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How to do damage to the era of low demand.
This is the transcript of my podcast last Sunday, THE WOLF STREET REPORT:
Now the plot is thickening: I have a former treasury secretary who supports me. We have already seen, including in my last podcast, how negative interest rates are shaking up the economy. Negative interest rates are so absurd that just thinking about it gives me a headache.
In the era of negative interest rates, the possession of financial assets such as government bonds, savings in a bank or corporate bonds, as well as more and more European bonds, does not generate more revenue, but a financial burden – because you have to pay the negative interest. one form or another. These "assets" are therefore not just a financial burden that you would normally want to get rid of, but by extension they are a burden on the economy as a whole.
Look at how economies and equities have evolved in countries with negative interest rates – such as Japan and the Eurozone countries – their actions have been crushed. Their bank stocks were annihilated. Shares of Japanese banks are down 92% from the peak of 30 years ago, and shares of European banks are down 76% from 12 years ago. The values of European banks are now back to their 1993 level.
The European and Japanese economies were mired in microscopic growth interspersed with declines. In Japan, this has been going on for more than two decades. In Europe, it's been a dozen years.
But it's not just the negative interest rates that will affect the real economy. It is also about "low" interest rates, which means "low" as those currently in force in the United States.
Treasury yields are currently around 1.5% to 2%. They are lower than the rate of inflation on the whole curve; and "real" interest rates are negative.
We will now see how low interest rates put downward pressure on demand, while demand is already the fundamental problem. And further reducing rates would be a massive policy mistake.
Low interest rates are meant to support a part of the economy that benefits from debt financing, such as the production of capital-intensive durable goods. It would be cars or furniture or computers. Lower interest rates would reduce the cost of borrowing funds from companies that produce durable goods to build factories and increase production.
According to the theory, low interest rates would also make businesses and consumers cheaper to buy or rent these goods, which would stimulate demand for these products.
Construction would benefit from low rates because it would be cheaper to finance projects and businesses and consumers would be encouraged to buy these buildings or rent them because it would be a bit cheaper to do so.
But these benefits, assuming they exist and work, are minimal when interest rates are already low and go from low to even lower.
And if the real The problem is not the cost of financing projects and the cost of borrowing to buy things. What is the real problem is the low demand?
And if the real problem is low demand, how to increase demand when interest rates are already low?
Or, conversely, what can a misguided central bank do to crush this weak demand that it has already been?
Whenever a central bank intervenes, for example by lowering or raising interest rates or buying assets, it is thought that some of the economic actors benefit at the expense of other participants. It is a known but pernicious effect, so-called central bank language, the "distributive effects of monetary policy".
These "distributive effects of monetary policy" take away the income and wealth of one part of the population and give it to others. That's how monetary policy works. And it is accepted. The reason is that it is thought that, through this transfer of wealth and income, the whole economy would benefit. The wealth and income of some people are sacrificed for the benefit of the entire economy, while others enrich it.
Thus, central bank policies, by definition, redistribute wealth and income.
The repression of interest rates has this effect. The idea is to encourage businesses to borrow and invest through low interest rates and to encourage consumers to borrow and spend, and the hope is that all of this would boost the economy as a whole. as measured by GDP, you guessed it.
And then there is the other side of these distributive effects: people who derive income directly or indirectly from these interest bearing assets.
These people are not just a few savers: In total, there are about 40 trillion US dollars with a T in US Treasuries, bank savings products, premium corporate bonds, municipal bonds and securities backed by assets. The people who hold these 40 trillion assets, directly or indirectly, get or will get an income on these investments.
When interest rates are reduced, these people see, directly or indirectly, their disposable income soaring. And guess what, they spend less, which crushes demand.
This is what is happening in Japan for over 20 years. This is what happened in Europe. And that's what happened in the United States.
When central banks, in this already weak demand environment, further reduce interest rates, they aggravate the problem of demand.
At the same time, since interest rates are already very low, their further reduction has little beneficial effect on industrial production and other capital-intensive sectors.
