We’ve talked about how NIRP – negative interest rate policy – tends to turn the world upside down and in ways that are unpredictable, given that no one now alive has had experience investing or making economic decisions in a NIRP world. I’ve also pointed out that central bankers, desperate to do something, have deployed unconventional policies that aspire to raise inflation and rates to about the 2% level, but which have actually driven inflation to 1% or less in the US, Britain and China and to negative levels – deflation – in Germany, Italy and Spain.
I’ve pointed out that the central banker notion that people aren’t borrowing because rates are too high is nonsensical. There are no uses of borrowed funds that make no sense at 1% interest but perfect sense at -1%.
In a normal recession economic actors recognize that while demand is currently low, it won’t be low for long. Therefore, when central bankers reduce rates, the risk of borrowing earlier (at lower rates), rather than later (at higher rates), goes down. People borrow and reinvest and the recession ends earlier than it otherwise would have.
Note, however, that this is not an unalloyed good. In a capitalist system, recessions perform a useful function, wringing excess, lax practices, and inefficiencies out of the economy. When central bankers force a recession to end early, the recession does only part of its job. The economy begins to grow, to be sure, but more slowly, less efficiently and less competitively than it should be growing.
The post-financial-crisis recession, widely dubbed the Great Recession, actually wasn’t that ghastly as recessions go. Globally, the recession lasted only one year (2009). In the US it persisted for 18 months (December 2007 – June 2009), but that was it. This was little more than the blink of an eye compared to other trauma’s we’ve endured as a country: the Civil War, the terrifying financial crises of the late 19th century, the Great Depression, World War II. Yet, everyone in the media seems to have been shattered by the Great Recession. They are stunned, heartsick, their faith in free markets devastated. A lot of manning-up needs to go on in the journalistic world.
Despite the relative mildness of the recession, our soft-hearted central bankers decided that what the US needed was a good dose of Fed interference in an economy that was already recovering. And not just any interference, but unconventional interference. Unfortunately, if interfering with the work of recessions isn’t an unalloyed good, interfering with a recovering economy is an unalloyed evil.
As I’ve argued many times, when central bankers manipulate interest rates and securities prices, nothing good can happen. Economic actors can’t make rational decisions and so they sit on their capital. Investors chase yield and return, taking on risk the way Italian cruise ships take on water. Workers abandon the labor markets. Capital is wildly misallocated. The net result is an economy running on one cylinder.
If the idea that people aren’t borrowing and spending because interest rates are too high is absurd, why aren’t people borrowing and spending? Well, here are a couple of possibilities:
1. Maybe economic actors don’t believe that growth will pick up in the future because they’ve looked around and noticed that most advanced economies are drowning in debt. Just since 2007, those economies have taken on $57 trillion of debt according the McKinsey & Co. And, of course, that doesn’t include vastly under- (or entirely un-) funded entitlements, what Reinhart and Rogoff call “a quadruple debt overhang.”(1) In their master work Reinhart and Rogoff showed conclusively that deeply indebted economies grow much more slowly than others.(2)
2. Maybe economic actors have noticed the accumulation of asset bubbles caused by QE, have compared them to the asset bubbles caused by the Fed in the late 1990s and in 2006-2007, and have concluded that the Fed isn’t in the business of stimulating economic growth, which is hard, but in stimulating asset bubbles, which is easy. The Bank for International Settlements (BIS) has pointed out that the devil the central bankers are fighting – deflation – actually has very little effect on growth, while the devil they’re nurturing – asset bubbles – is highly correlated with slower economic growth.(3)
3. Maybe economic actors have lost confidence in central bankers. People in the financial industry love the bankers, of course, because they’re pumping up stock and bond prices. But normal people might have noticed that when Japan tried QE in the early 2000s it did nothing except keep a few zombie banks alive. They might have noticed that interest rates and inflation in the US are lower post-QE, not higher. They might have noticed that the second time Japan tried QE (i.e., this time), the economy sank into recession and Japanese incomes plummeted. They might suspect that the same outcome is highly likely to happen in Europe.
These are a few of the reasons private investment fell 25% in the advanced economies between 2008 and 2014. These are a few of the reasons US companies are sitting on $5 trillion of cash. And when companies do spend their cash, they don’t spend it on anything that creates long-term value, like capex, R&D, hiring and training workers. Instead, they spend it on things that create short-term value: stock buybacks and dividends.(4)
It seems to me that these factors are sufficient to explain why people aren’t borrowing and spending, and that interest rates have nothing to do with it. That suggests that central bankers are causing a lot of harm for very little upside. Could it be that the real reason for unconventional central bank policies like QE has nothing to do with economic growth or jobs, and everything to do with the urgent need to keep the cost of servicing government debt down?(5)
But there’s another reason people aren’t borrowing and spending, and, unfortunately, it’s even worse than the three factors I’ve just mentioned. We’ll take a look at that fourth factor in my next post.
(1) Technically, Reinhart, Reinhart and Rogoff, known amongst us cognoscenti as R3. See Carmen M. Reinhart, Vincent Reinhart and Kenneth Rogoff, “Dealing with Debt,” Faculty Research Working Papers, Harvard Kennedy School, February 2015. R3 argue that, rather than attempt to stimulate the growth rate of their economies, most of the countries of the world will choose a second path: driving interest rates down, thus making repayment of their own government debt easier. I.e., there’s a wealth tax in our future.
(2) R2, This Time It’s Different: Eight Centuries of Financial Folly.
(3) Claudio Borio, BIS Working Paper No. 395, The Financial Cycle and Macroeconomics: What Have We Learnt?
(4) And these activities don’t even create much in the way of short-term value because, as Larry Fink points out in his annual letter to corporate CEOs, shareholders have few useful reinvestment options. See David Benoit, “BlackRock’s Fink, McKinsey Lead Group Fighting Wall Street Myopia,” Wall Street Journal, 3/11/15, and Andrew Ross Sorkin, “BlackRock’s Chief, Laurence Fink, Urges Other C.E.O.s to Stop Being So Nice to Investors,” New York Times Dealbook, 4/13/15.
(5) David Taft, CEO of IBS Capital, points out that interest on the US’s $18 trillion of Federal debt amounts to 2% of GDP, but that if rates were to rise to where they were in 2006, that would jump to a staggering 6% of GDP. See The IBS Turnaround Fund investor letter dated 4/10/15. In Japan, although current government debt is five times what it was back in 1986, the cost of debt service – thanks to QE – is lower now than it was then!
Next up: On NIRP (Part 4)
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