I was reading “Helicopter drops might not be far away” by Martin Wolf in the FT. By now those interested in macro economics/monetary policy/asset markets should be well aware of the long gradual easing in interest rates, especially since the 1990s. Lower interest rates did not just encourage people to borrow for consumption, but they also boosted the amount of borrowing for asset purchases with rising asset values also looping back into consumption for a while. During this period, global money supply growth also became ever more asset focussed.
For a while this helped stimulate consumption in key economies, also aiding in developing economy growth. Developed economy consumers became ever more indebted at a time when income growth was also slowing, but given that asset markets kept rising and interest costs kept falling, everything was able “to keep on going for a while”…many felt that this period of low interest rates and rising asset markets was a “great moderation” and few seemed to notice the enveloping divergence.
While the financial crisis was the bursting of this particular reality, it also marked the onset of a period of unprecedented financial engineering in response, itself a denial of that reality.
Today growth remains slow and low despite rock bottom interest rates and appears to be slowing further in key developing economies. The whole modern financial/consumption/production edifice is at risk of crashing inwards again, largely because a) in the developed world the monetary fuelled price of assets (and the supporting debt) is at odds with the growth capabilities of the world economy and b) in the developing the monetary fuelled investment financed growth is at odds with consumption growth expectations both at home and abroad.
Things would not be so bad if we had also not seen increasing income inequality, a factor which has also tended to increase the asset focus of money supply: monetary flows are siphoned out of the consumption/production/investment cycle and into the global asset portfolio. And of course this loops back into lower rates etc and so on.
Offshoring and the growing manufacturing base of China in particular further sustained both global growth and forces impacting income inequality, increasing the reliance of developed economies’ growth on an eventual rebalancing in these emerging global powerhouses. That transition has yet to fully develop and growth in places like China is arcing down, placing considerable pressure on the financial system.
Unconventional monetary policy that was supposed to right the ship (if you were one of those who believed the crisis was only a one off sharp shock whose impact on the economy would only be temporary) has unsurprisingly failed to re-establish prior trends in growth.
The latest round of monetary easing, negative rates, appears to have been at the forefront of recent market instability leading many to believe that interest rate policy had reached the end of the road. I would agree and so do commentators like Wolf.
I fail to see the long term “stability” rationale for negative interest rates:
Lower costs of borrowing may allow increased asset leverage without necessarily increasing fundamental expenditure/investment/production flows.
Negative rates of interest on cash could more likely impact the asset allocation of money in the asset portfolio and hence act as a hot potato irritant to asset prices. This may of course help support consumption derived from asset draw down for the aging portion of the population but higher asset prices are swings and roundabouts for future future generations and there are limits and additional economic risks to such strategies.
Additionally by encouraging yield focus it may well push portfolio allocations out to higher risk/less liquid asset classes with ramifications for the impact of asset price shocks on consumption.
Negative rates would also likely risk adding to deflationary forces for large parts of the working population: if your wages are reduced by an annualised x% a month you may end up spending less, or indeed finding yourself having to borrow more to finance the deficit. This may prove to deflationary and at the very least destabilising.
The banking system cannot lend out its reserves and while it can certainly purchase assets with these reserves, as a whole the banking system cannot avail itself of its “money” per se and therefore, even presuming the strategy is successful we risk creating highly risky spirals of consequence.
Money is both a consumption and asset transaction medium and the relationship between money and the economy/markets is a fundamental and delicate one. The relationship of both broad monetary aggregates (deposits) and narrower aggregates (reserves and notes and coins in circulation) is so clearly out of kilter. Broad money supply growth prior to the onset of the crisis already vastly exceeded nominal GDP growth in a number of key economies and post crisis the relationship between money supply and bank loan creation (as denoted by the increasing cash assets held in bank balance sheets) is increasingly likewise.
We know that in many countries (notably the US and the UK) recent consumer credit growth has been strong relative to wage growth. Do we really want to be encouraging highly leveraged durable goods consumption in the absence of higher wage growth?
And of course, what is the rate of interest? For some it is a charge on earnings for a loan of capital (as in traditional corporate fixed interest investment), in which case with earnings yields, on aggregate positive, there is no clear rationale for negative rates. For government debt it is a charge on its revenue, which is itself a charge on national income flows. For bank loans it is a charge on future income or income likely to be generated by a given project. As all these flows need, on aggregate, to be positive there is little rationale for rates to be negative. The higher the risk in the certainty of a flow on which the loan is to be repaid the higher the rate of interest, whereas in times of greater uncertainty with respect to flows, interest rates on those with higher certainty will fall relative to those with less and vice versa. Money flows are also relevant relative to the growth rate of an economy. As noted before in previous e mails, declines in interest rates that are not central bank initiated are indicative of an imbalance between the stock of productive capital and the economic frame.
Far too many think the only metric of relevance is the gap between rates, the margin and not the greater economic relationships. A given positive gap is a given positive gap whatever the rate, but the economic relationships are totally different at negative rates and the absolute matters. A naturally negative rate means that there is an excess of either productive capital or money seeking rates of return on productive capital and the rate most likely represents the risks to new loans or new money creation (at the margin). It may also of course mean that flows from capital or the growth rate of productive capital is below a natural or expected rate, but such a situation is more likely to be temporary and short term than part of a longer term trend. We are of course in the midst of a longer term trend in interest rate declines and divergence in asset values relative to economic growth. Introducing more money into the system, pushing interest rates lower is not going to right the imbalances. It is more likely to lead negative rates or by implication asset price shocks and in consequence further declines in economic flows as adjustment is forced onto the economy.
The other point in Wolf’s article was the so called savings glut argument. This is derived from the flawed National Income Accounting Identity, S=I.
Economic output at a very basic level (the identity) is = to consumption plus investment. GDP=C+I. This output is also more or less equivalent to national income, so income is also Y=C+I.
If Y=C+I then C=Y-I and I =Y-C and the assumption is that S therefore = I. But S ≠ I for the simple reason that S takes place at the end of the period and I and C take place during the period. To finance C+I where C+I exceed income in a prior period we need to borrow. So S=I +/- new loans/loan repayments and in totality so does Y= income in a prior period +/- new bank loans/loan repayment. Focussing on the identity as an organic process weakens the analysis provided by the so called Savings Glut hypothesis.
If we have borrowed a lot in any one period to finance consumption and investment, S≠I in any given period where S and I are derived from the end period Y or GDP. When we talk savings glut we are ignoring new money loan finance and hence the imbalances we see have a significant monetary root and not necessarily one of insufficient expenditure. Add to this the compounding over time of excess money supply growth and the problem becomes less that of a temporary drop in aggregate demand and more of one of an excess or imbalance in the system. Naturally, the imbalances in income distribution are having a bearing on consumption expenditure but this must surely be addressed in ways other than negative rates and or expansionary fiscal policy.
That said, helicopter drops may well spell the end of the capitalist model as we know it and could well be a monetary shock too far. This really is a case of feeding the animals to keep the zoo in business. The capitalist model would no longer be responsible for managing and allocating flows and capital. We would be entering a manufactured habitat and who would determine who controls and determines what? In a sense this is about preserving the status quo and its control. Brave New World?
I discuss many of the issues touched upon in previous posts, but the following provide reasonable summaries and lists of relevant posts: