Why so Negative?

These are days of grave disillusionment with the state of the world. Establishment parties of the right and left are being challenged by populist, anti-establishment political uprisings. These parties are being disrupted from within, as champions of anti-globalisation emerge and question the mainstream orthodoxy. They are controlled by globalisations beneficiaries, the cosmopolitan-elite, the capital owners, and where once populated with the losers from globalisation, those blue-collar workers who have seen real wages stagnate while inequality widens.

Political fault-lines have emerged across the western world. In traditional centre-left parties, champions have been found in Labour’s Jeremy Corbyn and Bernie Sanders of the US’s Democratic Party. Donald Trump, that orange anti-trade, anti-migration, anti-Muslim caricature of a politician has challenged the Republican establishment along many of the same lines that the populist anti-EU Ukip challenged the Tories.  In continental Europe, political fragmentation and disintegration are even more severe than in the UK and the US. On the EU’s periphery, anti-establishment parties tend to be on the left: Syriza in Greece, Italy’s Five Star Movement and Spain’s Podemos. In the EU core, such parties tend to be on the right: Alternative for Germany or France’s Front National ran by Marianne Le Pen.

This fragmentation and rising nationalism are just the first political ramifications of economic policies that has failed to resuscitate failing economies from 2008. It was expected that the unusually deep recession was to be followed by an unusually rapid recovery, with output and employment returning to trend levels relatively quickly. Yet even with aggressive monetary policy, the recovery has fallen significantly short of predictions and has been far weaker than its predecessors. No one in 2009 expected that U.S. interest rates would stay near zero for six years, that central banks in the G-7 would collectively expand their balance sheets by more than $5 trillion, or most importantly, that key real interest rates would turn negative.

Central bankers have long talked about the problem of the “zero lower bound.” That’s the idea that interest rates can’t be set below zero. It is an important concept because it would mean there is a limit on how much an economy can be stimulated using monetary policy. In theory, if banks charge a negative interest rate, people with money deposited pay the bank, rather than the bank paying them, so any rational person should just withdraw their cash from the bank entirely.

Yet it now looks as if the zero lower bound isn’t a bound. And it isn’t at zero. About $13 trillion of government debt now has a negative yield or, to put it another way, more than half of the outstanding stock of advanced economy government borrowings. Why is this so significant? Interest rates—the price of money—adjust to balance the supply of savings and the demand for investment in an economy. Excess savings tend to drive interest rates down, and excess investment demand tends to drive them up.

This phenomenon of negative interest rates has strengthened calls from prominent economists such as Larry Summers, ex US Treasury Secretary, and the Nobel-prize winning Paul Krugman, that most of the western world is entering into a period of ‘secular stagnation’.  The economies of the industrial world, according to this theory, suffer from an imbalance resulting from an increasing propensity to save and a decreasing propensity to invest. The result is that excessive saving acts as a drag on demand, reducing growth and inflation, and the imbalance between savings and investment pulls down real interest rates. Secular stagnation then occurs when the natural real interest rate, that is the interest rate that is required to ensure full employment, is sufficiently low that they cannot be achieved through conventional central-bank policies.

In the wake of the crisis, governments’ debt-to-GDP ratios have risen sharply, from 41 percent in 2008 to 74 percent today in the United States, from 47 percent to 70 percent in Europe, and from 95 percent to 126 percent in Japan. Yet ten-year government bond rates are incredibly low at around two percent in the United States, around 0.5 percent in Germany, and around 0.2 percent in Japan as of the beginning of 2016. Long-term rates as low as this suggest that markets currently expect both low inflation and low real interest rates to continue for many years. This is exactly what one would expect in the presence of excess saving. This greater saving has been driven by increases in inequality and in the share of income going to the wealthy, increases in uncertainty about the length of retirement and the availability of benefits, reductions in the ability to borrow (with lending more highly regulated than before) and a greater accumulation of assets by foreign central banks and sovereign wealth funds.  

To correct this imbalance central banks have tried to boost investment through the use of negative interest rates. Yet it has become apparent that most central banks’ pre-crisis models, both the formal models and the mental models that guide policymakers’ thinking, have gone badly wrong. In these models, the interest rate is the key policy tool, to be dialled up and down to ensure good economic performance. If a positive interest rate doesn’t suffice, then a negative interest rate should do the trick. And yet, as real interest rates have fallen, business investment has stagnated.

