Interest Rates and the Global Capital Imbalance

The Decline of Interest Rates

The decline of interest rates to near zero has been a feature of developed countries ever since the 2008 financial crash, when central banks did their best to ease credit conditions and encourage private consumption in an effort to kick-start growth. Nevertheless, over a decade later, interest rates remain chronically low and sluggish growth represents a continuous challenge in developed economies.

A primary function of banks is to act as the financial intermediator between savings and investments. Banks offer interest rates to attract deposits, and then use those deposits to generate returns through investments. From a classical economic perspective, low interest rates represent an excess supply of cheap capital (savings) in relation to the limited demand for investments.

There are several reasons explaining the over-abundance of cheap capital. The fiscal and monetary stimulus of the previous decade has vastly increased the monetary supply, a secondary effect of which can be seen in asset-price inflation over the last decade. The internationalization of global capital markets and accumulation of foreign exchange reserves (as seen in China’s federal bond purchases) has increased the supply of savings.^[1] High risk-aversion amidst aging demographics across developed countries has increased demand for stores of value.^[1]

All these factors have contributed to the excessive supply of savings represented in interest rates. Yet, by looking at long-term trends, we can see that low interest rates are not just a short-term phenomenon...

Instead, declining interest rates appear to be terminal. Demand-side factors for investment are perhaps even more important when explaining long-term interest rates declines than supply-side ones. In particular, the theory of secular stagnation argues that demographic disadvantages and low total factor productivity growth has permanently reduced the capacity for investment demand to absorb the supply of savings.^[2]

According to Robert Gordon, total factor productivity growth in developed countries has fallen from 1.89% during 1920-1970 to a mere 0.4% since the early 2000s.^[3] Declines in interest rates are a function of the decline in investment demand, itself a function of low productivity growth and demographic changes.

In the sciences, the costs of funding have gone up, the amount of collaboration has vastly increased and yet the pace of scientific progress has not increased commensurately as science becomes progressively harder.^[4] Of course, productivity gains are still to be had. Blockchains can help increase the efficiency of financial intermediation (as well as many other things), whilst artificial intelligence promises sweeping productivity gains across dozens of sectors.

Yet diminishing returns appear to be a structural trend across modern societies. As such, the depression of interest rates is unlikely to be a cyclical phenomenon, and instead points to structural changes in the underlying economy of developed nations.^[5]

“Money is cheap because it is less obvious what can be productively done with it”.^[5]

If people wish to generate higher returns on their savings, they must ensure their money is channeled into more productive investments seemingly unavailable in developed economies. However, this raises an interesting question. Given that capital is mobile, especially in the modern world, why doesn’t capital flow from rich countries into capital-poor developing ones where higher productivity gains are to be had?

The Lucas Paradox

This problem is known as the Lucas paradox. In theory, Africa is endowed with many attractive forms of capital, including an abundance of inexpensive labour, natural resources, advantageous demographics and in theory, high potential productivity gains.^[6] Indeed, African firms cite limited access to credit investment as the biggest constraint on their economic growth.^[7] The demand for cheaper forms of credit is clearly there. Why is there such limited supply?

In truth, there are several reasons for this lack of financing. Missing factors of production, such as highly skilled workers, lower quality institutions increasing risk and uncertainty, or capital-flow restrictions increasing financial frictions.^[8]

Yet, several economists argue that informational a-symmetries are the primary factor behind this investment gap.^[6][9][10] Indeed, information flows were measured as being at least as, if not more, important than distance when assessing international investment flows.^[9]

“It is not sufficient that socially productive investment opportunities exist on the continent. It is also necessary that potential external creditors be aware of such opportunities”.^[6]

Financial intermediation - the costs banks face when converting people’s savings into investments - requires resource expenditure. These include brokerage costs, loan evaluation, agency costs and contract enforcement costs. This process of financial intermediation is heavily restricted by poorly developed informational infrastructures in developing countries (as well as other factors). High information gathering costs and uncertainties create risk, discourage investment and result in high external finance premiums (when lenders must receive high returns to cover costs, subsequently decreasing demand for investment).

Solving Information A-symmetries

Therefore, solving the informational barriers to international investment flows is key if we are to unlock new credit investment opportunities. The explosion in internet and smartphone accessibility, as well as improving institutional quality has already aided in this process. Companies like Aella are leveraging the increased information connectivity in developing countries to assess risk through machine learning and other data analysis techniques.

However, a unified informational infrastructure layer for credit information sharing across all parties in the economy is still severely lacking. Outside investors still struggle to assess the risk and performances of individual lenders or credit opportunities, contributing to high external finance premiums.

Accessible information infrastructure can also unlock new kinds of economic relationships. Traditional lending intermediaries such as banks or fintech lenders, are not the only parties capable of financial intermediation. Local credit unions or businesses can also benefit from decreasing informational a-symmetries improving their access to capital.

If developing countries are to attract the cheaper capital flows they need to unlock growth, they must work to build informational infrastructure which is secure, reliable, auditable, and open to all members of the economy for purposes of financial intermediation and trust. Creditcoin is designed to be that standard.

Similarly, if savers and investors in developed countries are to generate greater returns from their idle capital, they must also seek ways to overcome the high financial intermediation costs associated with low information connectivity in developing countries. Creditcoin is designed to be that standard.

References

1) Michael NG, David Wessel, "The Hutchins Center Explains: The neutral rate of interest", Brookings, (22/10/2018) - https://www.brookings.edu/blog/up-front/2018/10/22/the-hutchins-center-explains-the-neutral-rate-of-interest/

2) Lawrence H. summers, Lukasz Rachel, "On Secular Stagnation in the Industrialized World", Brookings Papers on Economic Activity, (2019)

3) Robert J. Gordon, "The Rise and Fall of American Growth", Princeton Univesity Press, 2017 - https://www.google.com/books/edition/The_Rise_and_Fall_of_American_Growth/bA8mDwAAQBAJ?hl=en&gbpv=0

4) Patrick Collison, Michael Nielsen, "Science Is Getting Less Bang for Its Buck", (16/11/2018) - https://www.theatlantic.com/science/archive/2018/11/diminishing-returns-science/575665/

5) Berkeley Economic Review, "The Long Decline of Global Interest Rates", (30/03/2020) - https://econreview.berkeley.edu/the-long-decline-of-global-interest-rates/

6) Peter J. Montiel, “Obstacles to Investment in Africa: Explaining the Luca Paradox”, IMF, (2006)

7) Babajide Fowowe, “Access to finance and firm performance: Evidence from African countries”, Review of Development Finance, Vol. 7 No. 1 (2017), pp.6-17

8) Laura Alfaro, Sebnem Kalemli-Ozcan, Vadym Volosovych, “Why doesn’t Capital Flow from Rich to Poor Countries? An Empirical Investigation”, Review of Economics and statistics, pp. 347-268, (2008)

9) Richard Portes, Helene Rey, “The determinants of cross-border equity flows”, Journal of International Economics, Vol. 65, pp.269-296, (2005)

10) Roger H. Gordan & A. Lans Bovenberg, “Why is Capital so Immobile Internationally? Possible Explanations and Implications for Capital Income Taxation”, American Economic Review, (1996)