Secular Stagnation, The US Recovery, and Houses
Larry Summers and Brad DeLong have even more than usually stimulating thoughts about secular stagnation and extremely low interest rates. I notice a strong focus on non residential fixed capital investment.
disclaimer: I owe debts I can never repay to both of them, so this post might even be civil.
Summers responds to Marc Andreesen on secular stagnation. The post is rather brilliant (no surprise there). In particular, I very much liked and strongly agree with (the parts I understand) of
the evolution of productivity growth is not essential to the argument about whether equilibrium real interest rates have declined. This decline could have occurred for many other reasons – including increased foreign saving, lower priced capital goods, slower labor force growth, increased demand for safe assets, more burdens on financial intermediation, and lower rates of inflation.
I will discuss why I like Summers’s list of possible causes of secular stagnation after the jump, but here I just note that it is appropriately long. A model adicted economist would look at one possible explanation and assume away all the others. In fact the point (if any) of this post is to add another explanation — lower demand for housing. I note that the second and third explanations focus on non-residential fixed capital investment.
This passage also clearly focuses on non-residential investment
Marc and I agree that we are headed into a period of soft real interest rates, where there will be more money available than great deals. This may, as he suggests, not be all bad; as it will make it easier for risky ideas to get funded.
Brad too doesn’t mention houses. For example, here is his first concern about problems with low interest rates
safe interest rates expected to be very low for a long time artificially boost the value of long-duration assets–so capital is misallocated and we wind up with a capital structure that has in it too many long-duration relatively-safe projects that make at best very small contributions to societal well-being.
Emphasis mine and he doesn’t mean housing project.
Yet the latest bubble was in housing and the components of aggregate demand which have been strangely low during the long disappointing phase of the recovery (which phase might be over by now) were G and residential investment.
Standard macroeconomic models don’t include a housing sector. Compared to most economists DeLong and Summers are not at all model addicted. Yet even they ignore housing when discussing investment in general and long run growth and such.
I can think of two more explanations. First lower population growth causes much lower housing investment — houses last a long time so a whole lot of gross housing investment is expanding the housing stock not replacing depreciated and torn down houses. So far, I can see why houses factories and office parks are lumped together — the issues are basically the same.
Second and again, maybe there has been either bubbles or extremely low real interest rates since the productivity slowdown (starting 1973). That is maybe the housing bubble has lasted for decades and the generally recognised housing bubble post 2000 was just more extreme. People have long believed that houses are good investments because the relative price of housing trends up. Shiller has long argued that they have been mistaken. If he is right, demand has been high because of irrational expectations of price appreciation for a very long time. The argument that, during bubbles, asset prices must shoot up and become clearly crazy so the bubble can’t last is based on the standard assumption that investors know the full history of prices. This is true of stocks but definitely not true of houses. Again if Shiller is right, the current low forecast of house price appreciation and current low demand for housing might be the new normal.
Finally US housing demand has included the demand for huger and huger houses. The trend will slow if the desire for more and more floor space is satiated. This is an issue related to preferences and quite different from any discussed by DeLong or Summers.
There is a similar issue related to consumption and savings. The suspicion that inequality leads to secular stagnation is based on the idea that the super rich are satiated — that they can’t possibly consume a large fraction of their huge incomes basically because they don’t have the time. Standard assumptions about utility functions are made so that there can be unbounded growth at a constant rate with a contstant balanced growth real interest rate. It is perfectly possible to write a model in which growth stops because consumers are satiated.
Finally, back to housing
Some of the explanations on Summers’s list of possible causes of secular stagnation are obvious. For example “increased foreign savings” clearly can cause low US demand by causing low US net exports. In fact during the period when the US seemed to need bubbles to keep aggregate demand high enough for normal unemployment (at least the past 20 years) the US has always run huge trade deficits. US absorption (that is demand) has been greater than US production. The problem of low demand was imported. Slower labor force growth clearly reduces investment for a given required return on capital — it is the Alvin Hansen’s original explanation of possible secular stagnation. Higher demand for safe assets will make the requires safe real rate lower for the risky rate consistent with adequate investment. Increased costs of intermediation imply a lower safe rate paid to savers for the same cost to investing firms.
One is not obvious or conventional and very interesting.
I can understand the role of lower priced capital goods (an old topic for DeLong and Summers). If firms want the same normal ratio of capital to labor and capital is cheap compared to consumption, the value of investment in terms of consumption goods will be low so value of investment will be low compared to the value of savings. If extremely low interest rates are required for a higher than the old normal ratio, then they will be needed to make I=S. I think this story doesn’t work if the production function is Cobb-Douglas and that it requires an elasticity of substitution of capital and labor less than one, but I personally am sure that elasticity is less than one.
