Nobel Prize winner* Robert Merton and Arun Muralidhar have charged ZIRP and QE happy central banks with economic malpractice. One of the main justifications for low interest rates is that they create a “wealth effect” by elevating asset prices. People allegedly feel richer and spend more, stimulating growth.
As we’ve pointed out, the first central bank to try the bright idea of lowering interest rates to spur consumption was Japan in the late 1980s. We know how that movie ended. Japanese banks and companies engaged in what was then called zaitech, or speculation, funded by being able to borrow 100% against urban land.** The result was to massively inflate already-large commercial and residential real estate bubbles, and to funnel Japanese cash into largely misguided and/or overpriced foreign investments.
Merton and Muralidhar charge that investors are smarter than central bankers and understand the first rule of finance, that what matters is free cash flow. As one wag put it,
We’re from Darien!
Living off the income
Never touch the principal
Super low interest rates lower incomes to asset owners, producing what they describe as a “negative wealth effect”. The Fed seems to think that retirees and others who live mainly off their assets will happily eat their seed corn, um, liquidate some of their capital gains to make up for the loss of income. Instead, people in that position who come up short most often curb spending.
Since the economists made their case in Pension and Investments (hat tip Pwelder and EM). It’s a curious choice of venue (one would assume Merton could easily get a comment in the Financial Times) unless the authors wanted to road test their argument before taking it to a bigger audience. Key sections:
We have each separately made the case that asset pricing theory and investment practice for funding retirement should focus on how much income the member has in retirement instead of the amount of wealth at retirement….
What does this have to do with monetary policy? Your recent editorial (“Damage of low rates,” P&I, Jan. 26) discusses the effect of low rates on pension funds, and we describe why those in charge of monetary policy should consider an additional cost/benefit analysis of policy as it relates to pension and retirement security.
A straightforward approach probably familiar to most chief investment officers is that the amount of retirement income that can be purchased by a given value of assets depends on interest rates. A higher interest rate implies that more income can be purchased for the same wealth (i.e., lower liability value for DB [defined benefit] funds). Alternatively, lower interest rates mean that more wealth will be needed to purchase the same income stream. So, with policies to change interest rates, central banks change the price of retirement income. One of the goals behind quantitative easing in the U.S., Europe and even Japan has been to pursue the “wealth effect” — pumping up the value of assets to make individuals richer, thus getting them to spend more and, thereby, prevent deflation. Furthermore, the belief that lower long-term rates leads to more investment has led the Federal Reserve, and now the European Central Bank, to depress long-term interest rates. However, if decision-makers for institutional and retail pension funds and insurance companies are not focused on wealth (as in the standard portfolio selection model), but instead on retirement income as measured by funded status, then the outcome desired by central banks might not be realized. By reducing long-term interest rates, the price of the same retirement income level goes up and the price of other assets measured in terms of income units declines — i.e., relative wealth (funded status) declines and investors are actually poorer, thereby experiencing a negative wealth effect. In a perverse way, lowering long-term rates has dramatically increased the liabilities of DB funds in the U.S., U.K., Canada and Europe (as noted in “Damage of Low Rates,” P&I, Jan. 26), and has lowered funded status dramatically in 2014. Lower rates also raise the cost of the deferred annuity that targets a specific retirement income affecting DC [defined contribution] investors..
Lower relative wealth means investors need to save more to improve their funded status, especially where regulations are strict (i.e., divert funds from the business to the corporate pension fund or raise contributions for DC investors), and it results in less consumption and investment, and may not remove the deflationary overhang. Alternatively, investors could try to earn a higher return to improve their funded position. However, from 2003 to 2007 — before the financial crisis — funded status declined for most U.S. funds due to declining long rates, and the data shows it possibly led to an increased allocation to risky assets, which ended very badly in 2008….
