Paul Schmelzing on the 'Suprasecular' Decline of Global Real Interest Rates

Paul Schmelzing is an economic historian, a visiting scholar at the Bank of England and a postdoc at the Yale University School of Management. Paul has written an influential new paper on the long history of interest rates titled, "Eight centuries of global real interest rates, R-G, and the ‘suprasecular’ decline, 1311–2018." Specifically, Paul and David discuss the implications of this paper’s findings for secular stagnation theory, Thomas Piketty’s inegalitarian wealth spiral, and for macroeconomic policy more generally.

David Beckworth: Our guest today is Paul Schmelzing. Paul is an economic historian, a visiting scholar at the Bank of England and a postdoc at the Yale School of Management. Paul has written a riveting paper on the long history of interest rates. It is titled, "Eight centuries of global real interest rates, R-G, and the ‘suprasecular’ decline, 1311–2018." Paul, welcome to the show.

Paul Schmelzing: Thank you David for having me.

David Beckworth: Now, some listeners might chuckle when I use the word riveting for a paper that covers 700 years of interest rate history, but it really is, it really is interesting and it touches on a number of important topics we'll get to today like secular stagnation, wealth and equality and what can policy do in the future if interest rates are all negative. So it is riveting and it's fascinating and if you love history, you'll love this paper. So we'll have a link to it on our website and we're going to talk a lot about it today, but it's an ambitious project. Paul you're historian, I'm an economist. I don't know that I'd have the energy or heart to dig through the archives to collect eight centuries of data. But you did this. So tell us, how did you even get into this project? What motivated you to take on such a huge project?

Paul Schmelzing: Well, it was I guess my third year in the PhD in 2016 when I relocated to London for a year. This was just before the whole referendum and when the whole Brexit debate took over. People were still very much discussing secular stagnation and the new challenges for monetary policy all over the place. And so I got into these discussions pretty early on, the discussions outside of the Bank of England in London in the financial community were all about the big bond bull market unprecedented in history. And so I realized that the underlying core of these debates is essentially a debate about interest rates particularly real interest rates. And I came to realize after a while that people kept referring to one source in the end, which is the classic, Homer and Sylla, “A History of Interest Rates.”

David Beckworth: I have it on my shelf.

Paul Schmelzing: Exactly, and it's really fabulous, groundbreaking work. Nevertheless, for historian, you realize that it has a lot of issues not just because it's now 55 years old, I guess. But because it never relied on primary sources, it never relied on printed primary sources. So for all their great work Sidney Homer and Richard Sylla, they never actually went to the archives and tried to piece new data together.

David Beckworth: Interesting. So it's all secondary sources they use to create their time series.

Paul Schmelzing: Exactly. And so as a historian, naturally our habitat, our bread and butter is to go to the archives and try to recreate these series and get a better picture. And so I was kind of struck at a lot of these conferences that I went to, people discussing secular stagnation at some point went, now let's look at the history of real interest rates and brought up this shot by Mervyn King and David Low that basically starts in 1970s and so it makes historians naturally uncomfortable.

David Beckworth: It kind of begs the question, what is history? How far back you have to go to be a historian, 1970s doesn’t cut it.

Paul Schmelzing: I wouldn't say you have to go back to the 14th century, I guess, but a lot of financial historians would agree that it was at some point in the late 13th, early 14th century that modern finance in many ways came into existence per se in the Italian city states. That's when you had the first consolidated debt markets. You had bonds trading on secondary markets between people from all over the world, from all over Europe, certainly. And that's the first time when it can really create a continuous series for long-term real interest rates. That's when we also start having the price data, the inflation data. So that was a natural starting point. But certainly most people say anything before your birth is already history, so.

David Beckworth: So you were motivated by the fact that lots of discussions over secular stagnation and to really make the case or secular stagnation, it has to be done in an historical context. And historical context maybe goes back to the 50s, maybe the 70s, but more modern history. And so you wanted to really get to the long history. So you weren't satisfied with what economists were calling history. And so it prompted you to dig into the archives all the way back to the 14th century. And as a result, you now have, I'm guessing the longest time series we have in the economic history. I mean, are there any other time series that run 700 years?

Paul Schmelzing: I mean not on the interest side, but of course on the GDP side there’s increasing great progress to recreate a GDP series for most of the advanced economies. People like Steve Bradbury have done this for England. Others have done it for Spain-

David Beckworth: On an annual basis or?

Paul Schmelzing: On an annual basis. Yeah. And of course Bob Allen has done that for the price series.

David Beckworth: Okay. So for interest rate data, you're like the final word.

Paul Schmelzing: Exactly. But for interest rates, we didn't have this so far. I mean we have a lot of great country level studies of course for certain sub periods, but it's very much a patchwork situation out there. There's no aggregate attempt to really put all of this together. And I guess this would all be nice anecdotal evidence if it didn't have in the end, in my view, a big bearing on these current policy debates that we know.

David Beckworth: Absolutely.

Paul Schmelzing: And so it would probably have stayed as sort of a side project/hobby if I didn't really get the impression that it changes some of the narratives that we have currently.

David Beckworth: Yeah. So I'm going to get into your data itself and the process of how you did it. But this is kind of on a sidebar here. So unrelated to your paper. I'm just curious, is there evidence of interest rates before this time? So like if you go back and look at, say Babylonian cuneiform or tablets, do they talk about interest rates or is there ancient history interest rate data?