I don’t understand why inflation would cause a lower natural real rate of interest.
Robert,
I have an aversion to lists of things – for the reasons parodied by the Monty Python Spanish Inquisition sketch. They are notoriously incomplete and give the illusion of completeness.
But this list is clearly missing what I thought would have been item #1, increased leverage. (Leverage increases net return for a given nominal rate of return but at the expense of increased risk – at least increased risk for someone.) If leverage acts as an accelerator, lots of leverage will also push down rates of return by inflating asset prices.
Housing booms are mostly (until late in the cycle almost only) land price booms. Debt increases, values increase for not much increase in the volume of housing.
It has been often pointed out – people are reluctant to realize losses on house prices (really land prices + the big consumer durable called a house) so that prices don’t fall much when demand falls, but turnover stops. In the US estimates of the supply of houses compared to normal demand (even allowing for demographic effects) suggest that there is no longer an oversupply of houses. What there is still is an affordability issue.
“I don’t understand why inflation would cause a lower natural real rate of interest.”
Yes that doesn’t belong there – what was he thinking of (unless he means it has to do with the idea that the central bank tolerating higher rates of inflation, increases the risk premium for inflation).
Robert,
sorry to multiple post, but there is something else is also missing – incorrectly valued currencies (because the international financial system is dysfunctional). If domestic real productive investment gives a low return because the currency is chronically overvalued (as reflected for instance by chronic trade deficits at a time when demographic forces should be pushing the other way).
I never see anyone taking into account that the vast amount of home buyers are not investors. They just want their own home.
Thanks for the three thoughtful interesting comments.
Yes it is clear that the low inflation low r needed for full employment is based on the idea that low inflation means stable inflation which implies low risk premiums. ” Is the apparent decline in real interest rates something fundamental or just the removal of a risk premium that was present after the high inflation 1970s?”
But I don’t see how that story works. I note that real interest rates shot up during the Volcker disinflation. They weren’t high in the 70s..
Ohhhhh I have finally figured it out. Summers always used to insist that high real interest rates caused high saving. He was suspicious of Hall’s first result that interest rates have almost nothing to do with the growth rate of consumption. I am so firmly convinced that interest rates don’t have detectable effects on consumption that I didn’t think of that.
I know Shiller’s work always concludes that interest rates have no effect on consumption, but one thing about that statement confuses me.
Almost every single buyer of homes is a payment buyer. As a rule 28% of monthly income is the payment they all want. Obviously, the lower the rate, the more expensive the house.
I just cannot seem to take that thought out of my mind, and I have absolutely no desire(let alone ability) to go against Shiller’s work or Robert’s thoughts.
EMichael
“Obviously, the lower the rate, the more expensive the house.”
Yes but what does that have to do with consumption (rather than just the price of land)?
summers et al don’t seem to care much about the effect of low “safe” interest rates on those who were counting on a modest interest rate on “savings” to pay for their retirement.
not that i think something artificial should be done to boost interest rates over the “demand for money”.
also, it is hard for me to take seriously the concern for “societal well being” from Summers. it is not clear to me that we have seen any improvement in societal well being from “investment” in a long, long time.
this looks to me like a debate about the number of angels who can dance on the head of a pin. fun for the professors. not too relevant to those who have to cope with reality… except to the extent that those professors provide excuses for the politicians to let the folks with money do terrible things to people in the name of “growth.”
@EMichael purchases of houses is counted as a form of investment not consumption (just a weird definition). Interest rates definitely affect home sales and construction. Basically, the one thing which clearly critically depends on interest rates is housing.
In interviews, people do discuss houses as investments, but the important point is that even if price appreciation isn’t the principal concern, it affects things at the margin — for example house size and whether one insists on a good location even buy or rent for some people. In any case, a 10 data point regression suggests forecast house price changes matter a lot .
http://angrybearblog.strategydemo.com/2014/12/home-price-expectations-and-residential-investment.html
Also there was a huge amount of construction 2000-2006 then much much less.
Robert looks to me like the unusually high level of construction started in 2002 not 2000.
I found that useful:
https://hcexchange.conference-board.org/blog/post.cfm?post=3460&blogid=1
Economist
I didn’t and it is OT.
Reason,
If I buy a 300g home instead of a 250g home because of low interest rates I have consumed 50g more, haven’t I?(new construction of course)
If I buy a $25g car instead of a $22g car because of low interest rates I have consumed more, haven’t I?
