Low Interest Rates and High Asset Prices: An Interpretation in Terms of Changing Popular Economic Models
Shiller, Robert J., Brookings Papers on Economic Activity
MANY HAVE NOTED THAT we appear to be living in an era of low long-term interest rates and high asset prices. Although long-term rates have been increasing in the last few years, rates so far in the twenty-first century are still commonly described as low, in both nominal and real terms, compared with historical averages or with a decade or two ago. Meanwhile stock prices, home prices, commercial real estate prices, land prices, and even oil and other commodity prices are said to be very high. (1) The two phenomena appear to be connected: elementary finance theory states that if the long-term real interest rate is low, the rate of discount used to determine present values will also be low, and hence present values should be high. This pair of phenomena, connected through the present-value relation, is often described as one of the most powerful forces operating on the world economy today.
In this paper I will critique this common view about interest rates and asset prices. I will question the accuracy and robustness of the "low long rates, high asset prices" description of the world. I will also evaluate a popular interpretation of this situation, namely, that it is due to a worldwide regime of easy money. I will argue instead that changes in both long-term interest rates and asset prices seem to have been tied up with important changes in the public's ways of thinking about the economy. Rational expectations theorists like to assume that everyone agrees on the model of the economy, which never changes, and that only some truly exogenous factor, like monetary policy or technological shocks, moves economic variables. Economists then have the convenience of analyzing the world from a stable framework that describes consistent thinking on the public's part. But an odd contradiction here is rarely pointed out: the economists who propose these rational expectations models are themselves regularly changing their models of the economy. Is it reasonable to suppose that the public is stably and consistently behind the latest incarnation of the rational expectations model?
I propose that the public itself, largely independently of economists, changes its thinking about the economy over time, and indeed that these changes in popular economic models have been dramatic. I further propose that these changes in popular thinking have driven both long-term rates and asset prices and should be central to our understanding of the large asset price movements we have seen. (2)
I will begin by presenting some stylized facts about the level of interest rates (both nominal and real) and the level of asset prices in the world. Next I will consider some aspects of the public's understanding of the economy, including common understandings of liquidity, the significance of inflation, and real interest rates, and how these have impacted both asset prices and interest rates. This will lead me to conclude that the relation between asset prices and either nominal or real interest rates is very tenuous, and clouded from definitive econometric analysis by this continual change in difficult-to-observe popular models.
Changes in Decade-Long Trends in Long-Term Interest Rates
Figure 1 plots nominal long-term (roughly ten-year) interest rates on government bonds for four countries and the euro area since 1950. (3) With the exception of India, an example of an emerging economy, rates in all of these countries have been on a massive downtrend since the early 1980s, and even in India rates have been falling since the mid-1990s. The low point for long-term rates over this period appears to have been around 2003, but, broadly speaking, the upward movement since then has been small. Certainly one can say that the world is still in a period of low long-term rates relative to much of the last half century. (4)
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Economic theory has widely been interpreted as implying that the discount rate used to capitalize today's dividends or today's rents into today's asset prices should be the real, not the nominal, interest rate, because dividends and rents can be broadly expected to grow at the rate of inflation. …