Welcome to the negative rates universe. No need for a secular stagnation explanation. Normal growth will not return as long as central banking non-conventional monetary management combining tighter prudential regulation, quantitative easing, and low-interest rate policy holds up recovery.
Today Europe is a place where one can borrow money at almost no cost. It is as if borrowing were free! We even have negative interest rates – which means that private savers may have to pay the borrower in order to lend him money!
About a year ago, the Financial Times mentioned the case of a Danish doctor who signed up for a three-year loan at her local Danske Bank office. The following month she received from the bank not an invoice for payment of interest but a monthly check for about 17 Danish Crowns – i.e. € 2.20. Not so significant maybe, it represents an interest rate of only 0.0172 %, yet it is a clear signal that we are moving into a very strange new world and it extends to longer and longer maturities. Early this last July, yield on the 20-year Japanese government bond fell below zero for the first time. In Switzerland, government bonds through the longest maturity, a bond due in nearly half a century, was yielding below zero while, in Germany, government debt with maturities out as far as January 2031 were trading at negative yields. Du jamais vu!
No one has ever seen negative nominal rates... not ever, not even in the thirties. Not so long ago no one would have thought it could happen in our lifetime. Yet, here it is... today 30 % of all government debt in OECD countries – i.e. about $13 trillion in total – is trading on a negative interest rate.
Why are rates so low? What does it mean? This issue lies at the core of our interrogations about world economy future.
There is a well-known debate which sees heavyweights from the mainstream academic world pitted one against the other. Heavyweights such as former Fed chairman Professor Ben Bernanke and the economist and former adviser to Bill Clinton and Barack Obama, Larry Summers.
According to Larry Summers developed economies are now caught in the midst of a Secular Stagnation trend, along the lines described by Alvin Hansen in his 1938 American Economic Association presidential address.
Stated in a few words, the theory is that due to a number of long term structural factors such as: the decline in demographic growth; population ageing; rising income and wealth inequalities; reduced capital intensity in the new leading industries; and the fall of the relative prices of capital goods... the modern economy is characterized by the dominance of a long lasting disequilibrium between saving and investment.
The result is a glut of savings that firms are unable to invest at a positive interest rate. The advanced economies therefore find themselves saddled with extraordinarily low interest rates. To return to full employment, argues Summers, would require that market real rates of interest adjust to a Wicksellian natural rate of interest now well below zero. But under a fiat currency regime, this is impossible to achieve since economic agents would begin to hoard cash in bank vaults rather than have to pay a fine for lending their money (as is apparently beginning to happen in countries like Switzerland and Germany). When rates get as low as the zero lower bound (ZLB), market interest rates cannot fall by as much as the natural rate, which means that desired levels of savings keep exceeding desired levels of planned investment, and lead to shortfalls in aggregate demand. The economy then gets caught in an unfortunate and enduring state of under employment and under capacity utilization. Developed economies are thus trapped in a deflationary equilibrium akin to what Japan has been experiencing for the last twenty years. Western economies are becoming Japanized.
Professor Ben Bernanke criticizes Summers’ secular stagnation hypothesis mainly on the grounds that it pays no attention to the international dimension. This is quite right. Summers focuses on purely domestic structural factors, as if the outer world did not exist. This does not sound very clever, especially in these times dominated by the forces of globalization.
Bernanke thus comes up with his own explanation, a 'Global Savings Glut'. He concurs with Summers’ main assumption: present problems are caused by an excess of desired saving over desired investment, but according to him this disequilibrium does not originate from endogenous structural factors. It is a consequence of the way oil producers such as Saudi Arabia and countries like China and its Asian neighbors, adjusted their economic policies after the great Asian financial crisis of the late nineties. To prevent a repeat of the fatal scenario that cost them dearly in terms of lost standard of living, they chose to manage their currencies in such a way as to maximize export surpluses and to accumulate foreign safe assets and currency reserves while repressing internal demand and consumption. It is the flow of these global savings into the United States, argues Bernanke, that helps explain the paradox faced by Alan Greenspan in the mid-2000s with long term interest rates remaining persistently low while the Fed was raising short term rates.
The debate is not purely academic. It is key for the necessary policy-making and advisor strategies for getting developed economies « back to normal » growth prospects. If you are in Summers’ corner you will hold that the only hope to get out of the trap within a reasonable timeframe lies in a more active fiscal policy, increased government spending and investment in order to compensate for the individuals’ excess savings, higher taxes for reducing inequality, financial repression so as to penalize excess saving behaviors, and so on. If you side with Bernanke, the right response is not more government but concerted efforts at freeing up international capital flows and reducing interventions on foreign exchange markets for the purpose of gaining trade advantage.