I guess a house is an “investment” in that it costs a lot of money but with luck you can get most of it back when you are old and don’;t need so big a house. not counting the interest you paid of course.
this is in contrast to a car or anything else you can “use” but has essentially no resale value.
i think it might help if economists were not so married to their “concepts and definitions.”
Speaking of Summers, I heard this story. Maybe it was here.
The President was flying on Air Force One with the Pope and Larry Summers and a hippie they were going to use for “the little person” touch.
Suddenly the engines went quiet and the pilot ran into the cabin. He said, “The engines have quit and we are going to crash. Grab a parachute and follow me.” Then he jumped out of the plane.
But when they looked around they saw only three parachutes.
“You go first, Mr President. The free world depends on you.” So the President grabbed a parachute and jumped out of the plane.
Then Summers said, “I am the smartest man in the world. The world need me.” So he grabbed a parachute and jumped.
The Pope said to the hippie, “Take the last parachute, son. I am in God’s hands.”
“Don’t worry,” said the hippie. “There are still two parachutes. The smartest man in the world just grabbed my back pack.”
@Coberly, I’m so old I remember when that was a joke about Henry Kissinger
@EMichael I was using “consumption” as defined by the Bureau of Economic Analysis when they make the official numbers. They call new housing “residential investment”. I too think it makes more sense to consider owner occupied houses extremely durable consumption goods, but I use technical terms with the standard definitions even if I don’t like the standard definitions.
In general I think it is usually more important that people use the same definitions than it is that those definitions are the most reasonable definitions. It is very key that people understand what other people say and this requires agreeing on definitions.
Simiarly I usually use roughly approximately standard spelling. I think English spelling is crazy, but spelling words the way other people do aids communication so I use standard spelling to the limited extent that I can.
My claim that interest rates don’t have a noticeable effect on consumption is a statement about the official series call consumption (and the one called “consumption of non-durable goods and services”)
Waldmann
kissinger, summers… birds of a feather.
as for standard definitions… yes, but you need to make sure the people you are talkng to know the “standard” that you know. then you need to think once in a while if the “standard” is not impeding clear thought on the substance,
as for spelling. i used to be a champ. now i can’t spell my own name. i am glad to be able to say i didn’t get a big head about it then. and i don’t get a small head about it now.
Robert,
Thanks.
“Reason,
If I buy a 300g home instead of a 250g home because of low interest rates I have consumed 50g more, haven’t I?(new construction of course)
If I buy a $25g car instead of a $22g car because of low interest rates I have consumed more, haven’t I?”
No this doesn’t follow and the analogy doesn’t really work. The reason is that the price of the house is two prices mixed together, land and the production cost of the house. If everybody at the same time is willing to pay more for houses because they can borrow more, then the 350g and the 250g house, may well be exactly the same because the price of land changes in response to the increased demand.
Coberly,
I guess in the story in question, they would sure like to be birds.
Reason,
If it is the land that appreciates only, I agree.
How about the car?
Reason
I love it when someone gets one of my obscure jokes.
Reason,
One other thought while readily admitting I am out of my element here.
A couple of weeks ago I did a private refi for a buddy of mine. He was at 7.5% on 300gs, paying PI of $2084 a month. Now he is at $1578 while keeping the term the same at 4%.
That is $500 a month of potential consumption caused by low interest rates. And knowing my buddy, he will spend it. 🙂
EMichael
Yes that effect is significant. But I’m sure Robert will respond that that is not a change because of a change in interest rates per se, but because of a change in disposable income which is close to his Keynesian heart.
How about the car?
They just produce more cars (which is tough with land – at least in the short term).
Sorry I need to switch on my brain before replying. The correct answer they can make more cars, but not more land in the short term, so buying a higher value car probably is an increase in consumption.
P.S. I think land economics is much neglected, because some things about land economics are not all obvious from simple analysis. Like that urban building regulations may well increase the quality of houses but not the price of houses (since the cost of the regulations will come out of the price of land).
Waldmann said
“I don’t understand why inflation would cause a lower natural real rate of interest.”
Robert,
I may have missed someone else’s reply to this in comments, and you may be referencing a whole body of scholarship i know nothing about,
but based on what i do think i know something about it is likely that the statement that “inflation would cause a lower rate of real interest was just arrived at by subtracting the inflation from the nominal rate and calling that the real rate (assuming the nominal rate remains fixed at least for the moment).
I am sure that is not what you meant, and the context may suggest something different, but it is the sort of thing someone would “say without thinking,” which is most of what “someone” says.
@Reason actually, I will not say that the extra money available because of a refi is a change in disposable income. Disposable income is defined as income minus taxes. Money spent paying a mortgage is part of disposable income.
