Friday, November 28, 2014

Losing Interest

BERKELEY – Two of the world’s most prominent economic institutions, the International Monetary Fund and Former US Treasury Secretary Larry Summers, recently warned that the global economy may be facing an extended period of low interest rates. Why is that a bad thing, and what can be done about it?

Adjusted for inflation, interest rates have been falling for three decades, and their current low level encourages investors, searching for yield, to take on additional risk. Low rates also leave central banks little room for loosening monetary policy in a slowdown, because nominal interest cannot fall below zero. And they are symptomatic of an economy that is out of sorts.

Identifying the problem, much less prescribing solutions, requires diagnosing underlying causes. And here, unfortunately, economists do not agree. Some point to an increase in global saving, attributable mainly to high-saving emerging markets. Readers will detect here echoes of the “savings glut” argument popularized nearly a decade ago by the likes of former US Federal Reserve Board Chairmen Alan Greenspan and Ben Bernanke.

There is only one problem: the data show little evidence of a savings glut. Since 1980, global savings have fluctuated between 22% and 24% of world GDP, with little tendency to trend up or down.

Even if global saving slightly exceeds 24% of world GDP in 2014, it is unlikely to remain that high for long. China’s saving will come down as its GDP growth slows, the authorities decontrol interest rates on bank deposit, and the economy rebalances toward consumption. That will be true of other emerging markets as well, as their growth rates similarly fall from the exceptional peaks scaled at the end of the last decade.

The same empirical objection applies to arguments that blame low interest rates on the increasing concentration of income and wealth. It is plausible that the wealthy consume smaller shares of their income, and recent trends in income and wealth distribution certainly are troubling on many grounds. But to affect global interest rates, these trends have to translate into increased global savings. And the evidence is not there.

A second explanation for low interest rates is a dearth of attractive investment projects. But this does not appear to be the diagnosis of stock markets, notably in the United States, where equities are trading at record-high prices. And it sits uneasily with the enthusiasm with which venture capitalists are investing in firms commercializing new technologies.

Some economists, led by Northwestern’s Robert Gordon, argue that, stock market valuations notwithstanding, all the great inventions have been made. The commercial potential of the Internet, the human genome project, and robotics pales in comparison with that of the spinning jenny, the steam engine, and indoor plumbing.

Maybe so, but it is worth observing that technology skeptics have been consistently wrong for 200 years. History suggests that, while we may not know what the high-return inventions of the future will be, we can be confident that there will be some.

Still others, like the Fed’s current leader, Janet Yellen, suggest that investment and interest rates are depressed as a result of the damage done to the economy and the labor force during the Great Recession. Specifically, the skills and morale of the long-term unemployed have been eroded. Detached from the labor market, they lack incomes to spend; and, stigmatized by long-term unemployment, they are not regarded as attractive employees.

As a result, firms see inadequate demand for their products, and a shortage of qualified workers to staff their assembly lines. The result is low capital spending, one of the striking anomalies of the current recovery, which in turn can explain other troubling aspects of the recovery, from slow growth to low interest rates.

This argument has considerable merit. But, though it can explain why capital spending has been weak and interest rates have been low for the last three years, it cannot account for why capital expenditure has been insufficient to prevent rates from trending down for more than three decades. Here, the only explanation still standing is the shift in the composition of activity away from capital-intensive forms of production, like manufacturing, to less capital-intensive activities, like services.

If the disorder has multiple causes, then there should be multiple treatments. There should be tax incentives for firms to hire the long-term unemployed; more public spending on infrastructure, education, and research to compensate for the shortfall in private capital spending; and still higher capital requirements for banks and strengthened regulation of nonbank financial institutions to prevent them from excessive risk-taking.

Finally, central banks should set a higher inflation target, which would give them more room to cut nominal interest rates in response to a future slowdown. This is not something that a new Fed chair, anxious to establish her anti-inflation bona fides, can say out loud. But that is what her arguments imply.

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    1. CommentedDavid Donovan

      Tax and FICA payments cause the Fed to credit Treasury Tax and Loan (TT & L) accounts with reserves. Treasury coin sales and deposits at the Fed cause it to credit

    2. CommentedAntonio Staffoni

      A most interesting recap of economic views to explain the current world macroeconomic stand.
      Personally, I'd suggest economists to take a closer look at the low capital investment argument.
      With globalization, capital investment decreased in mature economies. China compensated in the 90's and at the turn of the century with massive purchase of capital equipment from developed countries. Now we are in another phase (where exactly is industry-dependent, but I get it is widespread) where local chinese companies build equipment for the factory of the world. Copies cost less and often match the "good enough" standards of cheap exports, which I understand still constitute the large part of chinese exports.
      The total effect is a growing China at the expense of a slumbering western world, which is left with services and finance to counterbalance the shift of manufacturing.
      Unemployed and low-wage workers in the western world fuel the demand for cheap imports, et voilà.
      And a huge cloud of printed cash that stops in the stock markets and in treasury bonds without trickling down to the real economy (certainly not in Europe, certainly not in Italy).