Paul Schmelzing: Yeah, I mean, in Homer and Sylla obviously they have some evidence from Roman times, from Greek times and even Babylonian times. And now that's really where I have to pass because it's already a challenge to decipher medieval sources.

Paul Schmelzing: And I think obviously you would have to cut out a lot of the, what historians called the dark ages. Anything between the Roman Republic and let's say the 12th, 13th century is really a completely dark territory in terms of the archival situation in terms of the data situation. So you wouldn't be able, I would think to build a continuous series so.

David Beckworth: Time series. But you have peaked at this data. I mean you read Homer and Sylla and forgive me, I can't remember. It's been a long time since I've looked at their book. But where were interest rates say back in Babylonian time, was it positive, had positive rates, generally positive or any negative rates back then or?

Paul Schmelzing: No, I think I recall a few extreme data points in the Babylonian times. I think they have a few triple digits.

David Beckworth: Okay. War times probably, or stress. Okay. Well, let's leave the ancient history behind, because that's not your paper. Not fair for me to ask you questions about it, but it's super fascinating. In fact, I had Mark Koyama on the show. We talked about the economy of ancient Rome. Peter Temin has a book on the Roman economy. Really neat stuff, but we'll leave that behind and stick to your paper today. So you again have this amazing paper, about eight centuries of data, 700 plus years goes back to the fourteenth. Countries include Italy, Holland, France, Spain, UK, Germany, United States, Japan. So you have data on everything from kings to the city states to modern governments. How did you actually go about collecting the data? What was the process? Because that sounds like a Herculean task to me.

Collecting Eight Centuries of Interest Rate Data

Paul Schmelzing: So for these countries we have varying degrees of published stuff that's out there. I would say probably England is of course very well documented and Italy itself is nicely documented. For most of the other countries you really pretty soon have to go into the archives physically or to the extent that stuff is digitized you have to rely on archival data in the end. I mean, there's great stuff like Gina Rosato work on Venice for instance. Quite a few books and papers came out in the late 19th century where we had this historical tour in the social sciences in Europe at least where a lot of this stuff was published from the political economy departments in Europe. But after that, there was really a long period of silence and people didn't work on these issues. And so actual archival research is one key of the sauce.

Paul Schmelzing: The other is what historians call printed primary sources. I.e. we have a lot of historians who went into the archives and simply copied what is in the archives and copied this stuff in chronological order in so-called registries and published this via publishers. And so we have for a lot of the leading municipalities in Europe, we have so-called registries, which are sort of, you can think of them as a political diaries to an extent.

Paul Schmelzing: So all the geopolitical events are recorded by the Duke of Saxony in the Saxonian registry, right? Same goes for the leading commercial cities in Northern France and in today's Netherlands, which were at the forefront of financial development. So we have these really chronological registries for these kinds of cities where they recorded their data operations among a lot of other things. And so these are a great resource to build these kinds of series. As far as I can see, they are criminally underused in these kind of exercises. But obviously these kinds of studies accounted for a big share of the debt market activity for the financial innovation that was going on. And they were in many ways a role model for the latest central states to aspire to. Yeah, so these three categories were really the printed stuff, secondary stuff, printed primary sources and the primary archives.

So we have these really chronological registries for these kinds of cities where they recorded their data operations among a lot of other things. And so these are a great resource to build these kinds of series. As far as I can see, they are criminally underused in these kind of exercises.

David Beckworth: So you have to travel around these different countries and look at these?

Paul Schmelzing: Yeah.

David Beckworth: Okay, so you speak multiple languages, I assume able to read in different.

Paul Schmelzing: I never would have thought that it will be useful in the end, but I took actually Latin in school and so-

David Beckworth: There you go. All you parents out there trying to get your kids to learn Latin. Here's a good example of why you should.

Paul Schmelzing: So unfortunately a lot of these 14th century things are a convolution of Latin and local languages put together. And it's a really a terrible mix sometimes, but to the extent that you only care about the data, you can extract the data points and calculate the interest rates. And I had to get help from medievalists who do this 24/7, people who read these kind of sources to double check that I'm not recording dates or something.

David Beckworth: So this is interesting because I've looked into the Roman period. I mentioned before we had Mark Koyama. I mean when I say look, I've glanced from a historian's perspective because there are some interesting financial events that happen in the Roman period. Including the financial crisis of 33 AD and it looks a lot like a liquidity crisis. It would be really cool to dig into the archives, and then I realized you got to speak Latin, you have to learn or whatever language the historians…

David Beckworth: There were several ancient historians who actually wrote about, there's three ancient historians who wrote about the crisis of 33 but to really understand them, you really need to know the original languages. And that's just a dead end for me at least. And I imagine for many other economists, but you took on the task, a labor of love for the rest of us so that we can use your series. So 707 years, is that right?

Paul Schmelzing: Yeah, I guess it starts really in the year 1311, which is when we have Bob Allan's North Italy price series. You can go back further on the nominal side, but since we were interested in real rates that was a natural starting point. Yeah.

David Beckworth: Yeah. So you had the inflation data, you had the nominal interest rate data and you also had some GDP data too that someone else had built as part of your story. Right?

Paul Schmelzing: So, yeah, like I said, I spent most of the time collecting nominal long-term interest rate data. The inflation data, as I mentioned, a lot of it it's based on the great work of Bob Allen. I replicate it in some cases his baskets to see how they perform in different cities that he didn't cover. He covered 20 cities across Europe, which is a sufficient basis for these kinds of series, but on the GDP side, certainly as I mentioned, Steve Bradbury for instance, has pioneered this for England. And we have series for basically all the countries that I cover on the interest rate side. Only I think Germany and France are still a bit patchy. I haven't seen really consistent, long run series, but we can interpolate on that side.

