The era of cheap money probably hasn’t ended yet

Interest rates are up. Stocks — especially glamour stocks, like Tesla — are down. And the crypto crash has been truly epic. What’s going on?

Well, many people I read have been offering an overarching narrative that runs like this: For the past 10 or maybe even 20 years, the Fed has kept interest rates artificially low. These low rates inflated bubbles everywhere as investors desperately looked for something that would yield a decent rate of return.

And now the era of cheap money is over, and nothing will be the same.

You can see this narrative’s appeal; it ties everything up into a single story. Yet to paraphrase H.L. Mencken, there is always a well-known explanation for every economic problem — neat, plausible and wrong. No, interest rates weren’t artificially low; no, they didn’t cause the bubbles; no, the era of cheap money probably isn’t over.

Let’s start with those interest rates. With respect to the real interest rate — the interest rate minus the expected rate of inflation — on 10-year U.S. government bonds since the 1960s, there was indeed a huge decline in real rates after 2000. But was this decline “artificial”?

What would that even mean? Short-term interest rates are set by the Federal Reserve, and longterm rates reflect expected future short-term rates. There’s no such thing as an interest rate unaffected by policy. There is something economists have long called the “natural rate of interest”: the interest rate consistent with price stability, neither high enough to cause depression nor low enough to cause excessive inflation.

So is the claim the Fed was consistently setting interest below this natural rate? If so, where was the runaway inflation? In fact, until 2021, inflation consistently came in more or less at the target of 2% a year.

But why was the natural rate so low? The immediate answer is, the Fed learned it had to keep rates low to keep the economy from slipping into recession. But if you think the Fed was setting rates too low, you’re in effect saying that the Fed should have deliberately kept the economy depressed in order to avoid … something..

Interest rates have gone up a lot in the past few months. Does this mean that the cheap-money era is over? To answer this question, you have to ask why the Fed felt compelled to keep rates so low so long.

The basic answer is that since 2000 and especially since the global financial crisis, businesses have persistently been unwilling to maintain a level of investment spending that used all the money households wanted to save, unless interest rates were very low. This condition has the unfortunate name “secular stagnation,”

What causes secular stagnation? The best guess is that it’s largely about demography. When the working-age population is growing slowly or even shrinking, there’s much less need for new office parks, shopping malls and housing, hence weak demand. And America’s prime-working-age population, which grew rapidly for many decades, began stagnating about the time interest rates began sliding.

And these demographic forces aren’t going away. So there’s every reason to believe that we’ll fairly soon go back to an era of low interest rates.

In that case, however, why have rates shot up? Well, the Fed is raising rates right now to fight inflation. But this is probably temporary: Once inflation is back down to 2-3%, probably by the end of next year, the Fed will begin cutting again.

Does this mean there will be more bubbles in our future? Yes — but there would be more bubbles even if interest rates stayed high. Hype springs eternal.