(republished from “A View from the Trenches“, September 2nd, 2012)
Click here to read this article in pdf format:Â September 2 2012
Over the past months (and particularly in the last weeks), we have increasingly read negative comments on the ongoing zero-interest rate policy (ZIRP) and in some instances, negative-interest rate policy (NIRP). We find these comments were anecdotal. Not superfluous but anecdotal. They touch on the influence of ZIRP on savings, on the profitability of banks, on fiscal policies, on debt, etc. Perhaps, the anecdotal format is explained by an inclination towards induction rather than deduction and perhaps our discomfort with this is driven by our familiarity with the Austrian method.
Today, we want to examine the origins of the idea that ultra-low rates of interest can exist, how this idea came about, why it was flawed and how it leads to an informal economic system. It was a fallacy based on misunderstanding of the rate of interest and human action.
Origins of the idea that ultra-low rates of interest can exist
From our very limited knowledge in the history of economic thought, we are inclined to believe that the topic of zero interest rates was first introduced by John M. Keynes, when he contemplated the possibility of the existence of a liquidity trap (chapter 13), in his so-called â€œGeneral Theory of Employment, Interest and Moneyâ€.Â Keynes did not see this as the result of explicit policy but as an aberration of market participants, driven by their animal spirits, which define their liquidity preferences.
Keynesâ€™ concepts were popularized in visual format byÂ Sir John HicksÂ , when he came up with the famousÂ IS-LM model. In the graph below, following this model, we can see that the equilibrium rate of interest is negative. The â€œSâ€ line is an indifference curve for the aggregate supply of loanable funds. In the axes, we see a benchmark rate of interest (r, vertical ax) and income (horizontal). The â€œIâ€ line is the indifference curve for investment demand. As the rate of interest falls or income rises, the demand for investment goods increases. If the rate of interest falls too, the aggregate supply of loanable funds decreases.
The chart also shows that there is an income level that would get us to a desired level of employment (Yp). Logically, it would seem that either a higher level of investment or a lower level of savings is required, to â€œbridge the income gapâ€.
In our view, the whole approach of thinking in terms of indifference curves is ridiculous. Nobody is ever indifferent. Everybody is always making a decision. Having said that, letâ€™s remember that Keynes challenged the notion that both investments and savings were sensitive to the rate of interest. For Keynes, investment demand was mainly a function of income and secondarily
of the rate of interest. In the same fashion, savings were also driven by income. To Keynesians, savings are by-product of consumption, that part of the income we did not consume at the end of a period:
Investment = f (Y)
Savings = Income â€“ Consumption, but as consumption is a function of income:Â Savings = Y â€“ C (Y)
Why the idea was flawed
It should now be clear that there is an inconsistency in simultaneously believing that investment demand and savings are mainly driven by income but that it is necessary to lower the interest rate to boost investment, as the Fed doesâ€¦and the Fed is Keynesian! Keynes also thought that fiscal policy was necessary to boost investment demand, so that the intersection between theÂ IÂ curve and theÂ SÂ curve takes place at a positive rate of interest. By the same token, Keynes must have not considered increasing savings to bridge the gap (i.e. an increase in the supply of loanable funds), because that would have meant a reduction in income! In his own words (from Chapter 13): â€œand whilst an increase in the volume of investment may be expected, ceteris paribus, to increase employment, this may not happenÂ if the propensity to consume is falling offâ€¦(= savings increase)â€
According toÂ Professor JesÃºs Huerta de Soto, Keynes lacked a theory of capital, which cornered him into an horrible circularity:
On one hand, Keynes thought that the rate of interest was determined by the liquidity preference of the public (as in the chart above, because the liquidity preference determines the supply of loanable funds). In his own words: â€œâ€¦whilst an increase in the quantity of money may be expected, ceteris paribus, to reduce the rate of interest,Â this will not happen if the liquidity-preferences of the public are increasingÂ more than the quantity of moneyâ€¦â€
On the other hand,Â Prof. Huerta de Soto rightly notes, if you asked Keynes what determines the liquidity preference of the publicâ€¦he will answer: The rate of interest does! WeÂ think (we are not PhDs in Economics or historians of economic thought)Â the evidence of what Prof. Huerta de Soto points is found onÂ Chapter 15:
â€œâ€¦In normal circumstances the amount of money required to satisfy the transactions-motive and the precautionary-motive is mainly a resultant of the general activity of the economic system and of the level of money-income(â€¦); whereasÂ experience indicates that the aggregate demand for money to satisfy the speculative-motive usually shows a continuous response to gradual changes in the rate of interest, i.e. there is a continuous curve relating changes in the demand for money to satisfy the speculative motive and changes in the rate of interest (â€¦).. Indeed, if this were not so, â€œopen market operationsâ€ would be impracticableâ€¦â€
In summary, Keynes thought that the liquidity preference of the public determined the rate of interest, and that the rate of interest was determined by the liquidity preference of the public (i.e.Â the aggregate demand for money to satisfy the speculative-motive). Keynes oversaw that the rate of interest is nothing else but an inter-temporal rate of exchange, between present and future consumption.
