Raising interest rates is not that simple, Lord Hague

Raising interest rates is not that simple, Lord Hague

The present period of very low interest rates is widely assumed to be temporary, a consequence of the 2008 financial crisis and subsequent central bank action. Because of this, as the financial crisis fades into the mists of time, there is growing political pressure for “normalisation” of interest rates. Here, for example, is William Hague warning that central banks must start to raise rates or face losing their independence:

The only way out is for the US Fed to summon the courage to lead the way to higher interest rates, and others to follow slowly but surely. If they fail to do so, the era of their much-vaunted independence will come, possibly quite dramatically, to its end. 

Hague gives ten reasons why low interest rates are a bad idea. His points can be summarised thus:

  • “reach for yield” by savers who want higher returns drives up the price of assets
  • higher asset prices increase wealth inequality, fuelling popular anger
  • pension funds are struggling, forcing businesses to put more money into them
  • banks are struggling to make a profit
  • people are struggling to save enough for their retirements
  • companies would rather buy back shares than invest productively
  • low interest rates support zombie companies
  • pumping up asset prices could result in an almighty crash
  • “emergency measures” shouldn’t still be in place after nearly a decade anyway

Few would disagree that these are the adverse effects of very low interest rates. But unfortunately none of them necessarily mean that interest rates should rise. If interest rates were naturally very low, rather than being artificially depressed by central banks as Hague implies, these effects would still occur. As Larry Summers has pointed out (pdf), asset price bubbles are a feature of “secular stagnation”, where the economy becomes stuck in a low-growth, low-inflation, low-interest rate equilibrium:

Let us imagine, as a hypothesis, that this decline in the equilibrium real rate of interest has taken place. What would one expect to see? One would expect increasing difficulty, particularly in the down phase of the cycle, in achieving full employment and strong growth because of the constraints associated with the zero lower bound on interest rates. One would expect that, as a normal matter, real interest rates would be lower. With very low real interest rates and with low inflation, this also means very low nominal interest rates, so one would expect increasing risk-seeking by investors. As such, one would expect greater reliance on Ponzi finance and increased financial instability.

Raising interest rates above their natural rate is ultimately unsustainable, since it means that the productive sector is slowly drained to provide rents to the unproductive sector. The problem therefore is identifying what the “natural” rate is. Is this just a blue funk by central banks, as Hague thinks – or are there other reasons why interest rates are still so low?

There is a growing body of research that suggests that not only are very low interest rates the “new normal”, they have further to fall. And the reasons have little to do with the financial crisis.

In an important new paper (pdf), Federal Reserve researchers blame demographic factors not only for the falling equilibrium real interest rate, r*, but also for declining GDP growth:

We find that demographic factors alone can account for a 1.25 –percentage-point decline in the equilibrium real interest rate in the model since 1980—much, if not all, of the permanent decline in real interest rates over that period according to some recent time-series estimates, such as Johannsen and Mertens (2016b) and Holston et al. (2016). The model is also consistent with demographics having lowered real GDP growth 1.25 percentage points since 1980, primarily through lower growth in the labor supply; this decline is in line with changes in estimates of the trend of GDP growth over that period. 

And they add that the apparent correlation between the financial crisis and low interest rates is an illusion:

Interestingly, the model also implies that these declines have been most pronounced since the early 2000s, so that downward pressures on interest rates and GDP growth due to demographics could be easily misinterpreted as persistent but ultimately temporary influences of the global financial crisis.

Gavyn Davies identifies three reasons why r* will remain low:

  • falling labour supply growth rate
  • rising dependency ratio
  • rising longevity

Together, these add up to an environment in which there is a growing propensity to save, a rising capital share and sustained downwards pressure on interest rates. Admittedly, as the US baby boomers retire, their propensity to save should diminish. But the rising dependency ratio will force working-age people to save a larger percentage of their incomes in order to support the growing number of elderly. This is the case regardless of the method of saving, as John Eatwell pointed out

Just how severe the demographic pressures will be in future is evident from these “beehive” charts produced by researchers at Cambridge University:

The researchers identify the introduction of the contraceptive pill in 1967 in Western countries as the principal cause of this striking demographic change. I would probably add to that liberalization of abortion services at around the same time. The effects are particularly pronounced in Germany:

…..the fertility rate fell from 2.5 in 1967 to 1.4 in 1970. In the long run, this will lead to a decline of the steady state population growth from 1.5% to -0.5% per year. However, during the transition to the new steady state, the age composition of the population will deviate strongly from its steady state structure. The fall in fertility led to substantially smaller cohorts born just after the introduction of the pill, with an echo-effect when the first, smaller, post-pill cohort of women starts giving birth themselves. The last cohorts born before the introduction of the pill are therefore much larger than the cohorts born before and after. For Germany, the cohort born in 1995 is just half the size of that born in 1968.