Bernanke is an optimist who believes spontaneous corrective actions through international cooperation are likely to achieve a return to more balanced global trade. He is right to point at the role government decisions played in the process leading to the financial crisis and the Great Recession. However it would be better if he were to take a look in his own backyard as suggested by another well-known economist, Kenneth Rogoff, the author of the famous if often challenged book: « This Time is Different », published in 2009.
Rogoff's claim is as follows: the anemic and protracted recovery which followed in the wake of the Great recession above all reflects the post financial crisis phase of a debt super-cycle.
According to his analysis, the US and perhaps the UK have reached the end of the deleveraging cycle while the Eurozone, due to weaknesses in its construction, is still very much in the thick of it. He claims such a slow U-shaped recovery, very different from most typical post-war V-type recessions, is nothing exceptional. Research on historical data and inter-country comparisons over almost a two-century-long time span confirms this pattern is commonly associated with recessions caused by deep systemic financial crises.
He concludes that policy makers should have more vigorously pursued debt write-down accompanied by bank restructuring and recapitalization; they should have paid more attention to how advanced countries have dealt with banking and debt issues in the past, even in the relatively distant past. Thus, overall, his main complaint is aimed at the deep historical amnesia that is common among many modern economists and central bankers.
There surely are elements of truth in what they say, but reality is infinitely more complex. Apparently they have no idea that the central banks and their economic advisors did play a large part in the processes that explain both the Great Recession and the very tepid and limited recovery which followed. Their own professional careers (at least for Summers and Bernanke) may account for their ideological blindness, but it is no excuse.
One may express three main reservations regarding their narratives:
1) The first one deals with the negative interest rate issue.
It is surprising how readily, even among the best renowned economists, this concept is endorsed without really questioning its relevance.
At the core of the present macroeconomic debate lies the idea that what economists call the equilibrium real interest rate (better known as the « natural interest rate ») has become negative as a consequence of a savings glut – whatever its cause. They draw the conclusion a negative real interest rate is required to bring saving back in line with investment, and thus rekindle a sustainable process of economic growth. But does a « negative equilibrium real interest rate » make sense? Unfortunately, it doesn’t necessarily do so.
Economic theory is replete with concepts which are apodictically true but cannot be used as operational tools by macro-social engineers to achieve their policy ends. This is the case with the notion of a « natural interest rate ». It does not express an equilibrium value (as in models), but a value differential resulting from the so-called Time-preference – a term which denotes the simple epistemological truth that the individual tends to value goods available at present more highly than goods available in the future.
It is important to understand that, by definition, time-preference is always and everywhere positive, and so is the natural rate of interest. The notion that time-preference and the natural rate could be zero is logically impossible since a truly zero natural rate would imply that the individual's planning horizon is infinitely long, as if saying he would never act at all but would continually postpone the attainment of his goals into the future. Thus, should a central bank ever succeed in making all market interest rates negative in real terms, savings and investments would come to a shrieking halt. It would be a recipe for wreaking havoc on the economy. Negative real rates are not a solution as suggested by conventional central banks macro-thinking. They are the shortest road back to central planning and totalitarian government.
As brilliantly explained by Joseph T. Salerno, from the Mises Institute in Auburn (Alabama), central bank conventional theorizing about negative rates derives from deep misconceptions about what Knut Wicksell really meant while writing in 1898. It is mere hot air.
2) The second focuses on the responsibility of central banks – more specifically the American Fed – in the chain of events that unfolded before and after the Great recession.
Many people rightly blame the Fed for causing the housing bubble by holding rates down below optimal « rules-based » levels (Taylor rule) in the aftermath of the 2001 dot.com recession. Others argue that the Fed tightened up too much after 2005 and precipitated the ensuing crisis.
This type of criticism – too easy or too tight – could be leveled at the Fed at any point throughout its existence to date. It overlooks that 2002-2003 was a period when the Fed engaged in a fundamental change of policy that gave birth to a very different set of risks for financial actors.
In order to guarantee that deflation would not occur, for the first time it signaled that it would do the following: firstly, always provide liquidity backing to protect the financial system from a precipitous fall in asset prices (so called Greenspan's put, 1998); secondly, keep interest rates low « for a considerable period of time » (Greenspan in 2003); and thirdly, only raise rates at a predictable pace.
