Since 1999, non-elected bankers have been in charge of economic policy in the US and other countries, with questionable results. Are we on the verge of a new financial crisis?
“There is the possibility… that, after the rate of interest has fallen to a certain level, liquidity-preference may become virtually absolute in the sense that almost everyone prefers cash to holding a debt which yields so low a rate of interest. In this event the monetary authority would have lost effective control over the rate of interest.”
John Maynard Keynes (1883-1946), The General Theory of Employment, Interest and Money (1936).
“For my own part, I did not see and did not appreciate what the risks were with securitisation, the credit ratings agencies, the shadow banking system, the S.I.V.s (Structured Investment Vehicles).
– I didn’t see any of that coming until it happened.”
Janet Yellen (1948 – ), 2010, first female Chairman of the Federal Reserve, the US central bank, since Feb. 1, 2014, Vice Chair from 2010 to 2014, and a member of the FED since 2004, (in a testimony to a congressional committee, Nov. 15, 2010). [N.B.: From 2004 to 2010, Ms. Yellen was president and chief executive officer of the Federal Reserve Bank of San Francisco, which oversaw the US’s largest mortgage lender, Countrywide Financial. Bank of America acquired Countrywide in 2008.]
The beauty of the Glass-Steagall act, after all, was its simplicity: banks should not gamble with government insured money. Even a six-year-old can understand that…”
Luigi Zingales (1963 – ), A Capitalism for the People (2014).
Ever since the lame-duck Bill Clinton administration (1993-2000) and his central bankers named at the Treasury abolished the seven-decades-old Glass-Steagall Act,1 in the fall of 1999, allowing investment banks to speculate with the people’s insured deposits in commercial banks, central bankers and mega private bankers have been, for all practical purposes, in charge of economic policy in the United States and in other countries. They have pushed monetary and regulatory policies to limits never seen before, and they have been followed by central banks in Europe and in Japan, and the results are most questionable. In fact, the world economy seems to be mired in a mix of economic stagnation and price deflation in the goods sector, and it appears to be teetering on the hedge of a new financial crisis.
I. Danger of too much liquidity and not enough borrowers
A question can be raised and it is whether the world economy, after numerous unorthodox monetary and financial policies, has not fallen, in many countries, into a huge close-to-zero-interest rate liquidity trap?2 That is a good question considering the current state of slow economic growth and an unheard of situation of extraordinarily low interest rates, and even negative nominal interest rates in a growing number of countries.
A liquidity trap is a situation where central banks have increased the monetary base3 and the money supply4 so much that nominal interest rates can hardly fall any more, or, said otherwise, the price of bonds is not expected to increase much further. In such a case, there could be a rush to hold cash money in order to avoid capital losses if and when bond prices fall later on, because the prevailing belief is that interest rates will soon begin to rise. We may have reached that point when savers and investors dump bonds and create a financial crisis. This is a likely possibility in the coming weeks or months.
What is more, real interest rates,5 (nominal interest rates minus the inflation rate or plus the deflation rate, whichever is the case), may be rising, even when nominal interest rates are kept extraordinarily low, when deflation6 becomes pervasive in the real economy. This has the effect of depressing the over-leveraged real economy with the crushing effect of heavier debts for consumers, corporations and governments alike. This in turn contracts real spending and aggregate demand.
When such a situation arises, central bankers may be said to have de facto lost control over the nominal interest rate. Their expansive monetary policy is stuck in a low interest rate environment, and they become impotent to influence positively and significantly the growth of the real economy.
Why is that so? Essentially because private banks, in such a situation of excess liquidity, are left flush with cash-holdings that they cannot lend, because they cannot find qualified borrowers to whom to make loans. It is a vicious circle. Banks are then forced to let their excess reserves7 stay dormant at the central bank, earning no or very little interest, or are induced to buy more outstanding government bonds. In the latter case, this has the effect of raising bond prices and of lowering long term interest rates further, with the entire yield curve8 falling and flattening. It is well known that a flat or negative yield curve is a leading indicator9 of hard economic times ahead.
The stock market is usually the main beneficiary of an artificial drop in nominal interest rates by the central bank, because earnings are compared to the ongoing market interest rates, and a stock market bubble10 may ensue, even though the real economy of production, employment and income is languishing.
It must be understood that extraordinarily low interest rates by themselves may not stimulate the real economy, when the demand for loans is low, but their influence on stimulating speculative activity in financial markets is undeniable. When this happens, there appears a disjunction between the real economy and the stock market; one goes down while the other goes up. That is pretty much the case nowadays.
