The Relative Well-Being of Generations: An Explanation for Falling Interest Rates?

Doing worse than mom and dad is a drag on the entire economy

We tend to think of the economy as this giant, faceless force, and of the people within it as mostly powerless individuals trying to adjust and survive. But the collective decisions of those individuals determine the shape and performance of the economy. Together, they’re not so powerless.

When our spending grows, it helps the economy grow. And when we reduce spending and instead save, if the change is significant enough, it saps economic growth. And it can also drive up asset prices as more dollars chase those assets. That drives up stock prices and bond prices. Rising bond prices are accompanied by falling interest rates.

The graph below shows generations of Americans (though generations that are defined as 10-year groups, not 18–20 years, as you’d expect) and their consumption, relative to all individuals’ consumption. The graph is designed to show off the generation that’s the big spender. Anything above 1.0 on the vertical axis represents a spending level above the average American household at that time. The horizontal axis is age. Until roughly age 45, people are consuming, buying and accumulating things. Their spending rate levels off and they become savers as they approach their 60s. The result is a similar horseshoe-shaped consumption pattern over each generation’s lifetime.

What’s significant in this graph, however, is that the arc of generational spending hasn’t in recent decades reached as high as it once did, relative to everyone else. Those born in the decade 1940–50 enjoyed a high crest in their consumption from ages 40 to 60 compared to other people, but the next decade, the bulk of the baby boomer generation born 1950–60, never reached those relative spending heights in their 40s and 50s. Neither have successive generations. Later, we’ll see that this shift had a powerful impact on the economy.

By the late 1940s, economists were already using generational consumption and spending to model economies. In a working paper, UC Berkeley’s Nicolae B. Gârleanu and UCLA Anderson’s Stavros Panageas modify one such model, the overlapping generations model (OLG). Application of their modified model, with a focus on the time period during which a generation moves from being net consumers to net savers, provides an answer to a question that has puzzled some researchers: Why did U.S. real interest rates begin falling in the mid-1980s, long before economic growth slowed? In the process, Gârleanu and Panageas provide evidence of a potentially somber economic future for millennials.

It’s often said that millennials will be the first generation to do worse than their parents. An examination of historical data through the overlapping generations framework gives evidence that this dynamic has actually been in play for some time.

As can be seen in the graph below, the real median household income in the United States has been generally rising over time.

The graph below illustrates how average real household incomes for the generations follow similar patterns over their lifetimes, with relative incomes rising sharply through a generation’s 30s and 40s and then peaking in their early 50s before falling as they approach retirement. (Again, these are 10-year generations.) As with the horseshoe-shaped consumption ratio graph, the arc of generational income ratios here hasn’t in recent decades reached as high as it once did, relative to everyone else. Those born in 1940–50 enjoyed a high crest in income compared to other generations, but the next decade, the bulk of the baby boomer generation born 1950–60, never reaches those relative income heights. Neither have successive generations.

This raises a concern that relative incomes for millennials (the generation born between 1981 and 1996) are starting from a much lower point, below that of age groups born in the 1960s and 1970s. Based on history, it’s reasonable to expect that this generation will never catch up with the relative income previous generations enjoyed in their 40s and 50s. Logically, one’s rate of spending on goods and services (consumption rate) is constrained by income. The baby boomer generation, born between 1946 and 1964, benefited from higher income levels relative to more recent generations, and their relative consumption rate was also much higher.

This fact, along with the sheer size of this generation, whose population peaked at 78.8 million in 1999, played a large role in shaping market trends over recent decades. In the mid-1980s, the oldest of that generation entered their mid-40s. This is an age at which people’s savings and investments typically rise relative to their consumption, as they’ve already bought their homes. They begin putting more of their income toward 401(k)s and IRAs. This generational shift helped fuel stock market gains from the mid 1980s through the end of the 20th century.

While the consumption pattern of baby boomers helps explain rising equity prices, what’s been less clear is what caused U.S. real interest rates to start falling in the mid-1980s. A principle of macroeconomics is that real interest rates follow growth rates. The reasoning is a simple one: For most rational people, consumption growth should be in proportion to their wealth and income growth. Therefore, the growth rate of return on assets (which reflects the interest rate) should be in proportion to the growth rate of income and consumption, at least over the medium run. Some in the investment community have explained the fall in U.S. interest rates as a result of a slowing real GDP rate that began in 2000.

Yet real interest rates actually began falling around 1984–85, a period when the rate of real GDP was growing, not slowing.

The researchers’ model supplies an answer to this puzzle. It was in the early to mid-1980s that the consumption growth of 45-year-olds versus the aggregate growth of the economy began to slow. Since it is the group of 45-year-olds and above that are the typical savers in the economy, it is their consumption and income growth that are relevant for the theory. If their income and consumption growth slow, this will be reflected in the interest rates.

Gârleanu and Panageas also find that generations born after the baby boomers have not been as successful, relative to others, so the ratio of generational consumption to aggregate growth has continued to fall. It’s this fall in the relative consumption growth that led to the continued fall in real interest rates since the mid-1980s, the researchers posit. From 2000, the consumption growth of those in the 45-year-old age range has been good compared to the average consumer, but not strong enough to outpace the aggregate economy; so real interest rates have not managed to climb higher.