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Thursday, June 11, 2015

Answering my own question about interest rates

Yesterday I asked

Hey, I'm only in 1st-year macro, but has anyone suggested that maybe interest rates are generationally low because of demographics? Yknow, old people are rich and savers while young people are poor and borrowers, supply & demand means the market clears at a really low interest rate?

Well, lo and behold, the internet gives me an answer:

Fraser Institute - yes, MOMN is right, interest rates are low because of demographics. Quote:

The Bank of Canada apparently surprised the chattering classes and everybody else this week by dropping its benchmark interest rate. The element of surprise, of course, reflected the firmly held convictions by Bank economists, and it would appear many others, that interest rates are now abnormally low and will soon return to more normal levels. In truth, it is the continuing hope/prediction/wish that interest rates would, will or should go higher that is surprising.

The false hopes and predictions of economists arise from the application to current circumstances of a model about economic behaviour that was built for a period of history that had a very different structure. All of the models and most of the theory behind them were built for an epoch of history - the first two-thirds of the 20th century - in which brisk population growth was a constant. While some model architects knew that constant population growth was necessary for the models to work, none of the current users seem to grasp it.

Why does population growth and its fluctuations matter for interest rates? Because it determines the relative number of (net) savers and borrowers in the population of a country. Young people are generally borrowers. Middle-aged and old people are generally savers. The relative number of savers and borrowers and the size of their need for one or the other have a determinative impact on the market for loanable funds.

In a steadily growing population, the largest cohort of people is the most recently born and therefore borrowers predominate and interest rates have to be high enough to temper demands of borrowers and encourage savers to do more. Constantly growing populations create a "savers market" where savers can select from a sea of qualified borrowers. If the population growth falters, stalls or declines the balance of saving and borrowing activity changes and the role of interest rates has also to change.

In the case where population growth falls and then ceases, like say Japan or Germany, or most of the EU, the largest population cohorts will be those that have been associated with the years of greatest population growth. As those largest cohorts age, they become the net savers in the country. The fact that the cohorts behind them - the younger borrowing-prone groups - are relatively smaller than in the past means that there are fewer opportunities for savers to deploy their savings. The loanable funds market becomes a "borrowers market." In such a market, interest rates fall to encourage more borrowing and to discourage saving.

I like this Michael Walker guy. First, he realizes that different periods of history have different economic characteristics; second, he paid attention in first-year macro when they taught about the market for loanable funds!

Now if only the "chattering classes" with blogs could understand this, instead of blathering on about a secret conspiracy by the Fed!

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