In China, where the fertility shift lags the others, the cause was undoubtedly the one-child policy. Interestingly, the US does not show such a dramatic fall in cohort sizes: the researchers don’t discuss the reasons for this, but I suspect it is due to immigration. But even in the US, increasing longevity will mean a rising dependency ratio. 
The researchers go on to discuss the effect on saving and spending patterns of this demographic shift:

People initially borrow to finance their education; next they enter the labour force and begin saving, at first to repay this loan and then to save for retirement; finally they deplete these savings during retirement. For this reason, the desired stock of assets is at its maximum just before retirement. The current demographic profile, with large cohorts approaching retirement, means that the population is disproportionately biased towards saving.  As the large cohort desires to hold a large stock of savings, there is a surplus of savings. At the same time, the absorbers of savings – the young cohorts who borrow to finance their education – are in short supply. This implies that the real interest rate will be low, in fact even negative.

The researchers omit to note that in many Western countries the young borrow to buy property, not just to finance their education. In theory, demand for housing should help to support the interest rate. But most people buy houses with mortgage loans. As property price rises outstrip wage rises,  reality, mortgage demand pushes up the price of property, putting additional downward pressure on interest rates. Rising property prices mean the young must take on ever larger mortgages, and rising mortgage debt relative to household income is unsustainable unless interest rates fall. When the acquisition of assets is generally financed by debt, asset price bubbles provide only short-term relief to the problem of falling interest rates. Over the longer term, they make the problem worse. 

This striking chart shows the sharp decline in the real interest rate since the 1980 peak:

Worryingly, this chart shows that the real interest rate still has further to fall. By 2035, if the researchers are correct, the real interest rate will have fallen to minus 1.5%, purely due to demographic factors. I suppose we should be relieved that it will gradually rise after that, eventually stabilising at minus 0.5% by the end of this century. But unless something changes, it will never be positive again.

Permanently negative real interest rates have huge implications for the structure of finance.  Firstly, banking as we know it will become impossible, since credit intermediation reverses when rates are negative. Secondly, maturity transformation would become unprofitable: although in theory yield curves could still be positively sloped when rates are permanently negative, they would be very flat. There would have to be a major rethink of the way in which financial intermediaries whose job is maturity transformation (banks, pension funds, insurance companies) work. 

More importantly, permanently negative real interest rates fundamentally affect the ordering of society. They do not support debtors at the expense of savers, as is popularly believed: rather, they favour those who own assets (mainly the old) at the expense of those who do not (mainly the young). This potentially sets up a highly damaging intergenerational conflict. The older people who expected higher returns on their savings than they will receive are already angry, and their anger is likely to increase. The younger people who see their hopes of owning their own home receding into the distance are also angry, and their anger is likely to increase too. And when younger people face confiscation of growing amounts of income, either in the form of taxes (even if disguised as social security contributions) and/or compulsory saving (auto-enrolment springs to mind – there are already calls for the percentage contribution to be increased), in order to support a rising number of elderly, they will become even angrier. 

So what is the solution? Sorry, Lord Hague, it certainly isn’t raising interest rates. That would simply transfer still more from young to old, and it would put financial stability at risk. When the supply of savings exceeds the demand for them, the returns on them must fall. However angry the baby boomers are, they have to accept that the high interest rates of their youth are gone forever, and their future is consequently poorer than they expected. This is not because they have been robbed by governments or screwed by central banks: it is largely because of their own failure to produce enough of the next generation to support them in their old age. 

Rather, we need to find ways of raising the real interest rate. The risks associated with NOT doing so are simply too great. So, since the real problem here is a structural imbalance between the supply of safe assets for retirement saving and the demand for them, the obvious thing to do is to improve the supply of safe assets. The Cambridge researchers point out that sovereign bonds, state pension schemes and asset price bubbles are logically equivalent:

In an economy with perfect foresight, bubbles, PAYG, and sovereign debt are perfect substitutes for trade in bubbly assets. Whether resources are transferred from the young to the old by the trade of bubbles, by a government enforced PAYG pension scheme, or by a government that sells bonds to the young to repay the last period’s bonds held by the old, the outcome is the same in all three cases.

Asset price bubbles put financial stability at risk, and government enforced PAYG pension savings sufficient to provide pensions for all those elderly are likely to worsen intergenerational conflict. So the solution is sovereign debt. Lots of it. Enough to meet the saving needs of the entire population. Or, if you prefer, government savings schemes – safe high-interest savings accounts such as those provided by NS&I. Lots of them.

And, at the other side of the government savings bank, investment of those savings in productive enterprises. After all, the structural imbalance is not just a problem of supply but also of demand. It is not central banks that are in a blue funk, but the whole world. Everyone is terrified of loss, no-one wants to take any risk, and the productive enterprises of the future are being starved of investment at the same time as savers are being deprived of returns. The effect of this will be to depress wage growth and productivity far into the future. If investment doesn’t improve, the future for both young AND old is an impoverished one.

As I have pointed out many times before, the primary purpose of sovereign debt is not to finance government, but to enable people to save. And when the private sector is too scared to invest, government must step in. In a world of ageing populations, growing need for saving and fear of loss, the political obsession with reducing sovereign debt/GDP must end. 

Related reading:

Rethinking government debt
Bond yields and helicopters
Keynes and the Quantity Theory of Money
The Great Yield Divergence
The safe asset scarcity problem, 2050 edition
Weird is Normal – Pieria
The broken contract – Pieria

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