“Nothing is more dangerous to men than a sudden change of fortune.”
– Quintilian, Roman scholar
“… We must figure out how to get the economic benefits of war without going to war.”
The markets’ slump has retraced much of its loss as investors reflect on the latest twists in the central banks’ war on global economic stagnation. Taking a cue from Japan, the European Central Bank (ECB) instituted negative interest rates along with expanding its QE bond buying program. Meanwhile, during congressional testimony, Federal Reserve Board Chair Janet Yellen delayed showing any of her Fed cards on negative interest rates.
Many argue there is no need for exploring negative rates here. Others aren’t so sure. Still others argue that further monetary stimulus would only be marginally effective while also increasing the potential hazards of unintended consequences. Dangerous side-effects, such as worsening financial inequality and asset inflation, could cause greater deflationary blowback as the central banks continue their override of naturally-occurring market forces.
Negative interest rates are a radical new approach for the central banks. And although the theory of negative interest rates has been around for some time, implementation has never gained any serious traction. It was a door that remained closed. Considering the potential for negative consequence from a policy that has no real-world precedent, the recent actions by the monetary authorities seem to point to a rise in the stakes for the global economy.
Where is the economic recovery? We’ve been told things are mending. But the new “desperate times and desperate measures” are likely adding more confusion and doubt – confusion in the trend of recent economic conditions and doubt in the central banks’ ability to control their brainchild. It would not be surprising, that at some point, financial markets may react violently to a final monetary overreach by the central banks.
Also not surprising, many people have no idea what negative interest rates are. There are two interest rates to consider – “nominal” and “real” interest rates. Nominal interest rates are the percentage terms of interest actually paid by the borrower to the lender and are based upon targeted interest rates. The real interest rate is the nominal rate adjusted for inflation expectations. Simply, if the Fed targeted rate is 2% and expected inflation is 3%, then the negative real rate of interest is minus 1%.
Real negative interest rates do happen – when the inflation rate is greater than the nominal rate determined by a central bank. A negative real interest rate serves as a tax on savings and is intended to force cash hoarders to divest, exchanging their savings for higher yielding and riskier investments. The money flow from savings to investment is hoped to be the elusive and long-awaited answer for stimulating global demand.
The difference between negative real and nominal interest rates is that with negative nominal rates, central banks actually do charge commercial banks for their deposits and some banks, in turn, will pass these charges on to their customers. The policy is intended to force banks to leverage their balance sheets with riskier loans rather than be penalized for their idle deposits.
But concerns have been raised over the effects of negative rates combined with a handicapped banking system. For instance in Europe, how much can the weakened banks actually expand their balance sheets with more loans? And will riskier leverage tip the banks into contagion with the non-financial sectors of the economy? At least these risks are obvious, what about others?
If commercial banks do pass on the cost of negative rates and charge for savings, bank customers may simply walk with their deposits. A liquidity squeeze could develop as customers hoard currency outside the banks, rather than pay for their deposits. The ensuing friction on the flow of funds would cause overall economic contraction followed by a drop in liquidity and a substantial increase in transaction costs – all deflationary and less than the desired results. Alternatively, if banks don’t pass along the costs, idle deposits could become a considerable drag on the banks’ profitability and reserves.
Pushing savings out of the banks is intended to spur investment and demand, but investment also creates supply. Enticing further supply capacity, in a world already awash, could only add to the global demand deficit. Look at what happened with the oil production craze and its subsequent bust. The cheap cost of money stirred huge increases in money thrown at investment, investment that that could not be sustained by a consistent level of demand. Ultimately, the bust was just that, and it likely created more economic dislocation on a net global basis.
The oil bust certainly qualifies as a supply bubble. With cheap money and the price of oil then around $100 per barrel, the opportunity looked too good to pass up. But the Fed-induced investment served only to drive supply up and prices down precipitously. It did very little to induce demand for more oil. Changes to oil’s supply and price structure caused unsustainable growth in the U.S. and Canada, while also creating economic chaos for Russia, Saudi Arabia, Venezuela, and Brazil.
A similar story can be told for all the bubbles that have occurred over the last few decades – The Chinese stock bubble, the European credit crisis, the banking crisis, the housing fiasco, the dot-com bust, the 1997 Asian financial crisis, the Japanese asset price bubble, etc.
And there are more potential bad outcomes with negative rates – like currency wars and flights of capital. Countries implementing negative interest rates may be choosing to lessen the weight of their excess capacity by capturing foreign demand with currency devaluation. Lacking global coordination, a zero-sum game of shifting global growth will continue developing, pushing economic winners and losers even further into wealth disparity. And in today’s digital and globalized world, capital flight across borders to avoid a tax on savings or other local deflationary repercussions represents a very real possibility.
Savings’ refusal to migrate into worthwhile investments may be more about longer-term structural barriers than solving for the optimum price of money. Demographics and culture, unattractive investment alternatives, politics, overreaching regulatory zeal, and the economy’s growing reliance on the non-capital intensive services – all have played a role in the global imbalances and none are swayed fundamentally by shorter-term monetary policy.
The bottom line: negative interest rate policy is very strong medicine with potential severe side-effects and probably needs more consideration before implementation. But it begs the asking, why have central banks been forced to resort to such extreme measures like quantitative easing and negative interest rates? What keeps thumping the global economy from its recovery?