David Beckworth: I've seen some of this data I think you've looked at questions of what did the average person's life look like 300, 400 years ago. I mean, the stark fact is that everyone or most everyone used to be poor. I mean, human history has been mostly poor people to few rich elites until the last few hundred years, the industrial revolution. It's fascinating. Look at these time series of GDP that go way back. You can see they all converged very low level. So that's been my limited exposure to some of these GDP data, but very fascinating stuff.

David Beckworth: Well, let's move on to your key findings and really, I guess the big finding, which is what's in the title of your paper, is that interest rates have been trending down for 500 years. Now, you have 700 years’ worth of data, but you find that interest rates have been going down for 500 years, and, I think, show 46 instances of negative rates since 1311.

David Beckworth: And you note there are some temporary stabilization periods. You list 1550 to 1640, 1820 to 1850, and then in our recent history, 1950 to 1980. I think many of us have as an anchor point that 1950 to 1980 and even after Paul Volcker and the disinflation rates come down up until 2008 all this talk about we've got to normalize interest rates. And I think even there's some confusion. I think central banks tend to follow the natural rate, but nonetheless talk about we need to get rates back up to normal levels. And what your paper clearly show is there isn't a normal level of interest rates and there is no what you'd call virtual stability. Also you look at capital returns as well as safe asset yields. Maybe talk about, you looked at two different measures of interest rates, maybe speak to that.

The ‘Suprasecular’ Decline in Interest Rates

Paul Schmelzing: So one of the headlines series is really GDP weighing these different geographies as you just mentioned. And together these countries account for roughly 80% of advanced economy GDP over time. So this is best thought of as advanced economy real rates of the long run, right? I mean, I'm leaving some out like Portugal or so, but these are 2% maximum advanced economy GDP. So it really tracks most of advanced economies over time for these 700 years. But then of course people would push back on several points on these aggregate series. They include funny stuff like default events of course, right? There's all sorts of market imperfections, which people might call market imperfections in there. So you can test these kind of trends on different levels of course.

Paul Schmelzing: I wanted to make hopefully a fairly robust case that we are seeing this downward trend irrespective of a certain financial assets, a certain geography or a certain risk premium associated with a certain issuer. And so the one headline series is this what I call the global GDP series where we see roughly 1.6 basis points on average downwards every year for these 700 years.

Paul Schmelzing: And in an observer, the bottom line, an observer in the late 15th century, early 16th century who had access to this kind of data would already have concluded with an extrapolation that we are facing this kind of zero lower bound problem in the early 21st century. And that's-

The bottom line, an observer in the late 15th century, early 16th century who had access to this kind of data would already have concluded with an extrapolation that we are facing this kind of zero lower bound problem in the early 21st century.

David Beckworth: We were joking about this before the show. If you had your data, if you'd started maybe say 400 years ago, you had a hundred years of data, you could have predicted where we'd be today, which is pretty amazing.

Paul Schmelzing: That's the point. And I think from what I can see we have a few nice historical studies like Barry Eichengreen has written a nice shorter paper on secular stagnation in history. But as far as I can see, no paper has shown that we have this kind of consistent downward trend and in real rates over a such a horizon.

Paul Schmelzing: Now to your question about the safe rates, of course I've had some people ask, well, aren't you just capturing the risk premium over time? Obviously these countries have become safer over time. These kinds of Kings and Dukes defaulted all the time and the 14th and 15th century of all these stories about the military going bankrupt and all these wealthy merchants being put into prison when they demanded repayment, which is true.

Paul Schmelzing: But in my view, it is not a case of the risk premium. And that's why you can build a series that tracks the safe issuer over time, the equivalent issuer to the US 10 year nowadays over time. Because when you look at the historical sources, it's quite clear that people over time hadn't had an idea about relative safety between different issuers. Right. And in a lot of sources actually they explicitly refer to what is the safe place where I can put my money-

David Beckworth: Oh, that's interesting.

Paul Schmelzing: ... Given all these wars and given all these risky events.

David Beckworth: So there's always been a safe asset shortage issue relative to the time they have.

Paul Schmelzing: Exactly. And you can broadly track, I mean it starts with the North Italian city states, which were really, apart from a few outliers, were really quite prudent in serving the debt.

Paul Schmelzing: And then you'll switch to Spain, you'll switch to Habsburgs, switch at the strongest military, a strongest financial centers controlled in the Spanish Netherlands and these kinds of areas. And then you switch to Amsterdam, London, and finally the United States. When you build this kind of series, which I call the safe issuer series you have not a single default event on the long-term debt over these 700 years.

Paul Schmelzing: And this is consistent with other research, i.e. on the GDP side, which confirms that the geography I track is the geography which with the fastest GDP growth and with the deepest and most innovative capital markets. And so I'm making the case that it's not really a story about the risk premium decline. The risk premium declines, no doubt, but the proportions are quite different.

David Beckworth: Okay. For this safe assets series, you found that it declines 0.9 basis points a year or almost one basis point a year. And that compares to the 1.6 basis points for the global measure. So one basis point a year. And you take this and I think I read somewhere, you take the implication and again this is a trend. There are deviations around this trend. I mean 1970 and 1980 was clearly a deviation around this. But you note that sometime in the next decade we're going to be a negative interest rate territory here in the United States, in advanced economies. I mean Europe sees it already, and that's something I've made on this show too.

