How to make a mess in the era of low demand.
This is the transcript from my podcast last Sunday, THE WOLF STREET REPORT:
Now the plot thickens: I’ve got a former Secretary of the Treasury backing me up. We’ve already seen, including in my last podcast, how negative interest rates screw up the economy. Negative interest rates are so absurd that just thinking about them gives me a headache.
In the era of negative interest rates, owning financial assets such as government bonds, or savings in the bank, or corporate bonds, and increasingly European junk bonds, no longer produces income but a financial burden – because you have to pay the negative interest in one form or another. And so these quote unquote “assets” are not only a financial burden on you that you would want to get rid of normally, but by extension, they’re burden on the economy as a whole.
Look how economies and stocks have fared in countries with negative interest rates – such as Japan and the countries of the Eurozone: Their stocks have gotten crushed. Their bank stocks have gotten annihilated. Japanese bank stocks are down 92% from the peak 30 years ago, and European bank stocks are down 76% from 12 years ago. European bank stocks are now back where they’d first been in 1993.
The European and Japanese economies have been mired in microscopic growth interspersed with declines. In Japan, this has been going on for over two decades. In Europe it’s been a dozen years.
But it’s not just negative interest rates that will whack the real economy. It’s “low” interest rates too – meaning “low” as the rates in the United States now.
Treasury yields are between about 1.5% and 2% currently. They’re below the rate of inflation across the curve; and the “real” interest rates are negative.
So now we will see how low interest rates put downward pressure on demand, when demand is already the fundamental problem. And cutting rates further would be a massive policy error.
Low interest rates are supposed to support part of the economy that benefits from debt funding, such as capital-intensive production of durable goods. This would be cars or furniture or computers. Lower interest rates would make it cheaper for companies that produce durable goods to borrow money to build factories and expand their production.
Low interest rates would also make it cheaper for companies and consumers to buy or lease these goods, the theory goes, and this would stimulate demand for these goods.
Construction would benefit from low rates because it would be cheaper to fund projects, and businesses and consumers would be incentivized to buy those buildings or lease them because it would be slightly cheaper to do so.
But those benefits, assuming they exist and function at all, are minimal when interest rates are already low and are reduced from low to even lower.
And what if the real problem isn’t the cost of funding projects and the cost of borrowing to buy things. What it the real problem is low demand?
And if the real problem is low demand, how do you increase demand when interest rates are already low?
Or conversely, what can a wrongheaded central bank do to crush this low demand even further than it has already been crushed?
Any time a central bank makes a move, such as lowering or raising interest rates or buying assets, it is thought to benefit one part of the economic participants at the expense of the remaining economic participants. This is a well-known but pernicious effect, called in harmless-sounding central-bank speak, the “distributive effects of monetary policy.”
These “distributive effects of monetary policy” take income and wealth away from one part of the people and give it to others. This is how monetary policy works. And it is accepted. The reason why this is done is because it is thought that through this shift of wealth and income, the overall economy would somehow benefit. The wealth and income of some people are sacrificed for the benefit of the overall economy, and other people get rich in the process.
So central bank policies, by definition, redistribute wealth and income.
Interest rate repression has this effect. The idea is to induce businesses to borrow and invest via low interest rates, and to induce consumers to borrow and spend, and the hope is that all this would crank up the overall economy as measured by, you guessed it, GDP.
And then there is the other side of those distributive effects: The people directly or indirectly deriving income from those interest-bearing assets.
Those people are not just a few savers: In total, there are around $40 trillion with a T in US Treasuries, banks savings products, investment-grade corporate bonds, municipal bonds, and asset-backed securities. People who hold these $40 trillion in assets, directly or indirectly, obtain or will obtain income from these investments.
When interest rates get cut, these people, directly or indirectly, see their disposable income go to heck. And guess what, they spend less, which crushes demand.
This is what has been happening in Japan for over 20 years. This is what has been happening in Europe. And it is what has been happing in the US.
When central banks, in this environment of already lacking demand, cut interest rates further they will make the demand problem worse.
At the same time, because interest rates are already so low, lowering them further has few and fading benefits for industrial production and other capital-intensive sectors.