There are three competing and interrelated economic imbalances sitting at the core of the problem and which stubbornly refuse to go away. Fix one, and the other imbalances go further out-of-sync. Turn to the new problem and then the “fixed” imbalances again become unstable. Watching the central banks’ response to the economic gyrations over the last few decades has been like watching a game of “whack-a-mole” with the central banks continuously behind.
The first economic imbalance is the high level of unsustainable consumptive credit that has become persistent in the industrialized economies. The second is the worldwide excess of supply capacity over sustainable demand. And finally, there is the savings glut stemming from the massive increase in the world’s money supply. And making matters worse, each imbalance has inseverable ties to the others.
Each imbalance is linked to the insufficient wealth creation coming from the world’s current production capacity. Real demand – not induced, easy-money demand from untenable borrowing – is not sufficient to keep the world’s factories, capital and labor above some magic threshold of utilization. Secular demand has not kept up with supply capacity over the last three decades. Did the supply-side economics mentality of “build it and it’ll come” go too far?
To understand the gap between global supply and demand, take a look at the chart below.
The chart depicts annual world GDP per capita growth and its ten-year average over the last half-century. U.S. data are presented for reference and to show correlation. Clearly, world growth fell consistently from the 1960s through the 1980s and has since averaged only between 1% and 2% per year. Surprising to many, the data show that the economic miracle of newly industrialized countries such as China and India has done little to expand growth on a global basis. Rather capacity was expanded without a corresponding increase in longer-term demand.
Since this period of slow growth began, or from the late 1980s on, the world has witnessed the failure of Japan’s economic expansion followed by failures in the U.S., Europe, and now China. Meanwhile, debt has skyrocketed with less productive value to show for it. Debt proceeds, rather than going toward meaningful investment, have ended-up mostly in consumption, savings, or the purchase of already existing assets.
The data also suggest something about the effectiveness of monetary policy on longer-term growth. Monetary policy has done little more than ignite non-sustaining economic bursts characterized more by shifts of wealth and growth rather than widespread expansion. Unless, of course, we assume that growth would have been worse had it not been for the effects of monetary policy.
There are many theories about the reasons for the bigger downturn in global growth: The completion of reconstruction and recapitalization of war-torn Europe and Japan. The Cold War’s space, military, and technology races coming to an end with the fall of the Soviet Union. The demographic changes from declining birthrates, and the increase in aging, non-working segments of the population. And there are many more theories out there with part-possible explanations.
But consider if the decline in growth was from a tapering of a major productivity boom similar to the end of every other major economic boom over the last five centuries.
Why would the ending of the Space-Digital Age be unlike the conclusions of the Age of Discovery, Colonial Mercantilism, and the First and Second Industrial Revolutions? The multi-decade boom following World War II is likely to end, or maybe better said, has ended just like each of its predecessors – with decades of overextension of supply, excessive credit, cheap abundant money, investment bubbles, shift in structural demand, lack of investment alternatives, persistent deflation, and financial crisis. It’s not a stretch to suggest that we are following a similar course to those followed in the past.
Each past period of global stagnation was resolved by enormous fiscal spending as governments or sovereigns attempted to right their woes with war. In addition to fiscal spending, war was also seen by the victors as contributing to their economies in other ways, too. War reestablished demand by a centrally-focused player that would direct massive amounts of investment and consumption.
As each period of war ended, pent-up secular demand took over for the eventual decline in military spending. And once peacetime and stability resumed, technology and production benefits from wartime investment quickly found their ways to the private sector. But also with war, excess supply was destroyed. The costs of geopolitical friction became muted (trade and currency wars, costs of terrorism, refugee crises, etc.). Imbalances were resolved. A new order reigned and stability returned. Reconstruction began. Structural barriers were removed, the slate was cleared and a new productive era ensued.
So what should we have learned from our past? First, that monetary policy will likely not end a period of stagnation of the type that rolls around once a century at the end of a major boom time. The inevitable is unavoidable and large fiscal spending will be necessary. Second, and more importantly, we must figure out how to get the economic benefits of war without going to war. We need the fiscal spending, investment, technological innovation, order, and new directions that come from war. Obviously, we don’t need the death and destruction.
Leadership also managed to materialize during each of the major past transition periods. History has also shown that for those countries that would evolve as trustees of the next boom period, leadership emerged either by fate or design. FDR, Churchill, Bismarck, Lincoln – the right person, at the right time had an uncanny knack for appearing to help steer the world through its chaos and towards its next big step in advancement.
But over the last few decades, leadership has hesitated as elected officials have punted on the fiscal spending issue and tasked monetary policy with the heavy lifting on economic recovery. It has been the easier path to follow. Supporting deficit spending for anything other than war has been political suicide and a non-starter for power on both sides of the political aisle. And the entrenchment on this issue has spilled over to other essential issues such as healthcare, defense, trade, and immigration. These issues unresolved are creating untold drag on the economy.
Soon elected officials around the globe will likely regard fiscal spending as the only alternative to shorten the world’s economic drought. It is bound to be the greatest test of political resolve coming from this newest election cycle. Let’s face it. Monetary policy has likely run its course and any additional runs at monetary solutions only delay and present the potential for a greater downside, especially if it forces the world down the same path taken by the generations before us.
Christopher Petitt is the author of the book, The Crucible of Global War: And the Sequence that is Leading Back to It. It is available for sale at Amazon.com, Barnesandnoble.com and for order at bookstores everywhere.