No, it’s not the aging population

When it comes to the impact of demographic changes one of the prime examples economists point to is the natural real rate of interest. Since the 1970s, the natural real rate of interest has steadily declined and is now almost at zero.

Natural real rate of interest in the United States and the UK

Source: Bloomberg

This decline in the natural real rate of interest is typically blamed on both declining trend growth and increased savings. And in an ageing society, the retirement of the baby boomer generation should lead to a lot of dissaving by pensioners, which in turn should push the natural real rate of interest higher. Thus, we should be prepared for a decade of rising real rates, which would be pretty bad for stocks and bonds alike.

The problem with this explanation, though, is that if you test the relationship between the natural real rate of interest and population ageing, it comes up with the wrong sign, as I have explained here. Furthermore, the decline in the natural real rate of interest has been persistent since the early 1970s, as the chart above shows. But in the 1970s and 1980s the working age population was still growing and the ratio of pensioners to working age people increased, which should have led to rising natural real rates of interest.

New research by economists from Princeton, Harvard and MIT now confirms that demographic changes have a really hard time explaining the observed path of natural real rates of interest. Yet, this doesn’t keep some people from making dire predictions based on these and other flawed assumptions, as I have discussed here.

But this post is not just a rant about how economists make predictions based on flawed models. That’s really not news. Instead, this is a post about the solution to declining natural real rates proposed by this research: Rising inequality.

We know empirically that people with higher income have higher savings ratios. In the United States, the top 10% of the country by income saves about 21.1% of its income, while the bottom 50% have a savings rate of just 1.5%. That is a large difference and this difference increases as income inequality increases. If the top 10% have higher incomes, their savings rates increase as well. The research estimates that the top 10% by income have increased their savings to the tune of 3% to 3.5% of US national income since the 1970s as more and more income has been concentrated in their bank accounts and investment portfolios. And this increase in inequality neatly explains why there is a ‘savings glut’ since the 1970s and why the natural real rate of interest has declined so much.

Going forward, this also means that as long as income inequality remains high, the natural real rate of interest should not rise. It requires a substantial ‘levelling up’ and reduction in income inequality to push the natural real rate of interest up significantly in the long run. And I for one, don’t see this kind of reduction of income inequality happening in the next couple of years.

Savings rates by income (left) and age group (right)

Source: Mian et al. (2021)