Like “consumption” “disposable income” is a technical term when used by economists. It has an official definition in official statistics.
As always, I don’t argue that the official definition is the most reasonable possible. I use terms as they are used in FRED so people can look up the data I use for themselves.
I will claim that consumption (as officially defined) is not noticeably correlated with interest rates. The key word is “noticeably”. I assume that EMichael’s friend’s consumption will increase. However, as far as I know, the effect of such events on aggregate consumption is so small that it doesn’t show up in the aggregate data.
The correlation between the achieved 3 month real interest rate and the consumption disposable income ratio is -0.13. OK I should look at the mortgage rate, but this is a blog comment.
Always I am discussing how to model the economy. I don’t claim that my story is a complete description of everything which happens in the economy. I am discussing which effects are small enough that they can be neglected when modelling.
Robert
i would guess that while emichael’s friend’s consumption would increase
(unless paying interest is “consuming” a financial product), the guy collecting the interest would decrease his consumption…. unless he got paid off and so increases his consumption with the money he now has “not lent.” in that case maybe the new mortgage holder would have less consumption than the first…
This comment thread is getting interesting enough to maybe pull back to the blog somehow.
@Coberly it is true that in standard mainstream macro new Keynesian DSGE models refinancing doesn’t affect consumption. Consumption is modelled as the choice of a large number of identical people (called the representative agent) who have average income, wealth and consumption. This means that the mortgage interest nets out.
However, such models are not realistic.
Sticking with the discussion of the meanings of words (not the interesting part of the thread) I note your odd use of the word “guy”. This is normally used to refer to a human being. But the mortgages in question belong first to a bank then are packaed and sold to … well in the end probably a pension fund or maybe a very rich guy.
In the standard models (at least those popular pre-2008) this doesn’t matter, but in the real world it matters a lot.
The old Keynesian way of discussing this issue is the concept of the marginal propensity to consume — the effect of of a change in someone’s income on their consumption. if debtors have a higher marginal propensity to consume than creditors, lower interest rates cause higher consumption (as the reduction in interest rates acts like a transfer from creditors to debtors).
Let’s pretend the bank didn’t package the mortgage into a mortgage bond and just kept ownership (so much for reality). Then the reduced flow of mortgage payments are going to a firm. Some will go to shareholders as dividends and some won’t. In some simple models this shouldn’t matter, but in reality it does. Undistributed profits aren’t personal income (they should cause personal capital gains eventually). The fact that consumption is more correlated with personal disposable income than with GDP is a hint that undistributed profits have less effect on consumption than personal income.
Also the dividends may go to a defined benefit pension fund and so not appear as anyone’s personal income. Finally, the dividends which go to individuals mostly go to wealthy individuals whose marginal propensity to consume is low.
Even old Keynesian models tended to ignore the distinction between stuff belonging to corporations and the personal belongings of the shareholders. Only when dealing with data was the distinction between GNP minus taxes and personal income minus taxes made (the difference is undistributed profits of corporations plus depreciation of capital which is ignored in GNP and GDP hence the G).
My this reply is getting long and confusing and probably confused. I’d say the effect of refinancing on consumption is ignored entirely in widely used models for exactly Coberly’s reasons. That more realistic models and evidence supporting them strongly suggests that there is an effect, and finally, the data on interest rates and aggregate consumption suggest that ignoring the effect is a reasonably approximation.
Robert
thanks for the lengthy and thoughtful reply. it encourages me to believe that at least some economists have thought about at least some of the complications. i obviously do not know what real economists are thinking. just the ones in the news seem to over simplify in favor of their favorite theory or sponsor.
as for my odd use of the word “guy”: i use it as a kind of generic “x”… “whatever entity carries the freight in the real world.”
i realize my usages seem “odd” to many people. still, it’s the way i think.
I like your use of guy. I think economists like to think about complicated models with “OK now what if the mortgage is pooled in a CDO how much does the value of the pension fund which owes the mezzanine tranche affect aggregate demand.”
The simplifying is necessary to get to anything approximating a conclusion.
Then is sure becomes a habit, so some economists sometimes forget that they have ignored a lot of complexities.
well, we are not so different then.
it occured to me that even when the bank is the “guy”, it is ultimately guys (people) who make the decisions and spend the money.
i have at times tried to explain to people that money “saved” (for a long period of time without being spent {by others, that is as investment) stops being money… at least until it is spent again, but with meanwhile effects on the economy that they were not considering.
you seem to be taking this into account, but it is also the case that “investment” is consumption of goods and services, not to say income to the producers of those goods and services… so at this point the whole thing gets too complicated for me to think about.