Recently I wrote about something I call the Economic Singularity, which is the point at which real interest rates hit zero, and asset prices approach infinity.
As a thought experiment, I took the example of a golden goose that lays an egg every year. I assumed that the egg was of equal value each year, and the the goose is immortal.
But what happens if the goose isn’t immortal? Let’s suppose there is a certain percent chance that the goose will die in any given year, but we don’t know when. So when we add up the net present value of all the eggs, we have to discount by our risk-free discount rate, plus a rate that reflects the possibility of the goose dying. This rate is the risk premium. If the value of the egg is E, the real interest rate is r, and the risk premium is p, then the value of the goose is now E/(r + p) instead of just E/r.
This can make a big difference if r is close to zero because it will be dominated by p. In other words, if p >> r, r doesn’t really even matter in determining the price of the goose.
Consider another example. Whenever you take out a loan, to the lender you are the goose. Since you will die at some point (or default, it’s all the same to the mortgage company) you will have to pay a higher interest rate. If the lender thinks you are particularly risky, you will have to pay a really high interest rate. For really unreliable borrowers, these rates can get pretty high. For example, according to this website, the average interest rate on payday loans is 391%! That’s really high. I don’t even care about the exact number, I just want to point out that the reason rates are so high has very little to do with the risk-free real interest rate.
One potential problem with my singularity analysis is that when real interest rates get really low, they cease to really matter. So will the risk premium save us from an economic singularity? No, no it won’t. Here are three reasons why:
Reason #1: Assets are Getting Less Risky
First, a theoretical reason. The risk premium won’t prevent economic singularity if if goes to zero along with real interest rates. So is there any reason to believe the risk premium for common assets might go down? Yes, yes there is. Namely, our economy is becoming more dominated by large companies:
And average people can invest in these companies very easily. We might be entering an age where the new tech companies (say, Facebook, Google, and Amazon) are just going to keep getting bigger and bigger because they will just buy up any promising upstarts.
This article humorously compares the revenue of various companies to the GDP of whole countries. At the top stands Walmart, with revenues similar to that of Belgium, a relatively rich western nation with over 10 million residents. If government debt has a low risk premium, shouldn’t that of these giant corporate behemoths? In fact, according to this article, two companies (Microsoft and Johnson & Johnson) actually have a higher credit rating than the United States!
So, while the risk premium won’t dominate all asset prices, it is likely to become a bigger factor for asset prices overall because the economy is becoming dominated by very large, very reliable companies.
And in fact, we do see that these companies can borrow lots of money at very low interest rates. Just last year, Google’s parent company borrowed $10 Billion with a coupon rate of 0.45%. Amazon got an even lower rate on their most recent bond issue.
Reason #2: The Trend Evidence Includes the Risk Premium
Take a look at this graph, which I shared in the Economic Singularity essay:
Note that on the vertical axis it notes that the numbers are corrected for inflation. Guess what they aren’t corrected for? That’s right, risk. In actual fact, in the case of any individual loan, there is really no way to separate the real interest rate from the risk premium. All we observe is the interest rate (i.e., r + p).
One plausible explanation for this whole trend is that real interest rates have always been zero, and that all we are seeing is a decrease in the risk premium. In other words, over time the reliability of government bonds has been increasing, so the risk premium goes down. The US Treasury is simply more reliable than King Sigmund or Edward III.
Of course, then we might have to explain why interest rates on US government bonds were so high in recent history. Basically, it was just a blip. Here’s another graph that depicts the weirdness of the last half of the 20th century (again, from this site).
So anyway, the point is that we don’t really have any way of knowing whether this trend is due to falling real interest rates, or falling risk premium. All we really know is that the combination of them is falling to zero. But if the combination is falling to zero, and we have some pretty good reasons to think that neither is negative, we can conclude that both real interest rates and risk premia are falling to zero.
Reason #3: Land
Land is like the immortal goose (i.e., what is called a ‘perpetuity’). Here’s an interesting discussion on the impact of falling interest rates on housing affordability. The article starts with the basic premise that if interest rates are really low, land will be very expensive, but this will be offset by more affordable interest rates. Then, they make the interesting point that a house on the land is not a perpetuity, and so it’s price might depend more on the risk premium.
However, even if houses are not perpetuities, they are almost always built on land. Thus, if real interest rates fall to zero, the price of land will skyrocket. If land is infinitely expensive, putting a house on it isn’t going to make it any cheaper.
This article laments the fact that houses have become so expensive that an average person can only dream of owning the house of cartoon deadbeat Homer Simpson. And it’s true, housing prices are skyrocketing:
Of course, if you look at the price per square foot, and adjust for inflation, you will see that housing prices haven’t changed that much relative to incomes:
So houses are getting bigger. But that’s interesting, because lot sizes are getting smaller. Check this trend out:
So what could explain that? One reasonable explanation is that land is getting relatively more expensive than houses because land is a perpetuity. When real interest rates fall, it affects the price of land more than it does the price of houses (which are subject to a risk premium). Therefore, houses get bigger and lots get smaller.
So, at the end of the day, it is true that not all assets prices will be driven by falling real interest rates. But some really important assets (like land, and big corporate stocks) might be, and this is enough to cause an economic singularity (i.e., some really weird shit happening in the economy).
