Why interest rates (probably) won’t stay high

Bubbles seem to be bursting everywhere. Cryptocurrency is the most obvious example, but the decline in crypto prices has been more or less matched by the decline in high-flying tech stocks: You would have lost roughly the same amount of money buying Meta stock last year as you would have lost buying bitcoin.

This broad-based decline in speculative assets might in part reflect a general disillusionment with tech bros. Derek Thompson at The Atlantic argues the tech industry is suffering a midlife crisis, with yesterday’s whiz kids trying to reclaim their magic with ever-worse investments and investors may be picking up on the whiff of desperation. But the decline also reflects macroeconomic forces, specifically a sharp rise in interest rates, which makes speculative investments less attractive.

Is the era of cheap money over?

I’ve written about this topic before and made the case that low rates will return. I still believe that, but what I want to do here is make the case in a slightly different way.

My starting point is the observation that the fiscal response to COVID-19 was truly extraordinary. Budget deficits normally rise when the economy slumps. During the pandemic slump, however, the effects of these “automatic stabilizers” were dwarfed by the effects of special federal programs designed to cushion the financial hardships of lockdowns.

I happen to believe this massive spending was the right thing to do. Maybe it should have been smaller, but better to have helped people than not. But even those of us positive on Bidenomics acknowledge that you would expect such a surge in spending to raise interest rates.

But the COVID-19 surge in deficits is now behind us. We’re still probably feeling the effects of pandemic spending: Households saved much of the aid, and consumer demand has stayed strong. But eventually, the boost to the economy will fade.

And once that happens, we’ll probably be back where we were before the pandemic, with weak private investment demand holding rates down.

Why will investment demand be weak? Last time I wrote about this I stressed demography plus what looks like disappointing rates of technological progress. That’s still my story, but let me now put it a different way.

One well-known concept in macroeconomics is the accelerator effect: Investment spending generally reflects not the level of GDP but the expected change in GDP. The logic is that investment spending is only high when businesses want to increase capacity, which happens only when demand is growing.

The CBO believes — and I agree — the future isn’t what it used to be. In the 1990s it made sense to expect growth at more than 3% a year over a decade; these days, expected growth is half that.

Why? Demography plays a role: Baby boomers have been aging out of the workforce while, thanks to low fertility and declining immigration, they aren’t being replaced. Another important factor is that aforementioned midlife crisis in technology. In the 1990s and early 2000s, productivity received a major boost as businesses figured out what to do with computers and networks, but the economic payoff to technology has seemed much smaller since. It’s a cliché but one borne out by the data: When was the last time you were excited by the latest iPhone?

What all this suggests to me is that the era of cheap money is not over. A few years from now, we’ll probably be back to a situation in which too much savings chases too few investment opportunities, and rates will fall to old lows.