These promises created a whole new set of incentives that changed the workings of the US financial system in very important ways. Basically they meant for investors in shadow banking they could make predictable spreads on safe investments and depend on the liquidity of the collateral to mitigate risks. It led them to respond by crafting new optimal portfolios, not with risky assets but with low risk collateralized assets, while relying on overextended leverage to compensate for low returns. It is this change in Fed policy that acted as a catalyst in the build-up of financial system fragility thus paving the way to the banking panic of 2008 and its economic consequences.
The Fed's post-Great Recession achievements are no better.
When you wish to understand why an economy keeps underperforming it is best to look at its monetary records. What do they show? A surprising fact. After seven years of the new unconventional monetary management, Large Scale Assets Purchases (LSAP) policy resulted in a fourfold monetary base increase. This is a very large number. But when you look at global monetary supply (Divisia M4) or at US private credit growth figures the picture is very different: a paltry +4% for the whole 2010-2013 period. Thus while the media believed the central bank was flooding the US economy with huge amounts of liquidity, monetary data reveal the country was still experiencing overtight monetary conditions. The same thing on the international money markets. A recent and little known study shows evidence of a widening shortage gap in Eurodollar supply since 2013 despite the commencement of so many quantitative easing programs around the world.
How is this possible, especially with short-term interest rates so close to zero? The explanation is to be found in the way financial regulations set up after 2008 (Basel III + Dodd-Frank), zero-interest-rate policy + forward guidance, and non-conventional monetary tools (QEs) combined to negatively affect bank credit supply. For example, increased tightness on the global wholesale money market (as revealed by the present dollar upward trend) has something to do with the recent extension of new US capital and liquidity ratios regulation to American banks’ off-shore subsidiaries and European banks’ subsidiaries working in the US.
Near-zero-rate policy is absurd economics. It acts very much like a price ceiling in a housing rental market where landlords react by reducing the supply of rental apartments, while the heavier weight of prudential regulation also increases the marginal cost of producing loans. This cost increase, and its consequence on loan supply, is far from negligible. Studies carried out by a German financial establishment suggest it may cut by half the average bank industry return on equity – thus pushing major banks and financial institutions to reduce activities (such as market making strategic management on global bond markets).
The same with QEs. Though the US QE may superficially seem to have been effective, it is not the panacea many imagine. By removing trillions of dollars of Treasury securities from the economy it amplified the scarcity of safe assets used as collateral by shadow banks. Such a scarcity contributed to hold back recovery by increasing the price of collateral and marginal costs of intermediation, while also playing a crucial role in unexpectedly driving interest rates further down to zero.
Finally, the focus of economists on macro-monetary management means policy makers have lost sight of the fundamental role interest rates play in a market economy and its proper regulation.
Central banks have been the target of much complaint and criticism. But most of them focus on global demand and miss the really important issue: how modern central bank management far from being an equilibrating mechanism ends up in a series of economic and financial supply dislocations à la Hayek. Few people are fully aware of the dangers resulting from the combination of quantitative easing, low-interest-rate policy and tighter prudential regulation.
It has now become clear that QEs do not work the way they are assumed to. The latest proof comes from Europe with its own one-year-old quantitative easing experiment. Last July, following in the footsteps of Switzerland and Japan, Germany was the first Eurozone country to sell 10-year government bonds at a negative interest rate. This is good news for government Treasuries, but not necessarily for the economy. It reveals ECB policy is presently exacerbating a severe shortage of market collateral that fuels a European wide price bond bubble, with the risks of: increasing liquidity difficulties; greater financial instability; and, possibly, the danger of a future epidemic of mass defaults.
Another little-noticed feature of QE is that it works as a penalty tax on the banking system. Banks sell Treasury bonds in exchange for liquidity which they are expected to employ in delivering more loans. But this is not a cost-free operation. For every new loan the banks must put up costly additional capital in order to meet the new Basel leverage ratios. According to estimates the ECB quantitative easing may reduce the profits of the European banking system by more than 100 billion euros per year. As time passes, it will make it more difficult for banks to raise new capital, finally compelling them to shed valuable assets, reduce their loans portfolio and enter into a decapitalization death spiral. Surely not the best solution to reignite growth.
