The Interest Rate is a Price, not a Prediction

There’s been general mockery of this Time magazine cover:debt-cover-final

The response has been to point out how interest rates on U.S. debt are, by historical standards, extremely low:


Financing federal debt is cheap, and it may remain cheap. But this is no more an unambiguous endorsement of our government’s solvency than a million dollar apartment in Williamsburg is an endorsement of the artisanal pickle industry.

This is why Treasury interest rates are low:


The supply of loanable funds has increased so much (S0 to S1) that in spite of increases in the demand for loanable funds (D0 to D1), the interest rate has decreased (R0 to R1) while the quantity of Treasuries sold have dramatically gone up (Q0 to Q1).  (An earlier expansion in supply of loanable funds, what NPR dubbed the Giant Pool of Money, was also the single most important factor in the run-up of housing prices that led to the housing crisis. )

Why has this supply of loanable funds increased so much relative to demand? Who knows. It has something to do with the increase in relative prosperity of the rest of the world compared to the U.S.:


But you’ll note that the lion share of the increase in loanable funds comes from China, Japan, and Europe. What do those have in common?


The collapse of birth rates and aging population in wealthy-and soon-to-be wealthy- countries is one of the key facts about our world. The economist Karl Smith, formerly of UNC and now seemingly incommunicado, wrote frequently about the impact of birthrates on savings and the demand for investment:

The most significant fact for economic growth in the 21st century is the sharp, now global, reduction in birth rates, population growth and hence labor force growth. There is quite literally no area of economic, political, or social policy which is not at least touched by this fact. Our most pressing issues are radically altered by it. Some standard concerns are well known: dependency ratios will rise, inherited wealth as a multiple of national income will grow, and debt dynamics will become less stable. As a result of these effects, both inequality and demands on the welfare state will increase.

I’d like, however, to press a more subtle, though potentially more damaging, concern. Lower population growth rates have the potential to undermine the virtuous cycle of risk-taking and innovation. Without policy changes, economies will find themselves trapped in rapid boom-and-bust cycles that net out to pathetically slow growth rates even in per capita terms.

Though the economic growth dynamics are complex, the underlying intuition is straightforward. A growing population provides a buffer for risky capital investments. A growing population, and hence potential workforce, demands more capital each year and crucially demands a larger total pool or stock of capital.  The economy cannot get by simply by replacing worn-out machines and refurbishing dilapidated buildings. The total stock of machinery and the total number of buildings needs to grow.  If not, capital will become scarce relative to labor, wages will fall and the profits from new capital investments will soar. These soaring profits will provide an irresistible lure for new investment.

The potential for soaring profits also provide a cushion for innovation. Innovators may guess wrong and invest in capital that turns out to be less, rather than more, efficient or effective than the current modes of production. If the population size is stagnant then society responds by shunning the innovation and simply continuing to replace existing machines and buildings using the existing technology.

A growing population can’t get by that way. They need new capital and will settle for the less effective and efficient innovation if nothing else is available.  In economic terms, a growing population provides price support for even unsuccessful innovations and thus limits the downside risk for innovators.

This is, I think, the founding intuition behind strong support for immigration by rich country elites: not that the importation of individuals with little education or marketable skills will reduce wages, as is often claimed, but that these individuals will be customers for goods and private and public services in a way that will keep the economy working (at least from the perspective of the people who create most of our perceptions and discourse.) Here, for example, are U.N. projection prospects for Europe, the Middle East, and Africa:


Those are a lot of potential customers. Most of them are currently without the money to actually be customers, but the right welfare state and sufficiently porous borders can correct that.

Mo Tkacic wrote something very smart about journalism several years ago that I think provides real insight into the world at large:

What I sensed was that while the laws of supply and demand governed everything on earth, the easy money was in demand—manufacturing it, manipulating it, sending it forth to multiply, etc. As a rule of thumb (and with some notable exceptions), the profit margins you could achieve selling a good or service were directly correlated to the total idiocy and/or moral bankruptcy of the demand you drummed up for it.

This was easier to grasp if you were in the business of peddling heroin, Internet stocks, or celebrity gossip; journalists, on the other hand, were at a conspicuous disadvantage when it came to understanding their role in this equation…That journalism’s ability to deliver that information—to fill that need—ultimately depended, to an unsettling degree, on the ability to create artificial demand for a lot of stuff that people didn’t actually need—luxury condos, ergonomically correct airplane seats, the latest celebrity-endorsed scent—was an afterthought at best, at least in the newsroom.

Journalists, by and large, had so little appreciation for their dependence on the larger engine of artificial demand that they were mostly blindsided when the Internet happened and they lost the benefits of that engine. A lot of them seemed to take it personally

This existential angst tormented even the commerce-savvy staff of the Journal, where I was assigned to the “youth” beat—which is to say, and it very much went without saying, youthful consumption trends.

Despite the superficiality of this beat, the people who inhabited it—the brands that were in demand—had money, power, and an attendant sense of entitlement that could be intimidating….I did not really identify with the cool-hunting, brand-building, sneaker-collecting generation of professional consumers I worked over for trend-story ideas, but neither did my colleagues in the bureau seem to identify with the megalomaniacal talent agents and casino magnates or the disgruntled aerospace engineers and short sellers they talked to all day.

In the end, the low rates for Treasuries has importance in of itself– among other things, in combination with falling property tax receipts, it presages a  shift in the relative power of federal, state, and local governments. But it also reflects even larger forces at work, the limits to the manufacture of desire that has hitherto kept our world in motion, particularly as automation and the virtual world increases our capacity to meet desires in some form if not in all. As Italo Calvino wrote in Invisible Cities:

 At the end of three days, moving southward, you come upon Anastasia, a city with concentric canals watering it and kites flying over it. I should now list the wares that can profitably be bought here: agate, onyx, chrysoprase, and other varieties of chalcedony; I should praise the flesh of the golden pheasant cooked here over fires of seasoned cherry wood and sprinkled with much sweet marjoram; and tell of the women I have seen bathing in the pool of a garden and who sometimes — it is said — invite the stranger to disrobe with them and chase them in the water. But with all this, I would not be telling you the city’s true essence; for while the description of Anastasia awakens desires one at a time only to force you to stifle them, when you are in the heart of Anastasia one morning your desires waken all at once and surround you. The city appears to you as a whole where no desire is lost and of which you are a part, and since it enjoys everything you do not enjoy, you can do nothing but inhabit this desire and be content. Such is the power, sometimes called malignant, sometimes benign, that Anastasia, the treacherous city, possesses; if for eight hours a day you work as a cutter of agate, onyx, chrysoprase, your labor which gives form to desire takes from desire its form, and you believe you are enjoying Anastasia wholly when you are only its slave.

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