In other words, these "distributive effects" no longer benefit the real economy, but they further crush the demand. And central banks that lower rates in this environment compound the problem.
Now, Larry Summers, Secretary of the Treasury from 1999 to 2001, has given me serious support. With his article published just before the Fed's annual crisis in Jackson Hole this weekend, he spoke to all the central bankers. And he put his finger where it hurts.
In this type of environment, which he calls "secular stagnation", where demand is the problem despite very low or negative interest rates, a further reduction in interest rates is a major policy mistake.
"Interest rate cuts above a certain threshold may limit rather than increase demand," he says.
Central banks, in this environment of lack of demand despite already low interest rates, are powerless to solve the problem, and they should not aggravate the problem by further tightening interest rates:
"Europe and Japan are currently caught in what might be called a monetary black hole – a liquidity trap in which the room for maneuver of an expansionary monetary policy is minimal. The United States is in a recession of a similar fate. "
In the United States, growth is slow and, in Europe and Japan, extremely slow, despite years or decades of low or negative interest rates, and despite massive quantitative easing that has had the effect of suppress long-term interest rates, even on risky assets such as unwanted bonds.
This image of slow growth or non-growth means that there is "a set of forces acting to reduce aggregate demand," says Summers and adds:
"There is good reason to believe that the ability of lower interest rates to stimulate the economy has been mitigated or even reversed."
One of the reasons the rate cuts will not do much is that, as Summers says, and as we have known for two decades, "the share of interest-sensitive durable goods sectors in GDP decreased. decreases. "Which is of course a part of the result of offshore production.
But "the negative effect of the reduction of interest rates on disposable income has increases while the government's debts have increased, "he says.
In the United States, these debts of the federal government alone reached $ 22.4 trillion. Total fixed income assets, including savings products, are almost double. These $ 40 trillion assets are spread over many people. And that income is shattered by lower interest rates. And the disposable income of these people goes down, and they have to cut back on their expenses – and therefore demand declines.
A 2% reduction in interest rates on assets of $ 40 trillion means a reduction of $ 800 billion in annual earnings each year for these people. It's a lot of money that can not be spent. And a good part goes to people who would spend everything.
A cut in spending of $ 800 billion would reduce GDP by 3.5%. It would be an abrupt recession – exactly what everyone is asking for.
Summers also points out, as I have already done, that falling interest rates in the current environment are hurting the real economy through the banks that make up the financial infrastructure. Falling interest rates are undermining banks' revenues and capital, which reduces their lending capacity, makes them more volatile, and encourages them to engage in risky activities that can lead to bank failure.
And even though interest rate cuts increase demand, "if that effect is small, there is a lot to worry about," says Summers. "It may be that any short-term demand benefit is offset by the side effects lower rates on subsequent performance. "
These negative effects are that low interest rates "promote leverage and asset bubbles," he says, and encourage investors to "earn a return," forcing them to take more and more. more risk for low returns, further reducing returns. And these inflated prices of risky assets are then used as collateral and are exploited to the maximum.
"Almost all accounts of the 2008 financial crisis attribute at least some role to the consequences of the very low interest rates that prevailed in the early 2000s," says Summers. Bubbles grow with easy money and lots of cash. And bubbles explode.
"There is something unhealthy in an economy in which companies can borrow and invest in a profitable way, even if the project yields zero return," he said.
This is precisely one of the many absurdities of low interest rates: they create zombie companies that would not be at the same rate as usual interest rates, but that put downward pressure on prices in their markets. industries.
In an environment where the problem lies in a fundamental lack of aggregate demand, he believes that "the reduction of interest rates may not be simply insufficient, but actually counterproductive, in response to secular stagnation".
And in this environment of secular stagnation, lower rates, he says, "is exactly what is do not necessary."
"What is needed are confessions of powerlessness" from the central banks, he said, "to encourage governments to redouble their efforts to promote demand by through tax policies and other means ".
Here. Central banks, including the Fed, have lowered rates too low, and do it even more to aggravate the fundamental problem that they have caused with their low rates, namely a lack of aggregate demand, even worse.
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