An economy is best described as a complex structure of expectations, decisions and outcomes interlocked by a web-like decentralized coordinating mechanism made of myriads of individual prices. Like all managed prices managed rates distort this process. The adverse consequences of these distortions remain limited when their originating policy cause is quickly reversed. But things are very different when, as is the case today, it lasts for six, seven years and longer. The longer it lasts the deeper discoordination creeps into the workings of financial and inter-industry relationships, generating a fatal cumulative process of speculation, waste and mal-investments that throw the proverbial spanner into the gears of economic growth. Pursuing that sort of policy means soon facing another great financial crash.
Overall, QEs, the central banks’ unconventional monetary management and prudential regulatory policies have had the unexpected perverse consequence of recreating the sort of financial casino environment that began to take flight in August 2007 when BNP suddenly stopped redeeming cash for investors in three of its American mutual funds. By fueling a never ending search for yields on stock markets (and thus moving investors to get on higher and higher risks); by making junk bonds ever more unreasonably attractive; by prompting corporations to prefer conservative stock-buyback policies rather than aggressive investing in maintenance and innovation; by stimulating rolling speculation on on government (even the most endebted ones) and private bonds; and by breaking down complex incentive mechanisms that sustained the rise of global finance and liquidity markets... QEs are laying down the very conditions for the sudden surge of a new and even deeper economic storm.
Along with the concept of Secular Stagnation goes the idea that today very low interest rates are a reflection of a declining trend in productivity observed in the US since the end of the seventies. It is suggested that they are part of a long term slowing down process in technological progress that is a harbinger of the end of economic growth as we have known it during the last two centuries. This conjecture comes from Northwestern University Professor Robert Gordon who argues the economic impact of digital technology has already largely run its course and is unlikely to generate the same mass productivity gains as those prompted by the big innovations of the previous technological revolutions.
Quite a claim. But there are good reasons to challenge and dismiss it. Basically, it is reasonable to believe that if, up to now, the computer revolution of the latter half of the 20th century had only a limited impact on overall economic growth, compared with what we expected, it can only mean we have yet to experience its full effect.
As explained by Professor Barry Eichengreen some technological breakthroughs very rapidly translate into large economic welfare gains because they can be very easily applied to a certain range of activities without significant disruptions and they do not need substantial adaptation and reorganization groundwork before positive impact on output and productivity can be observed. This was the case with such innovations as the steam engine or electricity. But Information Technology is of a different ilk.
Until now the computer revolution has had a relatively limited impact on overall economic growth because computerization has had deep transformative effects on only a limited set of industries such as finance, the production of computers or the wholesale and retail trade. That is why we may not yet find much evidence of it in macro statistics. But with the next generation of big innovations in the process of being developed such as new tools (quantum computers), materials (graphene), processes (genetic modification), robotics, and enhanced interactivity of digital devices, a very broad range of activities and industries – such as education, medicine, energy, industrial research, finance etc. - will be affected and are likely to be deeply disrupted and reorganized by these new technologies. Once this broad range of adaptations is completed, productivity should accelerate again and put an end to the lull apparently observed.
Moreover there is also a measurement issue. Our conventional macro-economic concepts are not fit to measure value and consumer surplus gains in a world where inputs like information, knowledge and creativity are becoming the main engines of progress and welfare. Thus it is quite likely present GDP or productivity growth data largely understate actual outcomes especially when measured over long periods.
This is why, contrary to what proponents of Secular Stagnation suggest, one may think that the present low rates of interest are not in themselves a cause for concern regarding long-term future growth prospects though, as an artificial outcome of the central banks’ wrong economics, they surely are a cause for concern about their more proximate consequences.
The coming financial crisis will be very costly for everyone but it will not be the end of the world. Being positive, we should rather think of it as a transition from a non-sustainable state of play (overburdened by heavy debt) through the wormhole to a wholly restructured and reorganized new economy.
Driven by new technology and globalization, this reorganization should on the whole lead the world back to an economic regime of deflationary-growth such as the one which propelled the United States to the top rank of developed nations at the end of the nineteenth century. Deflationary-growth is the normal regime of a prosperous capitalist society: real wages rise while prices are led by a steady slow decline benefiting non-active generations.
But, as demonstrated by the last financial crisis and the root causes of present stagnation, this promise will never have a chance to materialize as long as our economies remain under the tutelage of modern central banking institutions run with a planner’s mentality inherited from the old industrial age.