An alternate, more sophisticated approach to explaining why QE may not work to stimulate aggregate consumption is, perhaps, because the demographic mix of the U.S. (and most parts of the developed world) has shifted toward older people. Unlike 30 or 40 years ago, the enormous baby boomer generation, and even retirees, are much wealthier (including human capital) than in the past, and they are wealthier than current generations earlier in their life cycle. Since the older cohort would surely assign higher importance to funding retirement, the funded status effect is more pronounced. When long rates go down, baby boomers start saving more instead of consuming, driving asset prices even higher (especially for risky assets, but not housing assets which they already own). So the wealth effect does not lead to an increase in consumption and, potentially, has the opposite outcome…
We believe it is imperative for central banks and academia to examine this perspective immediately and develop a new monetary policy toolkit, because it would be tragic if the central banks’ attempts to improve economic security with the current orthodoxy leads, instead, to less consumption, less investment and greater retirement insecurity.
This is blunt by the standards of Serious Economists.
One of the ways the perverse effects of QE and ZIRP are playing out is via the devastation of life insurers’ balance sheets. For instance, the Financial Times describes how German savers may be hoist on the petard of central bank deflationary policies:
Tucked away in the International Monetary Fund’s latest analysis of global financial stability are a couple of pages of disturbing warnings — not about the crisis in Greece, nor China’s waning growth. This time, the bogeyman is Europe’s, and particularly Germany’s, normally low-profile but now high-risk life assurance sector.
According to the IMF, the failure of one life assurer “could trigger an industry-wide loss of confidence”, that in turn “could engulf the financial system”…
Lebensversicherungsgesellschaften — or life assurers — have been the bedrock of Germany’s long-term savings culture for two centuries, offering attractive guaranteed returns to millions..
Some of the challenges are common elsewhere — most obviously, the persistently low interest rates that constrain investment returns. But there are idiosyncratic pressures in Germany. A predominance of guaranteed long-term policies is doubly difficult for life insurers to sustain.
First, guaranteed rates far outstrip today’s meagre investment returns. Although new policy guarantees are capped by law at 1.25 per cent, the long tail of policies — which typically extend for 30 years — means average guarantees are still running at 3.2 per cent. Compare that with the 0.14 per cent yield on 10-year Bunds and the tension is becomes obvious. Second, there is a big mismatch between liabilities (due in 20 years on average) and assets (tied up for more like nine).
This situation is likely to worsen further…At the same time, assurers’ ability to grow their way out of trouble is constrained. New policy holders find the low level of guaranteed returns unappealing…
Regulators have sought to ease the pressure by instituting a Zinszusatzreserve, or ZZR: a requirement to set aside funds to meet long-term liabilities. Had this been introduced in the good times, it would have been sensible. Today, though, it is counterproductive. Because many assurers have had to cash in investment gains to fund the ZZR, it acts as a drag on longer-term performancee….
A Bundesbank stress test found that a third of the sector would be short of capital in the kind of extreme interest rate scenario that is already emerging.
“This might not be a 2008-style crisis in the making. But it could still hurt.”…
Germany is an extreme example. But it is not unique. From Norway and the Netherlands to Japan and Taiwan, similar issues are building.
The problem with saving is that they are someone else’s financial liability. Policies that focus on promoting savings rather than employment levels or incomes run the risk, as in the German case, of creating “savings” that turn out to be illusory, in that there aren’t enough reasonably sound parties who can provide the investment opportunities, as in liabilities. And the situation is getting worse not just by virtue of extreme monetary measures, but also by efforts to make the banking system safer without actually reducing risky product creation overall (as in prohibiting or severely restricting certain types of activities). The effect has been to drive more of this risk-taking into the so-called shadow banking system, and more and more, into retirement assets. For instance, in the US, regulators have put limits on how much leverage they will tolerate in acquisition lending. Private equity firms, which were already in the business of sponsoring debt funds to help finance buyouts, have expanded those activities as banks have been forced to pull back. And the biggest investors in private equity are…drumroll…public and private pension funds, with life insurers another major source of funds.
While Merton’s critique is welcome, it also comes late. The Fed, having helped mire the economy in low growth, clearly wants to raise interest rates but seems to have no idea of how to extricate itself, save by increasing them very very slowly, even assuming they dare begin. Can Merton help central bankers get out of the corner in which they’ve painted themselves?
* Yes, we recognize that this is a soi disant Nobel Prize…
** I am not exaggerating. I saw this happen routinely at Sumitomo Bank. And recall how inflated Japanese real estate was back then.