There is a new NBER working paper by Iachan, Nenov, and Simsek on the question of why short-term real rates are so low. Their model is simple: the cost of financial intermediation is falling, and furthermore portfolio customization is much easier these days. Investors can buy many more distinct assets, and so they are more likely to find favorites. In general portfolio investments go up and asset prices go up, but yields on the low-risk assets go down. The more you can customize, the more assets you wish to buy, and as part of general portfolio offset/construction, the more of the risk-free asset you wish to hold as part of your efficient diversification strategy.
I think of it this way: the more easily you are able to collect beloved artworks, the less risk-sharing you are doing, and the more you will invest in some kinds of safety as a risk offset.
Pretty neat, we’ll see how it stands up (does it predict the behavior of real investment as well? and what does it imply for the predictability of returns?).
The authors, by the way, are claiming only that this is a contributing factor to low rates on low-risk assets, not the entire answer. And note that in their model, unlike in standard accounts, falling risk need not cause the short-run rate to rise again. Their model also predicts that falling securitization leads people to invest more in the very safest assets, causing those yields to decline further; that is consistent with the post-2008 world.
Greater market participation, taken alone, does decrease the risk-free rate in the model. And arguably greater market participation came along in the early 1980s, more or less when risk-free rates started to fall.
So how do you get out of a liquidity trap? Well, if the trap is not benign, either restrict portfolio customization or facilitate securitization, in other words enabling a greater number of secure intermediate assets. Who would have thought?
File under “Don’t think you understand the real interest rate.“