From Ezra Klein: Larry Summers on why the economy is broken — and how to fix it.
In addition to the empirical observation that real interest rates over both the short and long term have declined substantially and the calculations suggesting that neutral real rates have declined, there are good reasons to expect that equilibrium real rates should have declined and stay low enough to be a cause for concern.
First, slower population growth and possibly slower growth in underlying productivity should reduce real interest rates.
Second, as I mentioned, an increase in demand for safe liquid assets coming from massive reserve accumulation in the developing world should reduce real rates and suck demand out of the industrial world.
Third, increases in inequality and in the share of income coming in the form of profits and retained earnings should operate to raise global saving and reduce real rates. As a rough estimate, the share of U.S. GDP going as wages to the bottom 99 percent of the population has fallen by about 10 points over the last 15 years. If one assumes that this group saves only 2 or 3 percent of their income and that the top 1 percent and the recipients of profit income (often pension funds with automatic reinvestment) save at a 20 percent rate, this alone would raise the over all saving rate by perhaps 2 percent GDP at a given interest rate.
Fourth, the nature of technology and production has changed. It used to take large sums to start a company. Now many are started with less than $1 million. It used to be that cutting-edge technology companies like the automobile companies 75 years ago were large absorbers of cash. Now our most dynamic technology companies like Apple and Google have more cash than they are able to deploy. Or to take a final example, considerable success in energy efficiency means that as a country we need far less utility investment than we once did. All of this is relevant to why companies have so much cash on their balance sheets and, so, interest rates are so low.
Fifth, reductions in inflation means that real rates have to be lower to achieve any given after-tax real rate. So, for example, if the inflation rate was 3 percent and the nominal interest rate was 5 percent, an individual in the 40 percent bracket would have a 0 percent real after tax borrowing cost and the pre-tax real rate would 2 percent. Now imagine a 1 percent inflation world. The same zero after-tax real rate would require a 1.67 percent real rate implying a pre-tax real rate of -.33 percent.
Sixth, to the extent that in the aftermath of the financial crisis there is more burden placed on financial intermediation, more uncertainty and fear for a sustained period, this will operate to reduce demand and neutral real rates.