David Beckworth: I mean, but I looked at more short term phenomenon, demographics, the inability of the developing world to produce safe assets. Everyone comes to the US looking for safe assets. But your kind of trend would tell a similar story that within this decade we're going to see short rates and long rates, zero or below. Is that fair?

Paul Schmelzing: I mean I have this graph which is deliberately a bit provocative and just extrapolating this kind of trend into the next decades or so. And if you extrapolate these trends it is obvious that that will not just hit the zero lower bound across the maturity structure. But we are going beneath it. Not radically. I do believe that there is some sort of negative point where people just pull all their assets.

And if you extrapolate these trends it is obvious that that will not just hit the zero lower bound across the maturity structure. But we are going beneath it.

David Beckworth: Effective lower bound?

Paul Schmelzing: Exactly. But, we're not talking about minus 3% or minus 4%, but we are talking about a consistent trend in that direction. So by the year 2050, I'm making the case that some of these slopes, the circle slopes that I show, have 0.7% negative rates. I guess other people might disagree, but this strikes me at a level which is still consistent with people tolerating it to some extent.

Paul Schmelzing: And the financial system being able to work around these kinds of levels to an extent. But I guess it requires a rethink of our frameworks and in a broader sense if once we accept that this is a long run trend, which has always been with us and whether it's, as you said, where there's really no indication that we have some sort of normal steady state level at say between 2% or 4%.

Paul Schmelzing: This is embedded in a lot of these macro models, I guess and a lot of these DCFs that people in investment banks have, but there's no historical basis for that.

David Beckworth: And this is fascinating because it has huge implications for financial intermediation. I mean, one thing would be, one offsetting factor would be if there still is a spread between long and short rates. So even if they all go negative or they are going to get compressed more, do you think or will it also be sufficient spread to motivate financial intermediation. Do you think that's an issue?

Paul Schmelzing: That's not something I've investigated. As you note, I'm talking about long rates only. In that one chart you refer to, I just made an assumption that the maturity structure that the 10 to two years will stay relatively constant. And then since we're moving down a long rate, what's the implication for the short rate? But of course the steepness might change.

David Beckworth: Well, to the extent this lower bound is binding, I mean it suggests to me that the spread will be reduced because at some point you want to get out. And so this could really change the nature of finance because finance is kind of premised on some fund short term invested or lend long-term with a higher yield. But this maybe putting a dent in that basic model.

Paul Schmelzing: But you touched upon an interesting point because I found in the wake of this research on the long rate that the structure of the yield curve has shown really curious properties over time as well. Its effect that the yield curve for most of these 700 years in many of these countries is naturally inverted.

Its effect that the yield curve for most of these 700 years in many of these countries is naturally inverted.

David Beckworth: Oh, really?

Paul Schmelzing: Even outside of-

David Beckworth: So you're saying the upward sloping yield curve is also a more recent innovation.

Paul Schmelzing: It seems to be, it would be interesting to do more systematic research on that. I've not done that in this paper.

David Beckworth: But you've seen glimpses of negative inverted yield curves going way back.

Paul Schmelzing: Exactly. And some authors imply that with the kind of data they have found. But it seems to be my hunch is it's a more systematic feature of the –

David Beckworth: Oh great.

Paul Schmelzing: ... Financial system.

David Beckworth: This show is getting really depressing here. Negative rates, inverted yield curves as far as the eye can see. Wow. Okay. This is a dystopian thought.

Paul Schmelzing: Sorry.

David Beckworth: No, this is good. Good stuff. We need to know this stuff and to prepare for it. I'm going to get to later, we'll talk about why this is the case and why don't we have like innovation, expected productivity growth that could offset some of those declines. We'll come back to that later.

David Beckworth: But just to reiterate what you find in a paper, and again, I encourage the listeners to take a look at the paper if you haven't already. But you know I'm going to read some quotes from your paper that this downward trend has persisted throughout the historical gold, silver, mixed bullion and fiat monetary regimes is visible across various asset classes, and long proceeded the emergence of modern central banks. So it's kind of independent of monetary regime because it's easy to say, oh central banks have not done a great job, or oh, it was the gold standard? Oh it was this standard. But you're saying it's a robust finding across these regimes no matter what. And in fact, you go on later, you say, “the forces responsible have been indifferent to monetary or political regimes; they have kept exercising their pull on interest rate levels irrespective of the existence of central banks, (de jure) usury laws, or permanently higher public expenditures.

David Beckworth: “They persisted in what amounted to early modern patrician plutocracies, as well as in modern democratic environments, in periods of low-level feudal Condottieri battles, and in those of professional, mechanized mass warfare.” So it's almost like a law of nature. It's like we could add another law. Law of gravity, we've got the law of declining rates. Now, not quite a law, but it's definitely a powerful force that seems to persist despite human innovations in how we run society.

Paul Schmelzing: I was surprised by that kind of consistency, almost the first thing they told me at LSC and in the economic history course was the North Weingast framework and the big institutional factors over time. So for instance, I would have expected some sort of big inflection point in 1694. And at the time when we have the Bank of England and successfully the other central banks that added to the picture. But surprisingly there's no big 1688 or 1694 inflection, neither when the Riksbank is founded, before that or after that, when we have the Fed founded. It has really and it persists, as you say, across these quasi feudal States, and then the 14th and 15th century just as it does in modern democracies. So there's something more fundamental to it. And it certainly did surprise me as well, the kind of consistency.

