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Low Interest Rates and High Asset Prices: an Interpretation in Terms of Changing Popular Economic Models 10922-08a_Shiller_REV.qxd 1/25/08 11:23 AM Page 111 ROBERT J. SHILLER Yale University Low Interest Rates and High Asset Prices: An Interpretation in Terms of Changing Popular Economic Models 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 phe- nomena, 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 pop- ular 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 expec- tations theorists like to assume that everyone agrees on the model of the economy, which never changes, and that only some truly exogenous factor, The author is indebted to Tyler Ibbotson-Sindelar for research assistance. 1. See also Shiller (2007) on real estate prices, written concurrently with this paper. 111 10922-08a_Shiller_REV.qxd 1/25/08 11:23 AM Page 112 112 Brookings Papers on Economic Activity, 2:2007 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 con- sistently 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. 2. The concept of a popular economic model is discussed in Shiller (1990). 3. The long-term government interest rate series used here is an update of the series I spliced together for my book Irrational Exuberance (Shiller, 2005), from Sydney Homer’s A History of Interest Rates (for 1871 to 1952) and the ten-year Treasury bond series from the Federal Reserve (from 1953 on). 10922-08a_Shiller_REV.qxd 1/25/08 12:46 PM Page 113 Robert J. Shiller 113 Figure 1. Nominal Long-Term Bond Yields in Selected Countries, 1950–2007a Percent a year 16 14 12 Euro area 10 8 United Kingdom 6 India 4 Japan 2 United States 1955 1965 1975 1985 1995 2005 Source: Global Financial Data. a. Data are monthly and refer to yields on government securities of approximately ten years’ maturity. 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 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. However, as Franco Modigliani and Richard Cohn argued nearly thirty years ago,5 it may be, because of a popular model related to money illusion, the nominal rate that is used in the market to convert today’s dividend into a price. The downtrend in nominal rates since the early 1980s is certainly tied up with a downtrend in inflation rates over much of the world since the 4. Long-term rates are not any lower now than they were in the 1950s, but the high rates of the middle part of the period are gone. In the United States, long-term rates are actually above their 1871–2007 historical average of 4.72 percent a year. The best one can say from this very long term perspective is that U.S. long-term rates are not especially high now. 5. Modigliani and Cohn (1979). The authors also stressed that reported corporate earn- ings need to be corrected for the inflation-induced depreciation of their nominal liabilities, and investors do not make these corrections properly. 10922-08a_Shiller_REV.qxd 1/25/08 11:23 AM Page 114 114 Brookings Papers on Economic Activity, 2:2007 Figure 2. Ex Post Real Long-Term Bond Yields in Selected Countries, 1950–2007a Percent a year 12 10 8 6 Euro area 4 India 2 0 Japan United –2 States –4 –6 United Kingdom 1955 1965 1975 1985 1995 2005 Source: Author’s calculations using data from Global Financial Data. a. Data are monthly and refer to yields on government securities of approximately ten years’ maturity. early 1980s. Figure 2 shows real ex post long-term interest rates on bonds with a ten-year maturity in the same countries depicted in figure 1. The annual inflation rate that actually transpired over the subsequent ten years has been used to correct the nominal yield. (For dates since 1997, the entire ten-year subsequent inflation is not yet known, and so the missing future inflation rates have been replaced with the historical average for the last ten years.) Note that there has been a strong downtrend in ex post real interest rates over the period since the early 1980s as well. Indeed, this trend is nearly as striking as that for nominal rates. Ex post real long-term rates in some countries were remarkably close to zero in 2003. And just as with nominal rates, real rates have picked up since then.6 6. The ex post real annual yield on U.S. long-term government bonds has averaged 2.40 percent over 1871–1997, which is below their yield in 1997 (the last year this yield can be computed without making assumptions about the future). Even today, using the latest inflation rate as a forecast, U.S. real long-term interest rates are not obviously low compared with this long-run average. The best one can say for the popular view that long-term interest rates are low today is that they remain relatively low compared with twenty or thirty years ago. 10922-08a_Shiller_REV.qxd 1/25/08 11:23 AM Page 115 Robert J. Shiller 115 Figure 3. Yield on Ten-Year Inflation-Indexed Bonds in the United States, the United Kingdom, Australia, Chile, and France, 1985–2007a Percent a year 9 8 Chile 7 6 Australia 5 United States 4 3 United Kingdom 2 1 France 1985 1990 19952000 2005 Source: Global Financial Data. a. Data are monthly, beginning in January 1985 for the United Kingdom, July 1985 for Australia, April 1992 for Chile, January 1997 for the United States, and September 1997 for Sweden, and ending in July 2007 for all. However, ex post real interest rates may not correspond to ex ante, or expected, rates. It seems unlikely that investors expected the negative real long-term rates that, in the 1970s, afflicted every major country except stable- inflation Germany. It is equally unlikely that they expected the high real long-term rates of the 1980s. After the very high inflation of the 1970s and the beginning of the 1980s, inflation in the United States and elsewhere came crashing down.
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