I rarely disagree with Alan Greenspan, a person for whom I have tremendous respect. But his recent public remarks on zero interest rates on long-term bonds in Germany are incorrect.
Greenspan contended that an aging population is driving demand for bonds, pushing their yields lower. This would explain the downward trend in yields in Germany and Japan, for instance.
Yet, what is happening has nothing to do with an aging society, in Germany or elsewhere. The real culprit is more likely an acceleration in the destruction of incentives to invest in physical capital in places other than the bond market.
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Greenspan is not the only one riding in the aging population wagon. But economists would do well to look elsewhere for an explanation.
In 1962, University of Chicago economist Martin J. Bailey published a fine book, “National Income and the Price Level.” He argued that capital investment would always be adequate to bring an economy to full employment. As a simple matter of arithmetic, the present value of a capital investment with an indefinite life and indefinite stream of returns would become indefinitely high as the interest rate approached zero. The present value would exceed any finite cost of building the investment.
Bailey’s argument is correct and essential to understanding low interest rates, but only under certain conditions, which Bailey never makes explicit.
First, the regulatory environment must be such that investors can build projects that have a long life. In a 2011 paper, I pointed out that such an opportunity sits idle in New York City today. I wrote: “On the East River side of Manhattan from roughly 100th Street to 115th Street, the water is only a few feet deep. Filling in some of these relatively shallow waters would also solve another problem—that of where to deposit silt dredged from the harbor to maintain adequate depth for shipping. The land created would be valuable and have an indefinite life.”
Why are projects like this one not being pursued in Germany, and here? The answer has nothing to do with an aging population. Instead, the reason is determined opposition by environmentalists to moving earth or digging into it.
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Second, investors must have secure rights to future returns from their investments. Bailey wrote at a time when property rights in the United States could be assumed to be secure. That is certainly not true in Africa today; nor, sadly, is it true anymore in the United States. Every investor faces the risk of partial expropriation though growing regulatory and tax burdens. That is, these risks are why U.S. business investment has been weak during the recovery after 2009.
Finally, Bailey argued that the scale of such opportunities is large enough to keep economies at full employment. If he was wrong about that, then we cannot count on reaching full employment through investment.
Think about the investment opportunities in Africa. How much investment would it take to bring the level of capital per capita up to the levels enjoyed in high-income countries today? The answer is roughly the amount of investment per capita in the high-income countries over the past 250 years. Why doesn’t a German entrepreneur contract with an African government to build a toll road? Given the durability of building the right-of-way, the project has an indefinite life and tolls would finance it. Why do we not see massive investment of this sort? Insecure property rights is the obvious answer.
As an exercise, one could add up the backlog of infrastructure investment in the United States. Why don’t we see an investment boom? Governments at all levels are financially stressed. They are stuck with outdated regulations such as the requirement that new tolls not be levied to build and repair interstate highways.
Why don’t local governments sell leaky water systems to private companies to rebuild? Would it be impossible to recover the costs through higher water bills? Baltimore is the closest big city to where I now live. The traffic disruption from broken water mains is almost non-stop. Baltimore helps its residents by maintaining an interactive map reporting water main breaks. As I write, the map shows three breaks labeled "Work in Progress,” nine breaks “Water Service Restored” and nine “Confirmed Main Breaks.” I guess the confirmed ones will waste water and disrupt traffic until the city’s over-worked and under-staffed Department of Public Works can get around to fixing them.
We will not realize the opportunities available to us if we keep looking in the wrong places. Our poor investment climate is the reason interest rates are so low. Destruction of investment incentives is the story. Is it not amazing – and frightening I might add – that there are so few investment possibilities in Germany that have a risk-adjusted rate of return of five basis points? There must not be, or otherwise there would be an investment boom in place in Germany.
William Poole was the eleventh chief executive of the Federal Reserve Bank of St. Louis.
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