David Beckworth: Well, let me just play devil's advocate here. I know some listeners are big fans of the classical gold standard. Not, not all of them, but I know some of them would say, hey, classical gold standard, late 1876 to 1914, it worked relatively well compared to say the inter-war gold standard, which was a big disaster, but that didn't matter either. Right? This trend still persisted even during the classical gold standard, so it's not again a monetary regime phenomenon or force.

Paul Schmelzing: We actually have a pretty constant adherence to a gold/gold silver standard in most of these. So basically between the 14th and 19th century, it's either with varying shares, silver or gold. When the Spanish discovered the new world, they bring in obviously tons of first silver and then gold and they changed the mix a little bit. But given the kind of persistence in the international financial system it was surprising to me that we still see this kind of trend continuing no matter what the exact.

David Beckworth: Yeah. I mean, because you're looking at real interest rates too. So in theory those should at some point in the long run be independent of the regimes, but regimes could influence in the short run, but it's still what you find is this downward trend. Okay. So pretty stark findings and we will look for, maybe we'll still be alive and our children will definitely live in this world of negative rates if these trends continue. What does this mean for current economic debates? I'm going to bring up too, actually is the third one I touched on in terms of like what monetary policy should do, but the two big ones I think that come up in your paper are secular stagnation. And the other one is the Tomas Piketty argument that there'll be endless wealth accumulation or the term he uses endless inegalitarian spiral. So let's do secular stagnation first. What do these findings imply about secular stagnation? And has there been any pushback from the advocates of secular stagnations to your findings?

Implications for Secular Stagnation Theory

Paul Schmelzing: So the way I understand secular stagnation, it makes us slightly different. It doesn't make a direct argument about real interest rates. And of course talks about neutral real rates. And that is something you cannot directly observe or directly measure. You have to make assumptions about how that neutral rate is determined. So some of the advocates of secular stagnation are making the argument that they're not exactly talking about the outright real rate, but an interest rate that is consistent with the economy being at potential output and with a steady inflation path I guess.

Paul Schmelzing: But my sense is really, and my read of recent papers estimating the neutral rate is that really the long term neutral rate and the observed ex-post real rate more or less move in tandem over the long run.

Paul Schmelzing: I'm not making an argument about the business cycle or about shorter term fluctuations where by all means state they could be out of sync and potential might deviate and et cetera. But the way I read the data by people like John Roberts at the Board of Governance for instance, he has published some data is really that the trend is the same for the neutral rate since the 1970s, more or less, these two rates moved together. And I don't see any particular reason why over the very long term these two rates should be radically out of sync. And so you would expect if you approximate the neutral rate of a similar horizon it involves a lot more challenges of course but to show the same properties.

Paul Schmelzing: And so in that sense, I think my skepticism about the secular stagnation theory still stands in the sense that the current levels of global real interest rates, long-term real interest rates is very much at historical trend. As I mentioned the bond investors of the 17th century or so who started collecting data systematically, if they extrapolated the trends, they would have arrived at the effect of...

Paul Schmelzing: Around these kinds of years in the early 20th century. That strikes me as evidence that we are talking about much more deeper more persistent phenomenon than the sort of post 1980 deviation that so many people talk about, not least Larry Summers and others. So we should be focusing on the 1960s and 70s as being a weird outlier in many ways.

Paul Schmelzing: Why do real interest rates break out suddenly? And why has such persistence in the downward trend occurred over such a time? And all we are seeing in many ways, I'm saying, it's a trend return since the 1980s, since Paul Volcker declared war on inflation he triggered a return to trend and we are still in that kind of adjustment process and it shouldn't surprise anybody who had access to that kind of data.

All we are seeing in many ways, I'm saying, it's a trend return since the 1980s, since Paul Volcker declared war on inflation he triggered a return to trend and we are still in that kind of adjustment process

David Beckworth: Little did Paul Volcker know that he was just returning us to trend. What has been the blow back? I know you've gotten some pushback from some of these folks. What do they say when they see your data and they're like, oh, maybe I am too narrowly focused or do they have some other thoughts?

Paul Schmelzing: No, I mean, I mentioned the risk premium has suddenly come up. I'm capturing the risk premium to varying degrees. It is a totally fair point to say, look, obviously countries have become safer. Default frequency has declined over time. We have a lot of examples and people like Hans-Joachim Voth have written this great book about the Lending to the Borrower from Hell. They refer to Philip II and the in the 16th century. Some of these issuers were notorious for defaulting, in that sense borrowing hell was a pretty cramped place historically and you could put a lot of other people in there. But as I mentioned one interesting anecdote is Philip II never defaulted on long-term debt. He always defaulted on short debt.

David Beckworth: Interesting.

Paul Schmelzing: Isolating data and series as I mentioned, that are completely default free. And where the investors had a reasonable expectation that this would stay the case.

Paul Schmelzing: You actually have sources from 15th century Venice where the religious orders contemplate internally where to put their money. Where do we put our money to make it safe? And they come up with, let’s put it into Venice, because it's out of the reach of these unreliable and greedy dukes in our own country. And so when you look at these default free series over time, as I mentioned, we're getting the same kind of trend, the same consistency over time and in almost similar proportions.