Low rates policy and quantitative easing combine with other features of monetary and financial management such as prudential regulation and forward guidance communication strategy. The interconnectedness of these different courses of action is a source of many contradictory outcomes pulling in opposite directions and holding up recovery. Here are a number of such examples usually little known by non-specialists.
By removing billions of dollars of Treasury securities from the economy large-scale asset purchases amplify a scarcity of safe assets used, increasingly, as collateral in the provision of new loans to corporations and households (on the Shadow banking markets). Such a scarcity holds up recovery by increasing the price of collateral and the marginal costs of intermediation. It also plays a large part in driving interest rates down ever closer to zero and then keeping them at those low levels.
When maintained for an overly long period low rates end up suppressing information about two of the most essential signals needed to ensure the smooth working of a market economy: the value of time and the relative value of risk. Like all managed prices managed rates distort the market coordination process. The longer it lasts the deeper the discoordination creeping into the workings of financial and inter-industry relationships. It generates a cumulative process of false signals, waste, and mal-investments that amounts bringing the gears of economic growth grinding to a halt.
By reducing the spread between long term and short term rates quantitative easing cuts down on the banks’ and financial corporations’ margins. Whereas the heavier weight of prudential regulation increases the marginal costs of providing new loans. The consequence is a reduction of global loan supply by the banking system though the governments want banks to lend more money to investors and consumers.
These cost increases – and their consequences on loan supply – are far from being negligible. Recent studies suggest it may cut the average bank industry return on equity by half. Thus, while the media believed the US economy was flooded with huge amounts of liquidity, monetary data revealed that the country was still experiencing conditions of a quasi- ‘credit crunch’.
A sustained squeeze on rate spreads also induces banks and non-bank financial establishments to look for increased leverage in order to compensate for lower rates of return (while reinforced financial regulation aims at lowering leverage ratios).
Similarly, when backed by the central bank promise to maintain low rates « for a considerable period of time », it leads investors to rebuild portfolios not with more risky assets (as is the supposed goal of quantitative easing) but around low risk collaterized assets accompanied by recourse to overextended leverage.
Main victims of such incoherence are thrift institutions like insurance, pension and hedge funds. They find themselves loaded with very-low-return assets to cover long-term high-cost liabilities. They are thus made highly vulnerable to any squeeze on liquidity or any future rate rise.
Overall, close-to-zero rates end up by generating far-reaching asset and price bubbles that fuel the risk of sudden liquidity difficulties, build up financial system fragility, and ultimately threaten the economy with the danger of a future spiral of mass defaults.
One source of increased systemic instability results from recent US decisions to extend bank new capital and liquidity ratio standards to American banks’ off-shore subsidiaries and European banks’ subsidiaries working in the US. The main victims of such regulatory moves are those few dominant international banks that play a crucial inventory role on world bond and safe assets markets. Due to higher regulatory costs and lower profitability, these firms are now in the process of moving out of their market-making activities. The consequence is three-fold : first, increasing fragmentation of international bond markets; second, higher price volatility and more market fails in specific segments; and three, an unexpected deflationary contraction of the global wholesale money market’s flows .
Zero-rate policy and QEs are also responsible for heightened instability on exchange markets that may degenerate into a global currency war and disrupt the most vulnerable emerging economies. For example it is no mystery that one of the aims of the ECB quantitative easing program, launched in 2015, was to obtain a lower and more competitive Euro rate. It worked, but not for Japan’s last maxi-QE, with FX markets not reacting as expected.
Last not least, by encouraging economic agents to lock themselves into long-term plans and contracts based on low-rate expectations, they make it next to impossible for central banks to exit and return to more conventional monetary management. They fear that when they raise rates, bubbles will burst and put an end to recovery; but if they do not raise them, the economy will remain locked in quasi-stagnation. The consequence of non-conventional monetary policy is thus to lock central banks decision making in the horns of an impossible dilemma. A dilemma they may escape only by a surprisingly strong acceleration of economic growth.
To sum up. Quantitative easing is devised to invite banks to swap Government (and other) securities for liquidity that is supposed to help them increase their loan supply. But reinforced regulatory rules increase production costs, squeeze bank margins and damage loan and liquidity supply all over the world. Central banks have been the target of many complaints and criticisms. But most of them focus on global demand and miss the really important issue: how modern central bank management, far from being an equilibrating mechanism, ends up with a series of economic and financial supply dislocations.
Conclusion: there will be no orderly QE exit before another great financial storm finally washes away the mess at great cost.