Where are interest rates going?

The debate between Blanchard and Summers can be boiled down to a disagreement about the future of interest rates. Are they going to go back down to the record-breaking low levels that we saw just a few years ago? Or should we be bracing for a new era of higher interest rates? An era, in other words, where it will be more expensive to borrow money, which could have huge consequences for the housing market, the stock market, and the capacity of the government to borrow and spend.

The epic decline of interest rates

Interest rates have more than doubled since 2020. This new era of rising rates is a dramatic departure from a long-run trend. For nearly 40 years, between the early 1980s and the early 2020s, interest rates kept falling. Not just in the U.S., but in much of the industrialized world.

In 2013, Larry Summers put forward an influential theory that helped explain why interest rates had fallen so low and why the economy was struggling to recover from the financial crisis. He said our economy was experiencing “secular stagnation,” the symptoms of which include persistently low interest rates, weak inflation and mediocre economic growth. (Read our past newsletters about secular stagnation here and here).

The term was coined during the Great Depression, when the economy was in a similar funk to the one we saw in the 2010s. And, when Larry Summers resurrected this term in 2013, it was sort of a big deal. He was saying that mainstream macroeconomic theory was failing to explain what was wrong with the economy. That there was a long-term, structural issue facing the economy: weak private demand, which could keep growth slow and interest rates and inflation low, unless the government stepped in with significant intervention (namely, more borrowing and spending).

In Summers’ explanation, the reason why secular stagnation leads to abnormally low interest rates was because, when the economy is experiencing it, something funky happens in the market for borrowing.

A brief primer on interest rates. They are basically just the price of borrowing money. And they’re very much shaped by what’s happening in the market for borrowing. That market is made up of borrowers and lenders.

Borrowers typically borrow money to invest in things, like creating new businesses, expanding existing ones, and so on. Investment is the demand side of the market for borrowing.

Lenders, which are usually banks, take our savings and loan them out to people to invest. Savings is the supply side of this market for borrowing.

Savings and investment — or supply and demand in the market for borrowing — plays a very important role in how high or how low interest rates go. And, sure, the Federal Reserve and other central banks play a very important role too. But they’re not all-powerful in setting interest rates. And even when they do adjust them, they are usually doing so in response to what’s happening to the market for borrowing. In a recession, for example, people want to invest less, so interest rates naturally want to fall. In boom times, people want to invest more, so interest rates naturally want to rise. The Fed adjusts accordingly (with an eye on its dual mandate of ensuring price stability and achieving full employment).

Before the recent surge in interest rates, they spent a long time going down, down, down. For example, the Federal Funds rate — the main interest rate that the Federal Reserve uses to try and influence many other interest rates — peaked in 1981, at 19 percent, when the Fed was trying to bring down runaway inflation. By the end of the decade, it was just above eight percent. And three years after that, in 1993, it had dropped to around three percent. The last time it was that low was in the early 1960s. But it wasn’t done dropping.

After the 2008 financial crisis, the Federal Funds rate pretty much bottomed out, going so low that it posed a serious problem. That’s because the Fed typically fights recessions and high unemployment by cutting interest rates. In the average recession, it cuts interest rates by about 5 percentage points. But when the Fed cut it to zero, in 2008, that conventional weapon lost its power. Something weird was clearly going on in the economy, and it’s what led economists like Larry Summers and Olivier Blanchard to gravitate to the theory of secular stagnation, which explained why interest rates had fallen so low.

Side note: the Fed could cut interest rates to below zero, but it basically hits a wall somewhere near there, because no rational person is going to, for example, pay banks lots of money for a savings account (normally, the bank is paying you for that!). Negative interest rates effectively mean you’re paying a lot of money for other people to hold your money. Instead of doing that, you can just hold cash, and put it under their mattress or something. This floor for setting interest rates is called in macroeconomics the “effective lower bound” (originally called the “zero lower bound”). Listen to our episode about negative interest rates from 2019 to learn more.

Same game; new rules

The way that Summers saw it, the reason why interest rates fell so low — so low in fact that it challenged the traditional economic policy playbook — was because of a glut of savings and dearth of investment. Lots of supply and limited demand in the market for borrowing. It’s a core aspect of secular stagnation.

