by Julius Probst
The decline in global real interest rates
Back in 2013, Larry Summers started to believe that most advanced economies have entered a new macroeconomic regime, a prolonged period of lower economic growth as a result of insufficient aggregate demand. In a recent piece, I argued that Summers’ revival of the secular stagnation hypothesis has been the most important contribution to modern macroeconomics (Probst, 2019a). According to the secular stagnation theory, a combination of macroeconomic factors have pushed down real interest rates on a global level. These forces include adverse demographics, falling productivity growth, and rising inequality. With the decline in interest rates, Central Banks increasingly struggle to keep the economy at full employment because they cannot reduce interest rates substantially below zero. Therefore, many countries will also have a higher risk of experiencing recessions and might suffer from prolonged negative output gaps when interest rates remain constrained by the so-called effective lower bound (Summers, 2015; 2016).
The chart below displays the secular downward trend of real interest rates for the Japan, the US, the UK, and the Eurozone. Most other rich economies have suffered the same fate since the 1980s. A lot of economic research has shown that global interest rates have declined significantly and that they are nowadays at record-low levels across advanced economies since the late 19thcentury (Probst, 2019c, Schmelzing, 2017). Some economists have even suggested that current interest rates have never been that low throughout human history since the early Antiquity (Haldane, 2015). The decline in interest rates also had the unintended side-effect of pushing up the price of financial assets around the world, both stock markets and real estate.
Figure 1: Real Interest rates
CB policy rates minus CPI, 1 year MA
Source: Macrobond
The global surge in real estate prices
The second figure below shows that inflation-adjusted house prices have almost tripled across many advanced economies since the end of Bretton Woods in the early 1970s. This has especially been the case for Anglo-Saxon economies, but the social-democratic economies of Scandinavia have been severely affected as well. While increasing financialization and the globalization of capital flows probably also played their part in pushing up local real estate prices in global cities like London, New York, and Paris, etc., researchers at the Bank of England have arguedthat a significant part of the increase is due to the decline in global real interest rates. The reason is simple. The value of any financial asset is simply the net present value of all its future cash flows discounted at the rate of interest. As interest rates decline, future cash flows become more valuable and therefore the fundamental value of the financial asset increases.
Figure 2: Real house prices, Dallas Fed Price Index
Source: Macrobond
A standard way of pricing financial assets is by using the dividend discount model, according to which the net present value (NPV) of a financial asset is given by the sum of all future cash flows (R) discounted by the rate of interest (i):
While the formula is usually applied to stock prices, it is equally valid to use it for housing or other investments. As inflation-adjusted interest rates have declined significantly across the world in recent decades (and the same is true for nominal interest rates), the price of real estate and other financial assets increases as future cash flows are now discounted at a lower rate of interest. Halving the rate of interest would roughly correspond to a doubling of financial asset prices. It therefore stands to reason that the secular downward trend of interest rates has indeed contributed to a large extent to the spectacular surge in house prices across advanced economies.
Germany and Japan are the outliers
However, the researchers from the Bank of England might have gone one step too far in attributing almost the entirety of the increase in house prices to falling interest rates. Dwellings are after all not only a financial asset, but they also provide us with one of the most important services in life, namely housing. The demand for housing in large metropolitan areas has increased significantly in recent decades as most jobs high-income jobs have been created in the large agglomerations. The forces of economic geography have increasingly favored big cities since the 1990s while more rural regions have largely lost out (Florida, 2016). This has been the case in the US, but also in most European countries like Germany, the UK, and Sweden. Consequently, house prices have performed extremely different across regions within countries. Furthermore, there also seem to be vast differences internationally. While some countries have seen their house prices explode in recent decades, mostly a combination of stronger population growth and restricted supply, other countries have experienced a very different trend. Most noticeably, real house prices in Germany and Japan have stayed relatively flat for a longer time period (see below). Japan has seen stagnating house prices for more than 2 decades since the explosion of its asset price bubble in the early 1990s while Germany’s house prices have only started to catch up to the international trend very recently. This suggests that supply-side factors are also extremely important in determining house prices. According to the following statistic, the metropolitan area of Tokyo added more individual housing units in 2014 than the entire country of England. Consequently, house prices in Tokyo have experienced a very different trend than most other metropolitan areas around the world where supply has been much more constrained.
Figure 3: Real house prices, Dallas Fed Price Index. Germany and Japan
Source: Macrobond
Conclusion
Summing up, the evidence for secular stagnation seems to be increasing as advanced economies continue to suffer from even lower interest rates and economic growth rates than what was widely expected just a few years ago (Probst, 2019a; 2019b). Moreover, this does not seem to reverse any time soon as financial markets have priced in low interest rates for the foreseeable future. Secular stagnation also had the undesirable side-effect of bidding up house prices around the world as a result of low interest rates. However, the financial blog by the Bank of England might have somewhat overstated its case. Dwellings are not only a financial asset, but also a real commodity. While the entire advanced world has suffered from low interest rates during the last decade, supply-side constraints can explain why San Francisco or New York have experienced exploding house prices whereas this has not been the case in Tokyo, for example.
References:
· Florida, R. (2016). Winner-take-all urbanism: Geographic divisions in the modern era. Brown J. World Aff., 23, 103.
· Gordon, M. J. (1962). The investment, financing, and valuation of the corporation. Homewood, IL: RD Irwin.
· Haldane, A. (2015). Stuck. Bank of England Speeches.
· Probst, J. (2019a). Lawrence Summers Deserves a Nobel Prize for Reviving the Theory of Secular Stagnation. Econ Journal Watch, 16(2), 342.
· Probst, J. (2019b). Secular stagnation: it’s time to admit that Larry Summers was right about this global economic growth trap. The Conversation.
· Probst, J. (2019c). Global real interest rate dynamics from the late 19th century to today. International Review of Economics & Finance, 59, 522-547.
· Schmelzing, P. (2017). Eight Centuries of the Risk-Free Rate: Bond Market Reversals from the Venetians to the ‘VaR Shock’.
· Summers, L. H. (2015). Demand side secular stagnation. American Economic Review, 105(5), 60-65.
· Summers, L. H. (2016). The age of secular stagnation: What it is and what to do about it. Foreign Aff., 95, 2.
Julius Probst is a Customer Specialist at Macrobond Financial, a macroeconomic search engine and analysis tool and provider of financial time series data. Previously, he was a PhD student at the Economic History Department at Lund University and a PhD trainee at the ECB. He also has a blog on macroeconomics at macrothoughts.