In other words, these “distributive effects” no longer benefit the real economy, but they crush demand further. And central banks that lower rates in this environment make the problem worse.
Now I’ve got some serious backing from Larry Summers, who was Secretary of the Treasury from 1999 to 2001. With his article published just before the Fed’s annual Jackson Hole shindig this weekend, he addressed all central bankers out there. And he put his finger where it hurts.
In this type of environment that he calls “secular stagnation,” where demand is the problem despite very low or negative interest rates, lowering interest rates further is a massive policy error.
“Interest-rate reductions beyond a certain point may constrain rather than increase demand,” he says.
Central banks, in this environment of lacking demand despite already low interest rates, are powerless to fix the problem, he says, and they shouldn’t make the problem worse by repressing interest rates further:
“Europe and Japan are currently caught in what might be called a monetary black hole – a liquidity trap in which there is minimal scope for expansionary monetary policy. The United States is one recession away from a similar fate.”
Growth in the US is slow, and in Europe and Japan dismally slow, despite years or decades of low interest rates or even negative interest rates, and despite massive bouts of QE that had the effect of repressing long-term interest rates even on risky assets such as junk bonds.
This slow-growth or no-growth picture means that there is “some set of forces operating to reduce aggregate demand,” Summers says and adds:
“There are strong reasons to believe that the capacity of lower interest rates to stimulate the economy has been attenuated — or even gone into reverse.”
One of the reasons why rate cuts won’t do much good is because, as Summers says, and as we have known for two decades, “The share of interest-sensitive durable-goods sectors in GDP has decreased.” Which is of course part of the result of offshoring production.
But “the negative effect of reductions in interest rates on disposable income has increased as government debts have risen,” he points out.
In the US, these debts of the Federal Government alone have risen to $22.4 trillion. Total fixed-income assets, including savings products, amount to nearly twice as much. This $40 trillion in assets is spread over a lot of people. And that income is getting smashed by lower interest rates. And these people’s disposable income declines, and they have to cut their spending – and thus demand declines.
A 2% reduction in interest rates on the $40 trillion in assets means a reduction of $800 billion in income per year, every year, for these people. That’s a lot of money that cannot be spent. And much of it goes to people that would spend all of it.
An $800 billion reduction in spending would reduce GDP by 3.5%. That would be a blisteringly steep recession – just what everyone has been clamoring for.
Summers also points out, as I’ve done previously, that declining interest rates in the current environment hurt the real economy via the banks that form the financial infrastructure. Declining interest rates undermines the banks’ income and capital, which reduces their capacity to lend, makes them more unstable, and induces them to engage in risky activities that can blow up the bank.
And even if interest-rate cuts increase demand, “there are substantial grounds for concern if this effect is weak,” Summers says. “It may be that any short-run demand benefit is offset by the adverse effects of lower rates on subsequent performance.”
These adverse effects are that low interest rates “promote leverage and asset bubbles,” he says, and that they encourage investors “to reach for yield,” which is where they take ever more risks to get a little yield, thereby driving up prices and reducing yields further. And these inflated prices of risky assets are then used as collateral and are leveraged to the hilt.
“Almost every account of the 2008 financial crisis assigns at least some role to the consequences of the very low interest rates that prevailed in the early 2000s,” Summers points out. Bubbles thrive on easy money and lots of liquidity. And bubbles blow up.
“There is something unhealthy about an economy in which corporations can profitably borrow and invest even if the project in question pays a zero return,” he says.
This is precisely one of the many absurdities of low interest rates – they create zombie companies that wouldn’t be around at normal interest rates, but that are putting downward pressure on prices in their industries.
In an environment where the problem is a fundamental lack of aggregate demand, he says, “reducing interest rates may not be merely insufficient, but actually counterproductive, as a response to secular stagnation.”
And in this environment of secular stagnation, cutting rates, he says, “is exactly what is not needed.”
“What is needed are admissions of impotence” by central banks, he says, “in order to spur efforts by governments to promote demand through fiscal policies and other means.”
So here you have it. Central banks, including the Fed, have cut rates too low, and are now cutting rates further, to make the fundamental problem they have caused with their low rates, namely a lack of aggregate demand, even worse.
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