What's behind low interest rates and high home prices? Cheap computers, according to one line of thinking.
As Bank of Canada Stephen Poloz ponders an interest rate hike in 2015, it's possible that technology will help keep rates stubbornly low for longer than most people expect.
In a recent paper, Gregory Thwaites, an economist at the Bank of England, begins by pointing out what most business readers already know – interest rates across the industrialized world have fallen steadily for decades, while home prices have soared and household debt has climbed.
He notes that economists have put forward many explanations for these developments. Depending on who you listen to, the cause is the aging of the population, or growing inequality among social classes, or a glut of savings from emerging markets.
But none of the warring theories can explain the broader picture. They predict that business investment should be soaring as rates fall and companies find it cheaper to borrow money. Precisely the opposite has occurred. "The share of [business] investment in total expenditure has fallen across the industrialized world over the past 30 years, a fall which … long predates the recent financial crisis," Mr. Thwaites writes.
So perhaps it's time to consider another explanation for today's low rates. He suggests that one reason may lie in tumbling prices for investment goods – the machines and equipment that firms buy to make products or service clients. This category of goods is becoming steadily cheaper, at least when compared to the cost of other goods in the economy. Observers have speculated that's because many investment goods are computers, which seem to fall in price every year.
Lower prices for such vital equipment are good news from an individual company's point of view, but they can have unexpected consequences for the economy as a whole.
As the price of investment goods fall, a given amount of money buys more of them, spurring purchases. But the increased volume of investment goods drives down the incremental profits to be made from each piece of equipment, lowering the return on investment that a business can generate from new capital spending. That leads to reduced demand from businesses for the available pool of savings and pulls down interest rates.
Low interest rates, of course, encourage prospective home buyers to whip out their chequebooks and pens. If the supply of housing can't expand quickly enough, home prices get bid up. And since homes are bought on credit, household debt soars as well.
It's an intriguing (if complex) theory and one that seems to fit the facts. Looking at 11 industrialized countries, Mr. Thwaites shows that as capital goods fall in price, household debt typically goes up. Of course, aging demographics, increased inequality and emerging markets may also play roles in this relationship, but cheaper computers and other equipment appear to play a larger role in encouraging household debt than generally realized.
What should policy makers do about it? As Mr. Thwaites notes, central bankers in many countries have delivered a flood of warnings about "excessive" levels of household debt. Many are searching for ways to discourage people from borrowing. But if what we're witnessing is actually the result of weakened demand from businesses for loans because of cheaper prices for capital goods, attempts to stop households from taking on debt will be counter-productive. Moves in that direction would just reduce further the demand for money and pull interest rates even lower.
If so, Mr. Poloz faces a fascinating conundrum. But if he continues to stand pat on rates, at least he can say the computers made him do it.
Ian McGugan