Paul Schmelzing: So I estimate and you can do, of course, you can make an argument and some of the mercantilists have made the argument, well, no, financial asset is really safe. The absolute the ultimate safe asset is land, right? Of course you have confiscations in land as well. So nothing is ever really a safe. But that was the concept in the 17th and 18th centuries. So you can calculate, you can approximate the risk premium by the spread between these kind of default free rates and land to test it in various ways. Well, it turns out that you come to the same conclusion that the risk premium measured this kind of way declines by something like 0.3%, 0.4% basis points per annum. That still leaves you with 0.8 2.2, 1.2 basis points unexplained by risk premium. So that's my answer.

David Beckworth: So the answer is you are looking at a truly safe asset yield over time. You've adjusted for some of the criticism you've gotten about the implications for secular stagnation. What also does your analysis say about the prescriptions of secular stagnation advocates? So they would say more fiscal policy, more government spending, do infrastructure projects kind of get government to step up and fill the gap in terms of spending. And I think your take is that well may not do that much to this. This trend is a pretty strong trend. Is that fair?

Paul Schmelzing: That's fair. I think I haven't addressed the fiscal aspect systematically over time, but we have data that show England for instance, it's pretty well documented. Public expenditure to GDP was something like 8% in the early 18th century. By the late 20th century, it's 35%. So fiscal activity by these advanced economies has gone up significantly over the same time frame that we saw the trend decline in real interest rates. So at least on a sort of permanent basis, on a long-term basis, I'm quite skeptical that's simply increasing public fiscal expenditure will radically change that kind of trend. That said in the short term we have these kind of breakouts from the trend. Often they are coupled with other geopolitical shocks.

So fiscal activity by these advanced economies has gone up significantly over the same time frame that we saw the trend decline in real interest rates.

David Beckworth: Like wars.

Paul Schmelzing: Like wars.

David Beckworth: Okay.

Paul Schmelzing: The French revolution or the-

David Beckworth: We need war to get yields back up. And that's awful.

Paul Schmelzing: But no for sure. I think if you read Thurmond, if you do a radical push in the short term, I would be surprised not to see a reaction in the yields. But look, I mean-

David Beckworth: The long term trends still goes down no matter what direction.

Paul Schmelzing: Exactly. And look at just the shorter term, I mean the US is now running deficits at 6% last year and 10 year treasury yields have declined over the same horizon. So that tells you that something is apparently out of sync even in the short term.

David Beckworth: Yeah. So interesting developments, interesting world we live in. Okay. So that's the secular stagnation. That's most of your discussion. But you had a few thoughts on Thomas Piketty's view, and this is a different R here. So the previous R would be like R versus G. Previous R was a safe asset R. This is the return on capital, maybe big R. Any thoughts on what your analysis implies for that debate?

Thomas Piketty’s ‘R’: Inegalitarian Wealth Spiral?

Paul Schmelzing: So Thomas Piketty uses this term a nonhuman wealth return as his R if I'm not misrepresenting him. And he claims that this non-human wealth return is almost stable over time. He has a chart, I believe that starts in year 1000. And then he thinks it's around about four and a half percent. This kind of yield. Now, I believe that he refers among other sources, but one of his key source is Homer and Sylla, our 55 year old standard classic there. I haven't been able to really distill from that work that we should expect a stable return on these financial assets over time. As you mentioned in the beginning, I'm focusing on different asset classes, not just government bonds.

Paul Schmelzing: I also have a series on private debt over time. And so it's interesting you can go to wills when elite investors died in many cases there was a legal battle over their financial assets. And it's documented in courts. You can go to these archives and in an ideal case, you can actually get wealth breakdowns from a number of prominent sources. You can get a rough estimate, of course not, by no means a continuous series or something. But we have ideas what the approximate wealth breakdown should have been over time without radical breaks or something. So when you put together public and private debt my estimate is a figure around 40% of the wealth portfolio for elite municipal investors between the 14th and 17th century, at least when Raymond Goldsmith's book starts on the more high frequency wealth breakdown.

Paul Schmelzing: So a significant share of wealth is showing a downward trending real yield. And that means that to get to stable returns, you have to have a full compensation on the capital appreciation part. Right. And that I think is not really shown in the Piketty work in my view. So R measured by public and private and wealth weighted yields is showing a clear downward trend over time. And it's by no means stable. And I don't think Homer and Sylla imply that it should be stable. So I don't know where this assumption from that capital returns should have been expected to stay stable because people like Gregory Clark have shown the same for land yields in England over the very long term. So land is obviously a big chunk of your 14th, 15th century wealth portfolio. You have all these great feudal landlords with 60, 70 councils and then some cases and there's a big chunk of total wealth of course. The evidence that we have it's not as comprehensive as we might like, but it points into the same direction that it's downward trending over time.

David Beckworth: Okay. No matter how you sliced your interest rate, whether it's return on capital or wealth or it's safe asset you got this downward trend. All right, so those are two kind of current policy debates we've touched on secular stagnation, Thomas Piketty's worries about endless wealth spirals. A third one I alluded to earlier was the implications for monetary policy. I don't want to get into them, but clearly the way monetary policy is done is through interest rates. And that's not the only way you could do it. But the way it currently works is through adjusting either short term rates now more and more also in the long-term. And this clearly has implications for it. So this paper of yours has gotten a lot of publicity. You're at the bank of England as well. Have several bankers come up to you and said, “oh my goodness, what am I going to do? You're freaking me out, Paul.” If you've had the central bankers of the world come to you and say, this is not good news for us.

Implications for Monetary Policy

Paul Schmelzing: Not yet.

David Beckworth: Not at that level. Okay.