    3. CommentedRobert Bostick

      These sensible remedies will not likely be adopted because none of our erstwhile leaders understands the enormous policy space provided to sovereign currency macroeconomic systems.

      In America, our government only needs a Congressional appropriation to complete the act of spending. Treasury and the Federal Reserve can always provide reserves to the GFA to spend appropriations. Revenue per se from taxation and bond sales are not required to fund Federal expenditures. Therein lies the simple operational reality of monetary sovereignty.

      Tax and FICA payments cause the Fed to credit Treasury Tax and Loan (TT & L) accounts with reserves. Treasury coin sales and deposits at the Fed cause it to credit the Mint’s Public Enterprise Fund (PEF) account with reserves, and Fed profits and asset sales cause it to credit other Treasury accounts with reserves. So that’s how reserves get into what might be called Treasury income accounts.

      There can never be an involuntary default by the Fed/Treasury. That being fact, the Federal Government can spend until full employment is reached.

    4. CommentedChee-Heong Quah

      It is starkly apparent that incessant monetary expansion by central banks and fractional-reserve banking systems the cause of low real interest rates. You don't have to look elsewhere. This has been the case since the fall of Bretton Woods and the demise of the gold dollar standard. You should know better in this regard. Don't blame the demand side.

    5. CommentedJohn Shin

      The clearest diagnosis of the low-demand malaise, with appropriate calls for increased public spending. Let there be follow-up drafting of policies and implementation for dramatically scaling up investment in infrastructure, education.

    6. CommentedAriel Tejera

      Well, given the mass of public debt held by the governments of most developed countries ... interest rates better stay low.

    7. CommentedGary Palmero

      Commodity labor is losing its relative value and pricing ability in more advanced economies as capital has replaced such labor in many industries or labor segments. Robotics has replaced assembly line labor, information technology has replaced administrative and record keeping functions, computer graphics has even lowered the value of most motion picture actors. Then we have off shoring and more sophisticated labor planning and staffing to add to the mix. These trends started to accelerate in the 1990s which cause many workers to borrow against the future to maintain living standards assisted by low interest rates and inflated asset values (especially for housing). This could not be sustained, thus the 2008 financial downturn of which we are very slowly building our way out. It will take another five to ten years to reach equilibrium, in my view.

      Meanwhile, economic planners should be retrofitting the economy for improved infrastructure, quality of life and other endeavors.

      As far as interest rates, I have maintained that the Federal Government should offer liquid savings instruments to individuals tied to a social security number (to prevent gaming). The minimum interest rate should be set at two percent and the bonds may be cashed in at any time without penalty. The interest paid must be withdrawn from the account. The certificates should be tax free. This would put funds into the hands of income starved middle class savers. The only major DIRECT beneficiaries of low interest rates are governments (and rent seekers) and high income individuals who can borrow at low rates. This has contributed to income distortion which politicians so ably lament but do little to allay.

    8. CommentedProcyon Mukherjee

      To gauge the economy by the stock indices is becoming more irrelevant as we go. What is the fundamental change that triggers the dis-proportionate change in the stock indices? It cannot be prompted by share-buy back programs, but by the delta change in the capital invested in fixed assets that are backed by viable projects for the future.
      The disorder, if at all, should make us look at the much neglected demand side of the equation. This part is more complex and does not bode well with the more prevalent rhetoric around money supply and multipliers. That is where the interest should be diverted to.

    9. CommentedJose araujo

      By the way, what happened to those economists against fiscal expansion with the argument that public investment would crownd out private investment?

      Those who were worried because of the lack of savings and that were demanding people to save more and avoid governments deficits because there weren't enough funds?

      Or those who swore for the Ricardian Equivalence (Barro and all).... The hyper inflationistas, the austrians....

    10. CommentedJose araujo

      Liquidity trap, liquidity preference and risk avoidance.

      Basic IS-LM stuff, only the miss informed or the ones who didn't wan't so see still have doubts about it.

      Low interest rates had nothing to do with Exansionary monetary policies, that's what we should be stressing now and asking for Many economists that were pushing this points retract themselves.

      We are tired of seeing the same names being proven wron and wrong again without any admission of being wrong.

      Hyperinflation, debt problems, QE, you name it this guys have thrown everithing out there and we have been rebatting them for 6 years pointing to the obvious.

    11. Portrait of Michael Heller

      CommentedMichael Heller

      "If the disorder has multiple causes, then there should be multiple treatments." Hmm, sounds good, but how about including market discipline under the heading of 'treatments'. As an experiment. Who knows, it might turn out to be the penicillin of economic science!