27 September 2015

Why You Will Never Again Earn Interest Rates Higher Than Zero (or, why capital wants to be free in a post-information, entrepreneurial economy)

In The Fourth Economy, I argue that capital no longer limits. We now have trillions in capital and unsurprisingly, returns to capital have fallen. When the market is flooded with potatoes, the price drops. When the market is flooded with financial capital, the price drops. The price of capital shows up as risk-free interest rates, and those seemingly want to be zero. Or less.

Frances Coppola concludes her post today with this (emphasis added)

 I suspect the post-Depression natural (real) rate is lower than we would like it to be, and it's just taken us best part of a century to understand this. If so, then this is not simply a matter of getting fiscal and structural policies right. It raises serious questions about the ordering of society. After all, a large number of people depend on there being significantly positive real returns on essentially risk-free assets. If significantly positive real returns on risk-free assets are a thing of the past, we owe it to those people to stop pretending we can restore their lost returns through "confidence-boosting fiscal consolidation" and "growth-friendly structural reforms". They simply aren't going to be able to live comfortably in their old age on the interest on risk-free savings.
The truth is we do not know when, or if, positive real returns on risk-free assets will return. If the future path for growth in future is low to zero, then they may never return. If this is the case, then the solution to the "Great Divergence" must be for nominal risk-free rates to drop. Permanently.

Gavyn Davies at the Financial Times questions whether the Fed might be wrong to raise rates this year. If Yellen is wrong about the economic recovery, and triggers a recession, she'll have little room to maneuver. Rates will still be low and she won't have many options then. Better, he suggests, not to risk another recession just yet and to keep rates at zero for a while longer.

Pete Spence reports on Sweden's Riksbank in the Telegraph. They have lowered interest rates to below zero.  Sweden has the third highest savings rate in the developed world and unemployment is still high. They have plenty of capital but low interest rates still don't seem to stimulate investment enough to create jobs.

What does this mean?

During the Industrial Economy from about 1700 to 1900, financial and industrial capital was the limit to progress. There was not enough of it and returns to capital were high. Returns to capital made the West rich.

During the Information Economy from about 1900 to 2000, knowledge workers were the limit to progress. Creating the public school systems to educate them took a lot of capital. So did creating the corporations for them to work in, the R&D labs, the information technology, and the factories able to produce the new products they designed. Between the demands of government and the burgeoning private sector, capital was still in demand and the price of capital - interest rates - was still high.

We seem to be past the limits of capital and knowledge work now. That doesn't mean that capital and knowledge workers are unnecessary.  It means that they no longer lead progress. Entrepreneurship is the limit.

Last century, we popularized knowledge work. In the US in 1900, less than 10% of 14 to 17 year olds were formally enrolled in education. By 2000, less than 10% were not. In a century, we transformed from an industrial economy dependent on child labor to an information economy dependent on adult education. The knowledge workers who were rare - who were often forced to be autodidacts who taught themselves during the 1800s - became the new normal.

Now, we will popularize entrepreneurship. Entrepreneurs who were largely self made in the last century will increasingly become the product of the system, just as knowledge workers are today. Along with a growing number of entrepreneurs, more employees will become more entrepreneurial.

This matters to capital because it gives capital a place for a return. Risk-free returns for government and corporate bonds may remain close to zero. Perhaps even negative. There is an abundance of capital. But all of these entrepreneurial ventures - most of which will fail - will require enormous sums of capital. The entrepreneurial economy will mean higher risks and higher returns for capital but of course those can be mitigated as corporations and investors diversify.

There are so many implications for this new, entrepreneurial economy. But from the perspective of capital, it means that it is going to be harder to get a return on investments without actually taking the risk to finance something new. And it means that we'll continue to have bubbles with startups as long as entrepreneurship remains the limit.

Probably for the next decade or two, capital will chase returns in corporations and IPOs. Already corporations have more money than they know what to do with, sitting on trillions in idle cash. The IPOs that really do have great potential - the products of great entrepreneurship - will command ridiculous equity valuations. It is going to be awhile before we manage to popularize entrepreneurship to the point that entrepreneurship no longer limits. Until then, stocks and IPO prices will be highly volatile, with trillions in capital chasing too few new opportunities.

But there is so much good that follow from shifting into this fourth, entrepreneurial economy. Among other things, it will do for unemployment what economic progress since medieval times has done for starvation. All of these startups will require employees. Just as the 20th century saw a growing proliferation of products, in the first half of this century we will see a growing proliferation of companies.

For now, central banks are flummoxed by capital markets. Given that capital no longer limits, though, it doesn't make a huge difference when they flood the market with more capital. And given that there is an abundance of capital even without central bank intervention, there is little or no reason to raise interest rates. Risk-free interest rates will stay close to zero in the developed world.

All of this means that governments are going to have to come up with a whole new bag of tricks for spurring development. And this time, the effective new tricks won't center around monetary or education policies that make it easier to invest or become a knowledge worker. This time the new tricks will center around the popularization of entrepreneurship.

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