It been remarkable to witness the casual way in which central banks have plunged into negative interest rate terrain, based on questionable models. Now that this experiment isn’t working out so well, the response comes troubling close to, “Well, they work in theory, so we just need to do more or wait longer to see them succeed.”
The particularly distressing part, as a new Wall Street Journal article makes clear, is that the purveyors of this snake oil talked themselves into the insane belief that negative interest rates would induce consumers to run out and spend. From the story:
Two years ago, the European Central Bank cut interest rates below zero to encourage people such as Heike Hofmann, who sells fruits and vegetables in this small city, to spend more.
Policy makers in Europe and Japan have turned to negative rates for the same reason—to stimulate their lackluster economies. Yet the results have left some economists scratching their heads. Instead of opening their wallets, many consumers and businesses are squirreling away more money.
When Ms. Hofmann heard the ECB was knocking rates below zero in June 2014, she considered it “madness” and promptly cut her spending, set aside more money and bought gold. “I now need to save more than before to have enough to retire,” says Ms. Hofmann, 54 years old.
Recent economic data show consumers are saving more in Germany and Japan, and in Denmark, Switzerland and Sweden, three non-eurozone countries with negative rates, savings are at their highest since 1995, the year the Organization for Economic Cooperation and Development started collecting data on those countries. Companies in Europe, the Middle East, Africa and Japan also are holding on to more cash.
The article then discusses that these consumers all went on a saving binge..because demographics! because central banks did a bad job of PR! Only then does it turn to the idea that the higher savings rates were caused by negative interest rates.
How could they have believed otherwise? Do these economists all have such fat pensions that they have no idea what savings are for, or alternatively, they have their wives handle money?
People save for emergencies and retirement. Economists, who are great proponents of using central bank interest rate manipulation to create a wealth effect, fail to understand that super low rates diminish the wealth of ordinary savers. Few will react the way speculators do and go into risky assets to chase yield. They will stay put, lower their spending to try to compensate for their reduced interest income. Those who are still working will also try to increase their savings balances, since they know their assets will generate very little in the way of income in a zero/negative interest rate environment.
It is apparently difficult for most economists to grasp that negative interest rates reduce the value of those savings to savers by lowering the income on them. Savers are loss averse and thus are very reluctant to spend principal to compensate for reduced income. Given that central banks have driven policy interest rates into negative real interest rate terrain, this isn’t an illogical reading of their situation. Ed Kane has estimated that low interest rates were a $300 billion per year subsidy taken from consumers and given to financial firms in the form of reduces interest income. Since interest rates on the long end of the yield curve have fallen even further, Kane’s estimate is now probably too low.
Even though central banks so far have tried to shield retail savers from the impact of negative interest rates, which would amount to an actual haircut of their holdings, they can anticipate that that might come next. The idea of keeping money outside the banking system to avoid that is also unsettling to a lot of people.
The second effect is that of inflation signaling. Again, consumers are reacting correctly to the message central banks are sending. Negative interest rates signal deflationary tendencies and that central banks think deflation is a real risk. And what is the rational way to behave in deflation? Hang on to your cash, because goods and services will be cheaper later.
Put it another way: How could economists possibly think that consumers would behave the same way in inflationary/deflationary times as they do during times of high inflation? In the mid 1970s, when inflation was running at 6-7% a year, I’d get a college spending allowance at the beginning of the school year from my parents. 6-7% was high enough inflation to lead me to buy everything I needed right away because my money would go further in September than the following May. Why would the officialdom expect people to behave the same way with the opposite fact set?
Yet here we have what passes for the policy logic:
Low interest rates should encourage consumers and businesses to spend by depressing returns on savings and safe assets such as government bonds. Such spending should create demand for goods, help lift sagging inflation and boost economic growth.
Earth to economists: savings and spending may look fungible to you because they are alternative uses for income but they serve very different functions. Once people have put enough away that they have a good reserve for emergencies and enough to have a comfortable retirement, then saving and spending can be regarded as close substitutes. But in the US, with safe income on investments running below inflation levels, and Medicare being actively crapified (for instance, a 70 year old friend with a bad leg break is having to pay for $25,000 of expenses in a rehab facility herself), a retirement-aged couple would need over $3 million in liquid assets to allow for 20-30 years of living expenses and possible medical costs. How many are in that boat?
Now perhaps this rationalization was simply central bank patter for wanting to depress the value of their currency and spur growth through more exports. Thus, the idea that consumers might spend more was just a convenient cover for their real aim that some economists who were not clued in took seriously. But whatever the cause, the central bank hallelujah chorus regularly claimed has been made that negative interest rates will lead consumers to run out on a shopping spree. The one bit of good news in this article is that the Bank of England is not persuaded, and even though the Fed has admitted it might take up the negative interest rate experiment, it remains keen to raise rates. Mind you, it’s not clear that this skepticism is due to greater intellectual rigor. Banks have lost safe sources of earnings with zero and negative interest rates, and are increasingly pressuring central banks to increase interest rates, even though they’ll take hits during the adjustment period.*
John Maynard Keynes said, “f economists could manage to get themselves thought of as humble, competent people on a level with dentists, that would be splendid.” He should have carried that thought out to its logical conclusion, that economists should be licensed. That way, they could be cast out of the discipline for malpractice. That sort of sanction would do a lot to reduce policy misfires like this one.
* Banks are structurally long financial assets; there isn’t remotely enough hedging capacity with credible counterparties for even a single TBTF bank to go net short its entire balance sheet. The best they can do is skinny up their exposures and minimize their holdings of long-dated assets. Thus, for example, the recent complaints about the lack of liquidity in the bond markets, which is being blamed on Dodd Frank, may be much more to do with banks minimizing their holdings of risky assets of all sorts now that the Fed is halting engaged in tightening.