Concerns about low interest rates

There has been some discussion about whether we are entering an era of permanent stagnation/low growth or whether the natural interest rate will remain low for an extended period.

Many have voiced concerns about low IR environments, but I don’t often hear discussions of skew:

when rates are low, future payments are discounted less, meaning that well-understood cash-flows are more valuable than more speculative cash-flows vis-a-vis the higher rate period.

As a simple example, if you had a choice between purchasing a firm that pays out $1 per period if alive, but has a 10% chance of dying every period, OR purchasing a consol that pays out $1 per period guaranteed, then even assuming quadratic utility, if the risk free rate were 5%, the risky firm would be worth 0.3 consols, but if the discount rate were 1%, the risky firm would only be worth 0.08 consols. Similarly, at a 5% discount, a firm that has a 15% chance of dying each period is worth 0.71 times the firm with the 10% death rate. But at a 1% discount, the riskier firm is worth only 65% of the less risky firm.

In other words, in a low rate environment, we must peer farther out in the future, and value stable cash-flows more relative to the uncertain cash-flow. As a result, investments that offer more stable returns (such as land) are given more preferential lending terms to investments whose distant returns are more speculative.


In this relative financing sense, the higher the interest rate, the smaller the gap between the risky and riskless investment (in the limit of an infinite discount rate, our firm would be priced at 0.9 of a consol, as we only care about the first period in which the firm has a 90% chance of paying out a dollar).

This is one argument for why demand-stabilization — effectively increasing certainty about future incomes, can be less distortionary and more supportive of risky investment than lowering rates, which skews the relative value of investments towards safety.

Even within the sphere of productive capital, firms like Coca-Cola will have better borrowing terms than firms like Intel. Of course this is always true to some degree, but the relative advantage increases as the interest rate falls. Safety becomes more important in a low IR environment.

Moreover, financing structure plays a role. In such an environment firms will tend to agglomerate and engage in all sorts of odd business practices — starting resorts, stockpiling metals, etc, as the larger the firm and the more diverse business practices, the greater the borrowing advantage vis-a-vis smaller, more focused firms. Political backing — being too big to fail — also becomes much more important as the interest rate falls. Any aspect of the firm that can increase the likelihood of survival 50 years from now becomes more important than total earnings in the next few periods.

The worst borrower would be the individual who is borrowing against their own labor income. The *relatively* higher rates that they pay for purchase of durables vis-a-vis the rates offered to landholders or well-established/diversified firms is effectively a tax on consumption and a subsidy to investment; or possibly more appropriately, is a tax on personal consumption and a subsidy to the consumption of the conglomerate.

May Day Irritations

Pre-May Day blurbs. Some old, some new.

  1. Yglesias believes in one dollar one vote. I hear the price of foie gras has gone up alot over the last decade. Must be because Americans prefer it. The real surprise is given the massive increase in concentrations of wealth, why land prices in the urban core have not become even more expensive. That the 99% who cannot buy land in the urban core continue to prefer to buy their own little spot of land farther away, and consequently live in less dense areas is a trend that has held up over a thousand years, and is not surprising at all, particularly as transportation and communication continues to become more efficient. But I don’t understand how the left can idealize living in the core while ignoring the centrality of land ownership and getting out from under the thumb of economic rent extraction by landlords. Handing over 1/3 of your income to a small group of incumbents is not fun. The automobile and similar increases in transportation efficiencies were viewed as liberating because they were, in fact, liberating. Perhaps new modalities are needed now, but moving back into the core is not going to happen.
  2. Last May Day, Obama did not dissapoint, joining many other presidents in declaring May 1 Loyalty Day. Who wants to place bets on what our President will do today as workers from around the world march?
  3. A beautiful post
  4. Now more than ever, I am reminded of this gem. In particular: “Furthermore, even when moderate adjustments could be made, they tend to be resisted, because any simplification discomfits elites.”

Mad Cow Disease Outbreak in Australia

Billions in Inherited Wealth Are Not Enough to Stem Neural Disorder

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Central Bank attempting to control the money supply

Great Unravelling, Part 2, What Price Stability?

Continuing with our chartbook investigation as to what was moderate during the Great Moderation, let’s turn to prices — based in part on this post.

Let’s start by looking at spreads in consumption prices versus investment prices:

Investment Price Index/Consumption Price Index, base year = 1 at 2005

The relative rise in consumption prices is driven primarily by health care and housing services:

Major PCE components

What about relative price volatility? I took the y/y percent change of the following PPI time series:

  • Producer Price Index: Finished Goods: Capital Equipment (PPICPE), Percent Change from Year Ago, Monthly, Seasonally Adjusted
  • Producer Price Index: Crude Materials for Further Processing (PPICRM), Index 1982=100, Monthly, Seasonally Adjusted
  • Producer Price Index: Intermediate Materials: Supplies & Components (PPIITM), Percent Change from Year Ago, Monthly, Seasonally Adjusted
  • Producer Price Index: Finished Consumer Foods (PPIFCF), Percent Change from Year Ago, Monthly, Seasonally Adjusted
  • Producer Price Index: Fuels & Related Products & Power (PPIENG), Percent Change from Year Ago, Monthly, Not Seasonally Adjusted
  • Producer Price Index: Finished Consumer Goods Excluding Foods (PFCGEF), Percent Change from Year Ago, Monthly, Seasonally Adjusted

Producer Price Index series dispersion

..and calculated the standard deviation of these series:

Price Dispersion measured as STDEV of % changes of Major Producer Price Indexes

In addition to spreads in producer prices, let’s look at spreads in rates, i.e. risk premia:

BAA-AAA spreads

From Shiller Data, we have the house price index relative to the consumer price index:

Real House Price Index

What price stability?


Adventures in cognitive dissonance: China may consume too much

We smelt the steel
to make the hammers
to dig the mines
to mine the ores
to smelt the steel

Update 2: Added a Youtube video
Updated 1: Added snark

Noah Smith doesn’t understand why everyone who’s ever looked at Chinese development seriously is calling for a re-balancing and consumption led growth. Instead, he is worried about bliss points:

Or does it mean that consumption should rise faster than the other components of GDP? Fine, but consumption’s share of GDP can’t increase forever. Eventually, consumption’s share will hit a ceiling, and the “consumption-led growth” – if this is what it means – will be gone.

On the other hand, we have the historical record:


Source  For those with low screen resolution, the declining right hand curve corresponds to China — an aging population filled with households that would very much like to consume if they were given the chance to do so. And yes, that is a consumption figure of only 35% of GDP which is most likely an overestimate.

The Great Unravelling

Is our economists learning?

Which eras are those of moderation, and which are those of excess volatility? What did the central bank succeed in stabilizing as a result of relying on interest rate adjustments rather than income flow adjustments?

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