First, investment. When the economy wasn’t growing much, it meant that there was less demand for investment: because the economy wasn’t expanding a whole lot, there were fewer new businesses, fewer existing businesses investing in new buildings, machines, factories, and so on. Summers says there was also likely less demand for investment because technology reduced the cost of doing business. In the past, for example, corporations needed huge supercomputers and large buildings filled with secretaries and filing cabinets to accomplish what can now be accomplished with just a single laptop or even a smartphone. Bottom line, in the era of secular stagnation, Summers saw an economy marked by limited demand for new investment.

But while there was a dearth of investment, there was also a huge supply of savings. One big factor, both Summers and Blanchard identified: the economy was seeing a rise in saving because people, both domestically and internationally, were getting richer. And rich people save. Second, many people, especially baby boomers, were saving for retirement.

So we saw a huge supply and limited demand in the market for borrowing, and that, in this explanation, is what led to abnormally low interest rates.

Larry Summers became, if you will, the chief secular stagnationist, and as late as March 2020, he was suggesting that secular stagnation would continue to result in slow growth, low inflation, and low interest rates for the foreseeable future.

Secular stagnation, however, disappeared with the pandemic. Both Summers and Blanchard say it’s because of a historic amount of government spending, which boosted economy-wide demand so much that it finally dealt a death-blow to the core problem of lackluster demand that plagued the economy for so long. But, both Summers and Blanchard say, we overdid it. Sure, this spending got us out of the rut and helped people during a public health crisis. But, they argue, the government spent too much, and that sent inflation and interest rates shooting up. The way they see it, we basically went from an economy that was underheated to an economy that was overheated, and both economists agree that neither is a good thing. They both want to see a “happy medium” for spending, enough to defeat secular stagnation but not so much that it results in an unsustainable economy with prices shooting up.

What Summers and Blanchard do not agree on is what happens next. As the pandemic and the pandemic-related rescue packages mostly disappear into our rearview mirror, a central question for Summers and Blanchard arises: is secular stagnation dead? Or is it just taking a nap — and about to throw off its blankie and come crawling back into the economy?

In a recent speech to the American Economic Association, Larry Summers gave his answer: “My guess is we will not return to an era of secular stagnation,” he said. Instead, Summers believes, we’re likely going to stay in an era of higher interest rates. He thinks there are political and economic factors that have and will continue to reduce savings and increase investment. These factors include baby boomers now retiring (so less savings) and greater investment in green technology (which will increase investment). Summers’ declaration that the economy will now likely see forces leading to higher interest rates was sort of a bombshell from someone who had spent almost a decade explaining why the opposite would be the case.

Olivier Blanchard disagrees. He doesn’t see the deep forces that led to a 40-year decline in interest rates — including a glut of savings from increasingly rich populations building nesteggs for longer retirements and lackluster demand for investment — as just vanishing. He believes secular stagnation will wake up from its slumber and we’ll soon be back in an economy that looks like the one we saw before the pandemic.

What this debate could mean for your investments

The debate between Summers and Blanchard has important implications for us all.

For example, Summers says, when we were facing secular stagnation, it meant there was a glut of savings and a lack of new investment opportunities. As a result, he believed, savings flowed to “existing assets,” like houses and stocks. It explained why, for example, corporations were buying their own stock (“stock buybacks”) instead of investing in new buildings, machines, and other stuff (capital) to expand their businesses. It also explained why we saw asset bubbles in the 1990s and 2000s in the housing and debt markets.

So one possibility, he says, if secular stagnation is really dead, is that it will result in a “less happy period ahead for the stock market.” Also, higher interest rates for a longer period, obviously, would not be great for people wanting to buy homes, and that could depress home prices.

So Blanchard’s world of low interest rates might prove better for investors. It would also prove better for governments that want to borrow and spend (deficit spending). While they may be only arguing over several percentage points in interest rates, Blanchard says, that amount could matter a whole bunch for the capacity of the U.S. government to service its debt.

For more, check out our most recent episode.

Also, if you are interested in further reading, here are some of research sources for the episode:

“Have we Entered an Age of Secular Stagnation?,” by Larry Summers, IMF Fourteenth Annual Research Conference in Honor of Stanley Fischer, Washington, DC, 2015 (Speech given in 2013)

“Accepting The Reality Of Secular Stagnation,” by Larry Summers, IMF, 2020

Fiscal Policy Under Low Interest Rates, by Olivier Blanchard, The MIT Press, 2023

“Back To Secular Stagnation?,” by Larry Summers, American Economic Association Conference, 2023

“Secular Stagnation Is Not Over,” by Olivier Blanchard, Peterson Institute For International Economics, 2023

“Summers and Blanchard debate the future of interest rates,” Peterson Institute For International Economics, 2023