I am not a fan of outsized monetary accommodation in a declining growth frame…but what can you do?

Irrespective, deflation is not the issue, but slowing growth within a complex frame over burdened with financial excess and key structural imbalances. 

A recent speech by Andy Haldane has kept the interest rate/zero lower bound debate “bubbling”.   In this speech, “How Low Can You Go”, Haldane broached the issue of monetary policy in the event of another demand shock.  He is quite right to do so since monetary policy would have little room for manoeuvre with interest rates only a scuff mark away from 0%.  His musings suggested getting rid of cash and bringing in negative rates.

Negative rates would allow the real cost of borrowing to fall, thereby providing stimulus for those who may wish to otherwise eschew borrowing and relief to those who may be suffering from cash flow constraints in a falling demand environment.   It may also encourage those with excess cash holdings to transact, although I tend to believe that this would favour asset price appreciation first and foremost. Clearly there are other issues here but this is not the scope of this particular post.

If a crisis hits then, of course, stabilising the natural rate of demand, whether this be for goods and services or for loans for the same etc, makes sense and, hence, a foray into negative rates is green for go in a certain context.   The question is what is the natural level of demand since rates of growth are relevant only in the context of the starting point? 

A temporary shock to a system where demand has fallen from trend would benefit, but a system where the shock is effectively already accumulated is another.   I believe we are in the latter, clearly, and this is a dilemma. 

My highlighted concern rests with the preoccupation of Haldane and other Central Bankers with falling consumer price inflation and the idea that negative interest rates should be used to drive inflation higher whenever we have “deflationary” forces.  As I have intonated, whether this is the correct policy depends on whether the body economic and financial was out of or in balance prior to the decline in prices and more importantly, the trajectory of the frame: that is a growth or a deflating frame.  A good indication that something is way out of balance is the very fact that interest rates are more or less at the zero bound in many countries and even already below in others and have been for some time.   More so, the trajectory of rates have been lower for some time as has the build up of financial and consumption excess and this should yield some clues.

Even in a deflating frame capital is still being invested, created and borrowed (just at lesser rates of activity) and there is still a return on productive capital: negative interest rates outside of arbitrary stimulus should not exist where the system is in balance. But as I pointed out in a recent post, there are many causes of imbalance in the current global economic frame:

A – A declining frame in key developed economies: population growth.

B- Changes in the natural growth rate of the frame given A: productivity growth and technological innovation.

C – Impairments in the frame: increasing income and wealth inequality.

D – Accommodations attempting to offset A,B and C: lower interest rates and higher money supply growth that has boosted debt amidst a slower growth frame and that have led to asset price shocks impacting both the financial system and the frame itself.

E – Inter temporal and structural imbalances: the maturing of developed economy growth and the accelerated growth of developing economies and the over dependence on the convergence of the two within an acceptable time frame.

F- Secondary impacts on C and B due to offshoring to developing markets.

G – Further accommodations: a secondary stage in the global debt cycle as developing markets looked to offset the lack of demand from developed markets post the financial crisis.

In a growth frame, demand, whether it be total or per capita demand, is expanding.  Productive capital is accumulating, population expanding, and money supply growth, via loans to finance consumption and investment and saving, is likewise expanding.  Money supply growth fosters increases in demand for consumption and investment goods (and assets) – debt increases but not necessarily debt to GDP.  Productivity growth may also be expanding: more goods can be produced for a given set of labour inputs, meaning capital and labour in the economy can either be used to produce more or be reallocated to produce other goods and services.  Productivity growth may well also result in higher returns to inputs: wages and/or higher returns on capital, fostering further consumption and investment.  Productivity growth combined with greater competition may well lower prices for certain goods, but again releasing labour and capital for other forms of expenditure and investment.  

In an expanding frame where there is a disconnect between the growth in demand (monetary excess) and the ability to produce demand, inflation is likely to happen and this was the typical reason for interest rate rises in earlier business cycles (i.e. in response to development of short term capacity constraints).  

In a declining frame, demand is contracting and so is productive capital.  What is important here is that capital is allowed to depreciate and cash flow allowed to flow out: depreciation is where cash flow is directed away from investment and to income/dividends and expenditure and/or debt repayment.  As cash flow flows out and investment growth (or investment as an absolute declines) we may see a natural disinflation as excess productive capacity adjusts.  The stock of money supply is also likely to be adjusting downwards as loans are repaid and the necessary stock of money declines.  Therefore low inflation and even disinflation, dependent on the frame and the cause, is not necessarily a danger.  