Paul Schmelzing: Maybe they still contemplating. I have no idea. No, but in all seriousness, I think I'm not focusing on short term of course. But you would expect, of course, this to have implications for the short term as well unless the-

David Beckworth: Well, expectation theory right with tell you for sure.

Paul Schmelzing: Exactly. Unless the maturity structure behaves in very weird ways here. So what I did get though is a lot of angry responses from particularly German savers who in some other countries desk this widespread belief that it was all the central banks who are responsible for the low interest rate environment. It stores up a lot of emotions in some places where they say, this was all the ECBs fault that our savings don’t yield anything.

Paul Schmelzing: It was actually, so in that sense it was actually from the other-

David Beckworth: Nice theory. Interesting.

Paul Schmelzing: Are still intend of blaming central banks for-

David Beckworth: You're given an easy out for the central bankers. You're giving them-

Paul Schmelzing: Not necessarily, I would say, because you have to think about what have we to show for all these trillions that we invested in increasing balance sheets. And in that we are now investing in potentially doubling inflation targets, all these kinds of things. What have we to show for it? I mean, inflation is still not a target in many places. Growth in the long-term context is still below trend in most places. And yet we have made these gigantic efforts on the monetary policy side. You have to wonder if that was really all in vain or if it was really worth it or when the results will really show if the theory is underpinning this already correct.

Growth in the long-term context is still below trend in most places. And yet we have made these gigantic efforts on the monetary policy side. You have to wonder if that was really all in vain

Paul Schmelzing: Now, I think if we accept this kind of long run trend, then it suggests that as I mentioned, maybe in the short term we can get with a really determined effort, we can get some sort of trend break. But this thing will come back haunting us in the longer term because the trend is pretty unidirectional.

David Beckworth: Okay. So this leads to the obvious question, the paper presents: Why? Why is there this persistent 500 year trend? Interestingly enough, do you have data to go 700 years? So it hasn't been going on the whole time, right? So something's changed within the past 500 years. It's still persisting and we're just now becoming aware of the savers in Europe are just now becoming cognizant of the fact that they aren't guaranteed a positive return on their savings, but it's almost like a force of nature. But again, because it starts only 500 years ago. What can you rule out? Maybe that's the easier way to start it. What could you rule out as causing this? We may not know what is causing it, but what isn't causing it?

Explanations, Plausible and Implausible

Paul Schmelzing: No, I mean, I have to disappoint the people who wait for the ultimate, waited 45 minutes for the ultimate answer. But I have stronger convictions on what doesn't really cut it at this point. So I've looked at the usual suspects growth demographic factors. And we have data on both sides for a similar period over time. So as I mentioned, we can reconstruct real GDP and we can reconstruct population growth over the same horizon. We also have a rough idea about life expectancy over time. So we can at least in a broader sense, we can look into the arguments about aging about Japanification because of the aging of, et cetera. I don't really find that either of these two drivers is as truly convincing. Over the long run advanced economy growth shows a sort of hockey stick development, right?

Paul Schmelzing: There are pockets of growth in advanced economies prior to 1800, say in Italy in the 15th century where we have clear growth. We have growth spurt in the Netherlands in the 17th and 18th century prior to the industrial revolution. But really it starts kicking off with the industrial revolution in the late 18th and 19th centuries. At that point real interest rates have already declined for 500 years. Right? And it goes into the wrong direction, obviously. Right? Growth start accelerating while real interest rates keep falling. So I have some sympathy for the literature that has questioned that kind of growth link. I mean I believe Hamilton for instance, and also I believe Larry Summers and Lucas Rachael have also questioned that direct growth link more recently. So I have some sympathy for these arguments.

Paul Schmelzing: On the demographic front a similar picture. I mean, in the short run, there's a clear correlation between demographic factors. I mean, look at the black death, for instance, one of the biggest demographic shocks over these 700 years. We have a massive maybe it's time to remind people of this with the whole coronavirus discussion, but 60% of European population was wiped out real long-term interest rates fall by up to 6% within a very short timeframe. So there is a very clear reaction from the capital market side. But over the long-term between the 16th and mid-18th century, for instance, life expectancy in England declines from something like 38 years to 33, 34 years. At the same time, real interest rates decline. So it's not this, my sense is not this over the suprasecular term if you will, it doesn't really cut it.

Paul Schmelzing: So you can make it a bit more nuanced and do stuff like multiplying life expectancy with population change. You would end up with the same sort of dissonance here I think. And the third is and a lot of people in the 17th and 18th century British thinkers have made these arguments linking interest rates to geopolitical factors, war frequency. William Pulteney who was a famous thinker in the 18th century and others, you find that some of these old tracks, have always said, well, he has the most enlightened democracy of the world. We are not quarreling on the continent like the emperor or the fringe Kings. We should have the lowest interest rates and we should have the inflows.

Paul Schmelzing: It turns out that war frequency between say the early 16th century and the Napoleonic Wars is on the rise, not falling down for advanced economies as a whole and yet real interest rates decline over the long-term. Even though you have these short term shocks when Napoleon on his campaigns, when the 30 years of war.

David Beckworth: Interesting.

Paul Schmelzing: This kind of things. They're visible in the short term but not-

David Beckworth: In the long run.

Paul Schmelzing: ... Not in the long run.

