Throughout the 19th and 20th Centuries, the world had far more investment opportunities than we had capital available to invest. With the population growing, there was always demand to borrow money to build more homes, offices, and stores. And with a steady stream of new inventions — railroads, telegraphs, automobiles, refrigerators, televisions, cell phones, and so forth — there were always plenty of opportunities to build new factories, to make productivity-enhancing upgrades to existing factories, and to do research and development to advance the state of the art.
But what if that came to an end? Obviously, we’re never going to reach a point where there’s no investment opportunities at all. There will always be some people wanting to build a new house or start a new business. But the pool of available capital keeps getting bigger and bigger, while population growth is slowing and many recent inventions are not as capital intensive as those in previous generations. We could reach a point where there are no more investment opportunities at the margin.
If we lived in that world, we’d see inflation-adjusted interest rates around the world falling to zero. We’d see cash and short-term investments piling up on corporate balance sheets. We’d see the CEOs of even America’s most innovative companies deciding they have nothing better to do with this cash than to give it shareholders through buybacks and dividends. And we’d see the few companies that do seem to offer the possibility for significant returns earning ridiculously high valuations as too much venture capital chases too few startups.
In other words, a world with too much capital and too few investment opportunities would look a lot like the world we’re in right now.
During the 19th and 20th centuries, interest rates served two important functions. One function was to reward and encourage frugality. If you spent less than you earned, you could put the difference in a savings account and earn a risk-free return higher than the rate of inflation. The money would be leant out to others who wanted to build a house, start a business, or otherwise make a productive investment that grew the economic pie, and you got a share of the gains.
The second, more subtle, function of interest rates was to prevent severe recessions. A healthy economy relies on a steady rate of spending, which requires that people, on average, not hold on to cash for too long. If a lot of people pile up savings that don’t get re-invested, the result will be a reduced rate of spending, a.k.a. a recession. This is why the Fed lowers interest rates during recessions — it’s a market mechanism that encourages savers to save less (and hence spend more) and borrowers to borrow more (and hence spend more).
If society has run out of productive investment opportunities at the margin, then frugality will no longer be socially beneficial (though of course it might be beneficial to the person doing the savings). More savings won’t produce faster growth, and so there’s no reason for society as a whole to encourage people to be frugal. An interest rate at or below the inflation rate is a market signal that society has enough capital, doesn’t need any more, and so won’t be rewarding people who accumulate savings.
The second function of interest rates poses a larger problem when interest rates fall to zero. Remember, recessions happen when spending slows because people are accumulating savings that doesn’t get re-invested in houses, factories, and so forth. When interest rates are positive, then interest rates can fall to encourage less saving and more investing. But when interest rates have fallen to zero, this doesn’t work any more, because it’s safer and easier to just hold onto the money. Central banks have tried to address this issue by flooding the market with more and more cash. But it’s been difficult to get the money to circulate — it just keeps piling up in peoples’ bank accounts.
The problem here isn’t that people are saving too much, it’s that they’re doing their savings in cash rather than by investing in assets like stocks or bonds. This wasn’t an issue in the past because banks would automatically invest the money on their customers’ behalf. But now banks are failing to do that, and so money customers save in bank accounts gets effectively pulled out of circulation.
Another way of looking at this is that we want people to use cash primarily as a medium of exchange rather than a store of value, so it’s important that cash have a lower rate of return than other investments. In the past, non-cash investments tended to have a significant positive rate of return, and so the fact that cash had a rate of return of 0 was plenty of incentive not to hoard cash.
If we can’t raise the rate of return on non-cash investments, then the alternative is to lower the rate of return on cash. The Fed already does this by setting a 2 percent inflation target — essentially that’s a 2 percent penalty for holding cash. In an era where inflation-adjusted interest rates were almost always positive, that was viewed as an ample disincentive for cash-hoarding.
But in a new era of ultra-low interest rates, it’s apparently not enough. So one solution would be for central banks to raise the cash-hoarding penalty — that is, its inflation rate target — perhaps to 4 percent. Then even if non-cash investments don’t produce a positive return in inflation-adjusted terms, there will still be a significant spread between the returns on cash and on other assets. That will discourage people from holding a lot of money in the form of cash, making it easier to prevent major recessions.