figures out that the Fed and BOJ and ECB have no clothes, we will have some interesting times to look forward to.

Andreas Steiner
Apr 26 2015 at 5:07pm

Many interesting perspectives in this talk, and some good – i.e. counterintuitive – economics. What I missed was a discussion of the empirical evidence on credit rationing in both the Great Depression and Great Recession. Credit rationing (and also costs of financial intermediation) are the microeconomic foundations of New Keynesian macro models. I would be very interested in Sumner’s view on the Financial Accelerator model and the Stiglitz/Weiss research on credit rationing. Thanks again to Russ and the Econtalk team for producing such interesting talks.

Apr 26 2015 at 5:30pm

Levi Russell,

One of the arguments for focusing on NGDP is that you aren’t bound by actions that rely upon assumptions like fixed V. It would be mechanistic to assume that a change in money base represents the stance of monetary policy. If you talk to a ship captain and he says his “policy” is to not move, how would you react? Would it not be more sensible to judge the policy stance of the captain by his goals given the tools under his command?

Apr 27 2015 at 9:38am

Russ that was a very interesting podcast and I found some of the ideas compelling.

I have a couple of issues with the interest rates that people on main street see and not what large Fed protected banks see. People see short term rates in excess of 20% in the form of credit cards. Then they may have a home equity line of credit or a loan against retirement savings at a much lower rates where they use their homes or retirements as collateral.

Jon B.
Apr 27 2015 at 10:16am

Russ & Scott,

Regarding low (or sometimes negative) risk-free rates that we see today on the short end of the curve, I would like your thoughts on the role of liquidity risk regulation requiring increasing the demand for risk free assets. As a response to the 2008 financial crisis, regulation such as the Liquidity Coverage Ratio (LCR) and proprietary stress tests essentially require banks to calculate stressed outflows, and cover them with both cash at the Fed or US Treasury / Agency securities. Because these securities have to be classified as “Available for Sale” (otherwise they do not qualify as High Quality Liquid Assets [HQLA]), banks tend to purchase short-term term securities as the mark-to-market of such securities would hit a bank’s P&L.

Furthermore, said regulation also forces banks to hold HQLA to support repurchase agreements (the lower the collateral quality, the more HQLA a bank has to hold in reserve). This has caused repo counterparties to raise their collateral quality requirements, thereby further increasing demand for government and agency debt.

Elliott Dubin
Apr 28 2015 at 10:46am

One reason, in my opinion, for the decline in real interest rates is the aging societies in Western Europe, Japan, and the United States. The elderly require more services rather than goods thus, the decline in investment. Further, the demand for services overall, probably has reduced the demand for capital goods. There are service industries that are capital intensive — air and rail transportation, medical services (becoming more capital intensive), and some others, but, in general, less capital is needed to produce these services.

State and local governments, which in past decades were large demanders of capital are currently, in the aggregate, barely replacing their infrastructure. Gross investment, as a proportion of total expenditures, has declined for all functions of spending.

Henri Astier
May 4 2015 at 1:01pm

I found this discussion illuminating – particularly the “reasoning from a price change” fallacy. Like all great ideas, once you became aware of it you start seeing it everywhere.

For instance I’ve just read this paragraph an article in The Economist on the puzzle of stagnating wages:

“The usual assumption is that once unemployment gets below a certain rate, idle labour becomes scarce and competition to hire already employed workers heats up. As firms outbid each other for talent, new workers get better starter salaries and valued staff secure juicy raises.”

The article shows that this has not been the case, particularly here in Britain where we have had a combination of low unemployment and rock-bottom wages for years. The Economist goes on to explain why (the usual suspects, technology and globalisation, are mentioned) and what can be done about.

But Sumner’s concept of shifting demand curves – in this case, fewer workers are needed to clear the market – has the virtue of simplicity and multiplicity of applications.

David Boreham
May 5 2015 at 2:32pm

I’m a little late in commenting, but I felt it important to point out (as a 30+ year software industry veteran) that the speakers’ notions on patents and copyright in high high tech markets are quite mistaken. While I’m willing to concede that there are isolated cases where a competitor decides not to enter a market for fear of patent or copyright action, this must be extremely rare because I have never in my career heard anyone say “we can’t build that because XXX co. has a patent on it”. In fact, nobody working in the field as a rule has any notion of who has patents on what (except through press coverage of celebrated “patent troll” court cases which tend to involve very old patents that are unrelated to current work). In addition, if you do go looking for patents you will find that a) they make no sense (to a practitioner) and b) for every idea you can think of, there are many (perhaps hundreds) of existing duplicate patents. Bottom line: in software, patents generate a lot of noise through press reporting on litigation but are hardly noticed at the coal face when making products or deciding what product to make and which features to incorporate.