Misunderstanding of the rate of interest and human action
This inter-temporal exchange rate is very relevant and we dare to say, instinctive. The fact that we understand it at its most basic level, which is the awareness of our mortality, is precisely what made us evolve into human beings. When time has a price, when the inter-temporal rate of exchange is relevant, when the rate of interest is positive and important, men tend to be more desperate than otherwise and they create, they take risks, they look for more efficient ways to produce what they need, they become more productiveâ€¦they grow!
This basic instinct is so strong that even if a central bank determines that the rate of interest should be zero, humans, aware of their life cycle, will refrain from consuming today in exchange for consuming more tomorrow. Before you disagree with us on this, think about the following: The curve â€œSâ€ above is for loanable funds, not for savings! If the interest earned from these funds is not â€œenoughâ€, that will not prevent people from saving. People will just not invest their savings in loanable funds, in securitizable assets (which is in line withÂ Hernando De Sotoâ€™s works on informal economies) . They will save in non-financial assets and if the public markets, manipulated by central banks donâ€™t acknowledge that inter-temporal exchange rate, the public assets will be privatized.
Thus, we should not be surprised if, under zero-interest-rate policies in the developed world, we witness a growing trend in corporate leverage, with vertical integration, share buybacks and private equity funds taking public companies private. It would be only natural. We warned of this back onÂ May 7th.
Another way of examining this is the following: The zero interest rate indicates that time is free. And as anything that is free is wasted, time will also be wasted. Therefore, the equity of a firm, which is the equivalent of a call option on the assets of a firm, will become very cheap in terms of the debt of the company, as the debt does not grow with time because no interest is due on it (this only holds true, if the company is profitable, as a friend pointed to us). Arbitraging for this distortion in relative value, lifts the price of stocks, and to make this process sustainable in time, central banks need to keep throwing liquidity to the system, until they no longer canâ€¦.
Now, if savings leave theÂ
matrixÂ â€œsystemâ€, we will see in the long run an important de-leveraging, as the credit multiplier becomes less and less powerful. With more assets outside the system, the pricing mechanism becomes less efficient, since there are fewer signals to market participants. Capital markets disappear, specialization decreases, economies of scale are threatened. With more assets outside the system, productivity plunges and with it, unemployment skyrockets in rigid (unionized) labour markets (characteristic of developed economies). As developed economies, with high stock of capital, rely on economies of scale, this fundamental transformation has enormous damaging potential.
The flight from the system brings more financial repression as a logic reaction. In those nations with establishedÂ
coercive savings plansÂ pension plans , politicians set their eyes on these virgin pools of capital, to force a bid to their liabilities (i.e. sovereign debt). This process eventually spirals, since the financial repression aimed to prevent market participants from protecting their inter-temporal exchange decisions, grows exponentially and brings about precisely the opposite outcome: A complete defence of savings, now fully thrown into an informal economy.
At this point, something has to be said about wealth transfer, because not every market participant is able to re-allocate his/her Â investments and re-direct his/her savings from the system to the informal world. Those who cannot save enough, those employed in firms and trapped in pension plans, will see their assets evaporate. If the harm is too significant, it may even be a cause for them to leave their condition as employees and become self-employed. This is the landmark of underdeveloped economies: A huge mass of self-employed, undercapitalized citizens in an informal system. The informality prevents them from accessing credit, which enhances theirÂ undercapitalization.
Finally, we ask that you note one last thing: As productivity, employment and production decrease, even a steady and low rate of inflation has the potential to morph into hyperinflation. Itâ€™s only a matter of time, and it occurs once the capital markets (including the futures markets) vanish, when the only reason to demand currency is for transactional purposes, when the demand of currency to settle debts is only marginal.
Mr. Sibileau currently works as Director for the Loan Portfolio Management team of a Toronto-headquartered financial institution. In his free time, he regularly writes on global macroeconomic developments at www.sibileau.com.
Since 1997, he has held various positions in the areas of corporate finance, strategy consulting, international banking, commercial banking and risk management.
Tags: capital markets, consumption, Debt, equity, Fed, Financial repression, Hernando De Soto, Huerta de Soto, human action, informal economies, inter-temporal rate of exchange, investments, John Maynard Keynes, liquidity preference, loanable funds, negative interest rates, NIRP, Savings, Sir John Hicks, zero interest rates, ZIRP