A deflating frame does not necessarily mean that the price of goods and services should fall, since this is more a question of the balance between demand and supply: demand and supply of goods and services and inputs, and demand for and supply of money. If capital depreciates and output declines at the same rate as demand then it is not a given that there will be deflation; if we have over invested in productive capacity, over borrowed for assets whose values depend on higher assumed future flows etc, then there will likely be such a disconnect and the risks of deflation, whereby the fall in demand moves out of synchronisation with the decline in capital and productive capacity, will rise.   But where there is an orderly decline of the size of the frame there is still need for capital expenditure/investment and hence a real rate of return on capital.  All that happens is that the amount of capital adjusts. 

If we have started from a position of excess capacity and excess debt and excess consumption and growth is slowing and this slowing is causing financial shocks to the frame, is the solution to expand productive capacity and demand yet further?

Well the answer is no if this raises demand and supply above levels associated with the economic frame: think the consumer debt financed binge of the noughties in many developed economies.  I believe that a large part of today’s deflationary risks are to do with declining frames with accumulated excess in certain economies, and excess capital investment in others with expanding frames, and the inter temporal transitions between the two. 

The developed economy consumption/real estate debt binges pre 2007 and developing economies post 2008 are a large part of the reason for disconnects between growth in demand and growth in productive capacity.  

In a declining economic frame (demographics/population growth, weakening productivity growth and increasing rates of capital depreciation) inflation is not something which should be or needs to be actively encouraged and deflation, or declining rates of inflation, not necessarily something which should be the subject of unusual monetary policy. 

Where we have imbalances, what needs to be supported is the adjustment process by which excess in the prior paradigm is written off in the transitioning phase, and remedy to other issues impacting the balance of the frame (note increasing income and wealth inequality). 

The problem with QE and negative interest rates is that they appear largely focussed on supporting the prior frame as opposed to its adjustment.  They also seem to be focussed on assets, and debt focussed on asset purchases (falling interest rates have increased the asset focus of money supply and its growth rate).

Making sure capital still flows to areas requiring capital investment while writing of capital in other areas requiring adjustment makes sense, but expansion for the sake of expansion no.  Inflation is not the problem and neither is deflation per se.  That said, deflation within a frame that has accumulated excess debt and productive capacity is an issue in the falling prices compounds the debt problem and the speed in which the excess pushes back through the system.

What is a danger is an attempt to create expansion in a frame which would otherwise be declining naturally, or perhaps pausing (note the long transition required fro China).  For example supporting asset price appreciation allows consumers with declining rates of income growth to finance higher rates of immediate expenditure: the asset price appreciation and the debt accumulation creates a latent asset price shock and a subsequent far greater deflationary force as debt defaults, and sharp declines in demand both reduce the stock of money supply and the velocity of MS.

Indeed, ever since the mid 1990s when falling inflationary pressure gained increasing traction with slowing growth rates and secular decline in growth drivers, monetary policy has placed much greater focus on low inflation and less focus on the impact of increasing amounts of monetary stimulus on asset prices and asset focussed debt.  Monetary policy has been focussed on sustaining demand growth, asset price inflation at the same time as building up demand/deflationary shocks. 

There has been a divergence between the natural evolution of stocks and flows and an unnatural support of a trend which has run contrary to the natural arc of these flows.  High levels of debt, high asset focussed money supply growth, high asset prices relative to growth and other key relationships creates especially pernicious deflationary shocks.

Fighting these shocks with low interest rates perpetuates the imbalance.  Unfortunately little has been done to acknowledge these imbalances, or how to adjust for them, other than to defer their denouement. 

Andy Haldane’s speech may presume that the starting point is one of a natural balance temporarily knocked off course: i.e. that negative interest rates may be needed to merely re-establish a prior healthy trend.   But, my reading of much of his other work suggests that he is aware of these imbalances.  What the article may therefore well suggest is a deepening and disquieting concern over financial and economic stability as well as an inability by the powers that be to effectively to differentiate and deal independently with the major issues.

Irrespective, deflation is not the issue, but slowing growth within a complex frame over burdened with financial excess and key structural imbalances.

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