Sunday, 17 July 2011

Low rates are the problem

In the post-crisis world, with the developed world facing anaemic growth prospects, we need to rethink the old 20th century economic models. The current group of central bankers are simply wrong to ignore the permanent destruction of household spending power which is accompanying uncomfortable levels of inflation. High retail inflation in the UK which has persisted for almost two years has eroded and continues to erode meaningfully the average household's purchasing power. Raw material and goods inflation is not "transient" in its impact on the economy. Permanent rises in the price of food, energy and other necessities for everyday life do not disappear even if the rate of their increase drops. Earnings by the majority in the UK which comprise of middle-income families, the young aspirational worforce, and the retirees have remained stagnant for this period whilst purchase prices have shot up. Unlike the rich, the young and the middle income earners have limited financial assets, the inflation of which by the persistently easy monetary policy, might offset this decline in real earnings. Unlike the rich, the retirees assets sit largely in liquid bank deposits, providing paltry income, and which they have accumulated through decades of thrift.

Persistently low rates also change the behaviour of the thrifty. Very often they become more thrifty. This is what happened in Japan over twenty years, a nation with notoriously high savings rates. And this is likely to happen in the UK and the US. This is because when rates' expectations fall, the saver feels the need to save more to earn the same return from their financial assets. This is how actuaries model pension liabilities, so this insight into households behaviour should not come as a shock. If banks had a symmetrical incentive to provide leverage at low rates then some of this impact might be more muted, although arguably households may be wary themselves of taking on more debt when their finances are being squeezed. In any case, after a credit bust, with capital ratios on the increase, credit will be remain far more limited and expensive for most.

Very few economic textbooks have analysed this perverse phenomenon of self-imposed rising thrift in a post credit-bust world. Low rates also exacerbate the public sector projected funding shortfall by lowering discount factors for future commitments. This provokes governments to cut spending by more than they would if rates were higher thus exacerbating the nations economic woes.

It is therefore highly arguable that persistently low rates are the right prescription in a high inflation, post-crisis world. It is too simplistic to assume the impact of low rates will push forward consumption, and assist deleveraging. Low rates as we have seen can also significantly and permanently erode the economic incentives of a nation's workforce as it is doing today (and has in the past). The sooner we have a central banker who recognises the negative feedback loop of low rates, the quicker we can arrive at a more enlightened economic model. Central banks last remaining great idea is to increase the wealth of the minority and hope for the trickle down effect to emerge. This is not working. Time to rethink economics.

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