The idea that large corporations precisely calculate the interest rate at which they are willing to undertake investment, that they would be willing to undertake a large number of projects if only interest rates were lowered by half a percent, is absurd. For larger firms there are a plethora of reasons not to invest, not least of which is to hold off on investment lest new technology soon make the old obsolete. Think about Airbnb’s impact on hotel construction, Uber’s impact on automobile demand, Amazon’s impact on the construction of malls, or the more general effect of information technology on the demand for copiers, printers, and office space. Furthermore the uncertainty caused by the political fightback against globalisation deters large scale investment, prolonging the economic stagnation and in turn fuelling the narrative of the anti-establishment parties, creating a downward spiral.

This imbalance between savings and investment has been widened further by slower growth in the labour force. Most firms, especially small or medium enterprises (SME’s), can’t actually borrow easily at the central bank’s ultra-low rate. This is because they don’t borrow on capital markets. They borrow from banks. And there is a large difference (spread) between the interests rates the banks set and the monetary policy rate. Moreover, banks ration. They may refuse to lend to smaller firms, especially given the risks highlighted above.  

The incomplete economic recovery of these last eight years has been increasingly reliant on monetary policy to accelerate it with fiscal policy acting as brake. Across advanced economies, the US and the Eurozone in particular, fiscal policy has been paralyzed by political gridlock, leaving the central banks as the only game in town. Increasingly desperate, tools that existed as academic thought experiments a decade ago are now becoming standard-issue parts of the central banks’ policy tool kit. Central banks have sought, through quantitative easing (QE), to loosen monetary conditions even with short-term interest rates at rock bottom. However these policies are running into diminishing returns and giving rise to increasingly toxic side effects. What ends up happening is that QE-supported nervous private banks do not lend money to real investors, but to nervous big companies who buy back their own shares in the stock market in order to increase their share price. So the money conjured out of nothing is used to inflate non-productive financialized share price bubbles. This has no real positive impact on the economy or on the banks.

There are other concerning impacts of central bank’s extreme monetary policy. It has been widely commentated that there is a global shortage of safe assets. Savers desire to hold some of their savings in something safe, but with fiscal austerity all the rage there simply aren’t enough of those assets being supplied while an increasing proportion of them are now owned by central banks. The excess demand from central banks has pushed the price of those assets up and the rate of interest on them down. This severely effects people dependent for a large part of their income on interest from investments, not the super-rich, but those with pension pots who wish to use the interest of their accumulated savings to supplement state provision in old age. What they generally want is exactly what is vanishing: a steady and safe income. Well-intentioned proposals to curtail prospective pension benefits, therefore, might make matters even worse by encouraging increased saving and reduced consumption, exacerbating this secular stagnation further.

Government debt compared to the size of the economy remains higher than recent experience but still manageable (and low historically speaking). Borrowing costs are at historic lows. By setting yields so low and bond prices so high, markets are sending a clear signal that they want more, not less, government debt. By stimulating growth and enabling an inflation increase that would permit a reduction in real capital costs, fiscal expansion now would crowd investment in rather than out. What are needed are measures to raise the share of total income going to those with a high propensity to consume (the less well off), such as support for unions and increased minimum wages. The famous economist John Maynard Keynes, writing in a similar situation during the late 1930s, emphasized the need for policy approaches that both promoted business confidence, the cheapest form of stimulus, and increased labour compensation.

The macroeconomic argument for more active fiscal policy has always been strong, but the political economy conditions that will drive it are becoming clearer. Secular stagnation and the slow growth and financial instability associated with it are starting to have political as well as economic consequences. If middle-class living standards were increasing at traditional rates, politics across the developed world would likely be far less surly and dysfunctional.

There is growing evidence that economies entering a severe slump with low inflation can all too easily get stuck in an economic and political trap, in which there is a self-perpetuating feedback loop between economic weakness and low inflation. Escaping from this feedback loop appears to require more radical economic policies than are likely to be forthcoming. Theresa May has called for an economy that works for everyone. For that to become a reality, establishment politicians need to rethink the role of government in the economy, or face falling foul to the nationalistic narrative that has infected our political discourse.