For macroeconomists
Secular stagnation means different things to different people, but a common motivation is the steady decline in real interest rates since the 1980s. There have been many explanations for this (some of which I discuss here), and a common feature is that while some mechanisms are quite plausible (in particular a reduction in population growth will reduce real rates in most models) individually they do not seem quite enough. It therefore appears likely that we could be looking at something with multiple causes. So here is another possible mechanism that can be added to the list, which is the fall in the price of new investment goods.
Although this link between investment goods prices and secular stagnation has been suggested before, I want to focus on a new paper by Gregory Thwaites of the LSE and Bank of England [1], which explores this effect in a complete model. His paper has some similarities to the paper by Eggertsson and Mehrotra that I talked about in this post (for example it uses a three period OLG model), but it has much more of a focus on this investment goods price effect.
One of the very striking features of recent decades has been the relatively slow growth in the price of investment goods compared to the more familiar price of consumption goods. As Karabarbounis and Neiman (2014) [2] note, this is often attributed to advances in information technology and the computer age. Thwaites extends Karabarbounis and Neiman’s data across countries and time, and shows that this decline in the price of investment goods occurs across countries, and did appear to begin around 1980.
A key issue is how much firms react to the fact that capital is becoming cheaper by substituting capital for labour. In Karabarbounis and Neiman they react with an elasticity of substitution greater than one, and they use their analysis to explain a decline in the labour share. However, as Thwaites notes, there are many studies which suggest a less than unit elasticity of substitution.
To see the implications of this, consider a very simple OLG model with log consumption and where agents only work in the first period. This implies that the proportion of income saved is constant. So if the fall in the price of investment goods leads, ceteris paribus, to a fall in the value of capital required by firms, then to equate the demand and supply for savings real interest rates will fall. (You need an OLG framework here. In the benchmark representative agent model, the real interest rate equals the rate of time preference plus the growth rate.) This is a steady state result, and the paper explores the dynamics.
That is the key idea. For me, a really interesting aspect of the paper is that it integrates housing into this analysis. If real interest rates fall, and for whatever reason the supply of housing is fixed, house prices will rise (see these two posts). This leads to an increase in gross household debt, because agents borrow from the old to buy houses. Thwaites’s model shows that this dampens the fall in real interest rates, because this is an alternative destination besides capital for retirement savings.
I recognised the mechanism, because I had been playing around with the same effect when looking at steady state changes in government debt. A permanent reduction in the ratio of government debt to GDP would in an OLG model free up savings for capital, reducing real interest rates (as we explored in this paper for example). But lower real rates also raise the demand for housing, which can be an alternative way of saving for retirement. More generally, whatever the causes of this apparent trend decline in real interest rates, the implications for the housing market - and what we think of as ‘normal’ in that market - are likely to be profound.
[1] Thwaites, G (2014) Why are real interest rates so low? Secular stagnation and the relative price of investment goods, Centre for Macroeconomics Discussion Paper No. CFM-DP2014-28
[2] Karabarbounis, L. and B. Neiman (2014). The global decline of the labor share. The Quarterly Journal of Economics 129 (1), 61–103.
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