David Beckworth: So the usual suspects don't make the cuts. So I mean you think of a typical growth model in economics and won't falls out of it is the real interest rate in equilibrium is equal to like expected productivity growth would be the growth trend you mentioned. It's related to population or labor growth. You have more labor workers. The return to capital goes up. Also if you have faster productivity growth, not just the level of productivity, the growth of productivity, that should also increase return of capital. And then the third thing they usually throw in there, there's like a discount rate. How do people value the future versus the president can influence, but you're saying like the two big ones we often think about expected growth and population. They don't pass the test. And Joe Weisenthal, he's a journalist for Bloomberg News. He had an interesting piece recently back in probably September because back in August long-term yields got their lowest.

David Beckworth: I think the 10 year Swiss yield got down to minus 1% that German yield was half a percent and then the US and it'd be one and a half. And I think as of today they're coming back down again. But August was kind of like the low point and it came back up for a bit. Any events, so there's a lot of talk about negative yields at that point. And he wrote this piece for the magazine, Bloomberg Magazine he says “what's the big deal about negative interest rates?” He goes, that's kind of a normal state of nature. And he made this argument that, look if you're a squirrel and you're storing nuts, you've used negative real interest rates, and he starts with something simple like that, farming, farming faces and then he kind of generalizes that up to like, well, the entire universe is dying a slow death eventually we're going to find out that the stars will run out of energy.

David Beckworth: Entropy, entropy itself should have some bearing on interest rates. Now, that's a very interesting argument and the thing is-

Paul Schmelzing: Here's someone who's more bearish than I am.

David Beckworth: Well, the thing about it is, is that your trend is a 500 year trend. You think you'd see this story maybe? Oh, I mean this has been true for a long time. I think two things. One, the scale is much longer than probably most humans think about number one. So I don't know if that's really a part of the story. And two, it's difficult to maybe weave that into the standard equation. Maybe you can't, maybe entropy effects, expected productivity growth and your discount of the future. So I go back to the standard culprits and what you say is you don't find that they have a bearing. So has anyone else suggested an answer to this trend? Any other possible takes like journalists, people who've looked at your paper, trying to put the pieces of the puzzle together and come up with a solution?

Paul Schmelzing: No. What I've tried to do is look at a few of the inflection points at least where we had significant movements where we have clear breaks in the sense and see what this is associated with on a broader level. So I talk a bit in the paper about the period in the late 15th, early 16th century where we have a quite a significant decline in global yields from double digit levels down to around six, five and a half, 6% within two or three decades, far bigger decline than the post 1980 context.

Paul Schmelzing: These kinds of people could really talk about secular stagnation and things. But my hunch right now is that there are different factors at play, at different points over time. The unifying theme might be related to capital accumulation per se, but with different factors pulling at it at different points in time. Demographics can lead to capital accumulation in a bigger sense, as can growth, as can imbalances between savings and investments obviously. Now, there's an interesting story in the late 15th century, which illustrates to me the kind of different factors we're talking about.

The unifying theme might be related to capital accumulation per se, but with different factors pulling at it at different points in time.

Paul Schmelzing: So what happens, we have the context, we have the big black deaths catastrophe in the mid-14th century. So half of the European population is wiped out. Now what happens? Capital per worker per surviving citizen rises exponentially suddenly, capital costs come down.

Paul Schmelzing: But the bigger impact on capital markets is actually a sort of psychological, all of the historical sources speak about a big shift in the mentality in Europe suddenly. Why? Because people realize how quickly everything can end suddenly. How mortal their own-

David Beckworth: So people's discount rates change.

Paul Schmelzing: ... On earth are. The effect is that you see a massive increase in consumption, especially luxury goods. You see in these historical sources that people go something like, and I'm simplifying, well, if it can be all over tomorrow, let's enjoy life on earth rather than up there.

David Beckworth: Rather than be frugal and save.

Paul Schmelzing: Exactly. So that is consistent with the high rates actually rising between the 14th and late 15th century, right? Consumption capital demand is actually growing in these kinds of, for these surviving people.

Paul Schmelzing: Gradually, the church pushes back. It is very unhappy about this kind of luxurious immoral display everywhere. You remember the Bonfire of the Vanities. This is the kind of apex of the religious pushback against luxury consumption.

David Beckworth: You can thank the church the higher yields, huh?

Paul Schmelzing: Exactly. And what happens is in a legal sense, all over Europe, sumptuary laws come into existence. You're no longer allowed to wear fancy clothes in public. You're no longer allowed to play board games in public, you're no longer allowed to throw expensive feasts when you marry a soldier. So in a very short period of time savings rise massively. You can look at Italian wealth data where it's nicely documented. Your European savings rates go up massively in a very short time. And at the same time we see long-term real interest rates decline.

Paul Schmelzing: But it's a very, I guess this is completely outside of the scope of most macro models, these kind of drivers, these kind of social dynamics and debates that have often pulled and influenced real interest rates over time. The origins are very worried and I guess stuff like sumptuary laws or Savonarola is not really incorporated in most of macro models. So I think capital accumulation per se, as a big term is a promising explanatory variable. But I wouldn't pin the explanation on any of these drivers that we have discussed, like demographics, like growth per se.

David Beckworth: Well, Paul, you have created a great research agenda for some budding young economists to look in and to find out what is driving this. So your work will spawn future work trying to answer this puzzle and it's great that you have started, kicked it off.

David Beckworth: Well with that, our time is up. Our guest today has been Paul Schmelzing, Paul's paper is, "Eight centuries of global real rates, R-G, and the 'suprasecular' decline, 1311-2018." Check it out. Paul. Thank you for coming on the show.

Paul Schmelzing: Thank you so much David for having me. And any pushback or comments from your listeners are always most welcome.