In my opinion the significant barriers to entry for competitors in the cited markets are Network Effect and secondarily the relative high cost to produce software that meets the needs of large numbers of users in a way that they are willing to pay for. eBay is valuable because it is eBay (and everyone knows to sell there and so everyone knows to buy there), not because they have some voodoo software up their sleeves. Note also that many of today’s successful market participants do not attempt to directly sell software or software-driven services. Instead they are selling advertising and advertising-like services. So they are not really high tech vendors at all, and different economic factors apply that are relevant to the advertising business.

Finally, I would observe that straightforward rip-off products are in fact very common. There is a company in Germany that specializes in making accurate clones of successful US-based Internet businesses before they have a chance to expand into Europe. Their activities are a major factor behind the recent trend for US startups to raise very large sums in their later funding rounds : to “beat those guys to market”. In addition there are Chinese clones of Twitter, Facebook, and so on. I am not aware of any significant success in using patent or copyright action against any of the above.

Gregory Barton
May 14 2015 at 8:02pm


A few comments on your investment anxiety:

I’m kind of anxious that it (the S&P strength) 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.

Why? What’s different this time?

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.

There is no ‘risk free’. ‘Risk free’ is a myth. Treasuries usually offer a low return in real terms. In real terms they offer a high risk of long term capital loss unless you speculate on rate movements which is usually high risk.

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.

You confuse volatility with risk. The stock market is always volatile, not just the next ten years, but also the previous ten and the ten before that. But volatility is not the same thing as risk, unless you are trading short term.

So that to me is what’s weird–and unpleasant–about the current environment.

I put it to you that it is not different this time. You are merely enunciating the wall of worry.

Thinking in terms of risk-free, high risk and low risk is probably unproductive. Far more productive to think in terms of optimal risk. We have to take some risk in order to reach our financial goals (unless we have more than we can spend in a lifetime). The question should be ‘what is the lowest risk I can take to reach those goals?’

My advice: make the calculation and climb the wall without the worry.

Jeff Guernsey
May 15 2015 at 4:16pm

The first part of this podcast was golden, as the guest and Roberts discuss the interaction of supply and demand, resulting in price AND quantity determinations.

Comments are closed.


EconTalk Extra, conversation starters for this podcast episode:

About this week's guest:

About ideas and people mentioned in this podcast episode:Books:

      • The Theory of Interest, by Irving Fisher. Fisher's famous historical (and easy-to-read) explanations of real vs. nominal interest rates, his cautions about common pitfalls, and his derivations of the demand and supply curves for credit as a function of the rate of interest based respectively on savings and investment decisions. On Econlib.


Web Pages and Resources:

Podcast Episodes, Videos, and Blog Entries:




Podcast Episode Highlights
0:33Intro. [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 actually not the 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 by higher consumption. 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 the demand schedule. 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 go with the 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 shift along a 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 would seem that it would be followed by a reduction in prices and that would mean that your house 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 the cause of 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 me constantly--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, that sort 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 to boost growth 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.
7:54Russ: 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, at every interest 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 investment falls. 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 a huge expansion 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. I don't think 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 high nominal rates. 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 can temporarily lower real interest rates, but at a cost of higher inflation. If you have a contractionary policy you can raise interest 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 it were, 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.
16:42Russ: 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--expected inflation. 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 want more than $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 by expected inflation. Of course, we don't really know what expected inflation is. We have actual inflation, 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 you want and 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 found that isn't quite right. Interest rates have gone slightly negative in Europe. And it seems like 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 pay some sort 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 being safer than 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 are rising in 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 very risky investment to make, because of the high inflation, high interest rates, and so on.
24:27Russ: 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 of investing going 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 on quantity. 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 will use that extra oil. Russ: Moving down that demand curve, if that did not shift. Guest: Moving down that demand curve. Now, in this case, 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 down along that 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 we are going 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 moving along 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.
30:14Russ: 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 this unbelievable explosion of creativity there. And it's not just hypothetical. People are doing stuff: 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 that fact with 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, they knew they 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 about the interest 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 the risk-free rate 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 a lot of money over the last few years by putting money aside. A huge amount of money. The returns are extremely high. 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.
38:50Russ: 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 maybe have been 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's so much 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 a huge amount 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 for capital could 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 not giant capital 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 already in those 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.
48:13Guest: 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 the opposite claim--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 the safe assets--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, you identified 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 a huge return. 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 too little housing 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
56:45Russ: 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, the mix of 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.
1:00:10Russ: 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's plausible, 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, he thinks it'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 much longer it 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 it is only 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.