R* is the real rate of interest that, averaged over the business cycle, balances the supply
and demand of loanable funds, while keeping aggregate demand in line with potential
output to prevent undue inflationary or deflationary pressure. Two key features of R* are
that it is (i) expressed in real terms (i.e., excluding inflation) and (ii) not subject to credit
risk. Hence R* is meant to capture the equilibrium (real) rate of return of a safe asset.
More generally, however, an abnormally low R* is first and foremost a sign of economic malaise and imbalances … Consensus explanations point to factors that simultaneously and inefficiently push global savings up and global investment down. Some of these factors are slow-moving and predictable. This is the case of accelerating population ageing in the West and in East Asia (China, Japan, South Korea). As individuals approach retirement age, higher wage income and the prospect of lower pension payments encourage them to save more to smooth their living standards over their remaining lifetime.Yet, the issue is why these extra savings do not find their way into investment. After all, the effects of ageing on investment are not necessarily negative on balance. While the anticipation of shrinking markets in large economies is undoubtedly a drag on investment plans, a relative fall in the working-age population could be expected to raise the return on capital. In addition, a larger elderly population could entail reallocations of productive capacity, fostering innovation and, ultimately, investment as the aggregate consumption basket changes in favour of goods and services intended to alleviate the consequences of dependency. For instance, the return on investment in robotics, telemedicine and other innovative options to deal with dependency could be expected to rise. What prevents these arguably desirable developments from moving faster and on a greater scale?
Other slow-moving but less easily predictable factors include the significant rise in income inequality in many countries, the slowdown in trend productivity growth and an increase in market concentration. Greater income inequality is generally thought to raise aggregate saving as the income share of more affluent households – who tend to save relatively more – increases. Weaker productivity gains and greater market power could both contribute to lower private investment and boost corporate savings, resulting in sizable stock buybacks and purchases of low-risk financial assets, such as sovereign bonds from reserve currency issuers. And in fact, the corporate savings glut is an essential part of the story.
A more fundamental problem is that as one looks around the world, it certainly seems as if there are plentiful opportunities for productive investment. The world is full of poverty and low consumption levels, together with low levels of health and education, environmental concerns, aging populations, and many other issues. There are also waves of new technologies, including not just digital technologies but scientific breakthroughs in biology, materials science, and many other areas. However, the high levels of global savings are not translating into a surge of global investment. This suggests something is wrong with the economic environment at a deeper level, perhaps with the financial system, or with maybe with issues like taxes, regulation, trade, or how scientific breakthroughs are being translated (or not translated) into consumer products.
After the Global Financial Crisis, advanced economies had to come to terms with their vulnerability to the kind of economic and financial instability usually confined to some chronically unstable emerging and developing economies. … As in emerging and developing countries, the events that bring about instability are not necessarily low-probability, high-impact shocks, such as devastating earthquakes or deadly pandemics. They can also be (and usually are) the result of a vicious circle of negative feedback loops, which allow even a seemingly benign disturbance to quickly escalate into ‘tail events’. Bernanke (2013, pp. 71-72) explains this when he recalls that ahead of the GFC,
“… if you took all the subprime mortgages in the United States and put them all together and assume they were all worthless, the total losses to the financial system will be about the size of one bad day at the stock market, they just weren’t that big.”Taken in isolation, a root disturbance of the size of a bad day in a given segment of financial markets would likely not be enough to instantly alarm policymakers and push them to act … Hence, when things unexpectedly get out of control, policymakers can be caught unprepared and unable to respond as quickly and effectively as possible with the right mix of instruments. Whatever their root causes, the endogenous vicious circles that define tail risk are mostly financial.