LOW INTEREST RATES AND HIGH ASSET PRICES: AN INTERPRETATION IN TERMS OF CHANGING POPULAR MODELS By Robert J. Shiller October 2007 COWLES FOUNDATION DISCUSSION PAPER NO. 1632 COWLES FOUNDATION FOR RESEARCH IN ECONOMICS YALE UNIVERSITY Box 208281 New Haven, Connecticut 06520-8281 http://cowles.econ.yale.edu/Low Interest Rates and High Asset Prices: An Interpretation in Terms of Changing Popular Economic Models By Robert J. Shiller October, 20072Low Interest Rates and High Asset Prices: An Interpretation in Terms of Changing Popular Economic Models Abstract There has been a widespread perception in the past few years that long-term asset prices are generally high because monetary authorities have effectively kept long-term interest rates, which the market uses to discount cash flows, low. This perception is not accurate. Long-term interest rates have not been especially low. What has changed to produce high asset prices appears instead to be changes in popular economic models that people actually rely on when valuing assets. The public has mostly forgotten the concept of “real interest rate.” Money illusion appears to be an important factor to consider. Robert J. Shiller Cowles Foundation for Research in Economics 30 Hillhouse Avenue New Haven CT 06520-8281 [email protected] Interest Rates and High Asset Prices: An Interpretation in Terms of Changing Popular Economic Models1 By Robert J. Shiller It is widely discussed that we appear to be living in an era of low long-term interest rates and high long-term asset prices. Although long rates have been increasing in the last few years, they are still commonly described as low in the 21st century, both in nominal and real terms, when compared with long historical averages, or compared with a decade or two ago. Stock prices, home prices, commercial real estate prices, land prices, even oil prices and other commodity prices, are said to be very high.2 The two phenomena appear to be connected: if the long-term real interest rate is low, elementary economic theory would suggest that the rate of discount for present values is low, and hence present values should be high. This pair of phenomena, and their connection through the present value relation, is often described as one of the most powerful and central economic 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-rate-high-asset-prices” description of the world. I will also evaluate a popular interpretation of this situation: that it is due to a worldwide regime of easy money. I will argue instead that changes in long-term interest rates and long-term asset prices seem to have been tied up with important changes in the public’s ways of thinking 1 This paper was prepared for the “Celebration of BPEA” Conference, Brookings Institution, September 6 and 7, 2007. The author is indebted to Tyler Ibbotson-Sindelar for research assistance. 2 See also my paper on real estate prices, written concurrently with this, Shiller (2007).4about the economy. Rational expectations theorists like to assume that everyone agrees on the model of the economy, which never changes, and that only some truly exogenous factor 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 public thinking. But, there is an odd contradiction here that is rarely pointed out: the economists who propose these rational expectations models are constantly changing their models of the economy. Is it reasonable to suppose that the public is stably and consistently behind the latest incarnation of the rational expectations model? I propose that the public itself is, largely independently of economists, changing its thinking from time to time. The popular economic models, the models of the economy believed by the public, have changed massively through time, this has driven both long rates and asset prices, and that these changes should be central to our understanding of the major asset price movements we have seen.3 This paper 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 their thinking has impacted both asset prices and interest rates. This will lead to a conclusion that there is only a very tenuous relation between asset prices and either nominal or real interest rates, a relation that is clouded from definitive econometric analysis by the continual change in difficult-to-observe popular models. 3 The concept of a popular economic model is discussed in Shiller (1990).5 Low Long-Term Interest Rates Figure 1 shows nominal long-term (roughly ten-year) interest rates for four countries and the Euro Area. With the exception of India, all of them have been on a massive downtrend since the early 1980s. Even India has been on a downtrend since the mid 1990s. The lowest point for long term interest rates appears to have been around 2003, but, from a broad perspective, the up-movement in long rates since then is small, and one can certainly say that the world is still in a period of low long rates relative to much of the last half century. Long 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 now. In the US, long rates are actually above the historical average 1871-2007, which is 4.72%. The best one could say from this very long-term historical perspective is that US long rates are not especially high now.4 Economic theory has widely been interpreted as implying that the discount rate used to capitalize today’s dividend or today’s rents into today’s asset prices should be the real, not nominal, interest rate. This is because dividends and rents can be broadly expected to grow at the inflation rate. However, as Franco Modigliani and Richard Cohn argued nearly 30 years ago, it may, because of a popular model related to money illusion, be the nominal rate that is used in the market to convert today’s dividend into a price.5 4