This, in a nutshell, is the predicament into which central bankers and passive or paralysed governments have lead many industrialised economies over the last decade.
Presently, in most economies, the demand for loans11 from the real economy (consumers, corporations and governments) is stagnant or declining. At the same time the supply of liquid funds is unduly high. Many central banks, over the last few years, have flooded their economy with newly printed money by buying toxic financial assets from near insolvent banks with this new money, in order to save their banking sector after the 2007-08 financial crisis.12
That is one reason why the price for money, i.e. the nominal interest rate, is way down. This is a situation of too much money (money base and money supply) chasing too few borrowers (demand for money).
II. The world has excess capacity in many sectors
Another related factor reinforcing the perverse effect of the excessive monetary policy followed by central banks over the last decade is the reality that the world economy, after a quarter of century of economic and financial globalisation,13 suffers from an excess of production capacity14 in many sectors (commodities: oil, mining, agricultural products, etc., and industrial and manufactured goods, etc.), thus lowering the expected return on capital15 on new investments. This overcapacity and this overproduction create deflationary pressures worldwide. The world economy seems to be caught in a vicious cycle as countries and companies attempt to produce more to counteract falling prices, thus making things worse.
What is worrisome is that this happens at a time when most governments are paralysed by their inability to increase public spending and public capital to compensate for the stagnation of private spending and private investment. In such a context, corporations and investors see no need to borrow and invest in new capacity, i.e. in new plants, new equipments, new technologies or new inventories, because expected investment returns are low or because there is a general fear of an incoming economic stagnation or recession.
On the consumer side, consumer debt16 is at an all-time high and consumers hesitate to borrow any further. Baby-boomer retirees,17 in particular, who have seen their retirement income go down with the decline of returns on their financial nest eggs, have less income to spend and must reduce their expenses. Indeed, expecting more deflation ahead and a durable drop in nominal interest rates, retirees and consumers in general see a need to save more, i.e. spend less, to buffer themselves against economic hard times ahead. This creates a disastrous downward spiral and a form of self-
defeating and self-fulfilling prophecy.18
In 2010, when the US Fed was pursuing its policy of quantitative easing19 (QE), an asset purchase program with newly printed money, I wrote an article20 entitled “Save the Banks and Kill the Economy”, anticipating what would happen if central banks only aim at recapitalising the mega banks with newly printed money, without having the government adopting appropriate economic policies to correct the economy’s structural problems, such as deindustrialisation, unsustainable large external trade deficits, widespread job outsourcing abroad, lower tax returns from corporate profits stashed abroad in tax heavens, and huge unproductive and costly military expenditures abroad.
III. The failure of unproductive debt finance to stimulate growth in an open economy
To attempt to stimulate domestic spending through more unproductive debt in an open economy is like trying to heat a home in winter with its doors and windows wide open. It cannot be done. This can sometimes work in a closed economy, when local industry and local employment are protected. It cannot work in an open economy, as it is the case currently.
Nowadays, the level of financial debt in the economy is historically very high. For example, at the end of 2015, total world financial debt21 (excluding stock market capitalisation) amounted to about $225 trillion, with global public debt at around $58 trillion, as compared to a total world production valued at around $76 trillion, for the same year. This translates into a ratio of world debt to world production at close to 300%.
Approximately 30% of these debts are in the United States, where total outstanding financial debt by governments, corporations and consumers was about $66 trillion, in 2015. Since the US gross domestic product was valued at around $17.97 trillion in 2015, we can say that the ratio of outstanding financial debt in the US to its GDP is around 367%. This is historically still very high.
On the same topic, here is what I wrote22 in 2010:
“The debt load imposed on the economy is even higher today than it was in the 1930s when total debt reached the level of some 300 percent of the annual production or GDP.
Well, today, the ratio of total debt to the US Gross Domestic Product (GDP) is close to 400 percent.
Keep in mind that it took nearly 20 years to bring this ratio down to about 140, in 1952.
What this means is that today it takes about $4.00 of debt to create one dollar of economic activity while it took only $1.40 of debt in the early 1950s to create one dollar of GDP activity. This shows how complex the financial system has become. The question that remains to be answered is whether it will take 20 years to lower the debt ratio from 400 percent to, say, 200 percent!”
Because of the 2008-2009 Great Recession and relative economic stagnation afterwards, the debt/GDP has declined somewhat, but it still takes $3.67 of new debt to generate one dollar of new production. The debt overhang on the economy is bound to last many years.
III. The contestable idea of negative interest rates
For some time, central banks in the eurozone, Denmark, Japan, Sweden and Switzerland have all experimented with the unconventional policy of negative interest rates. In so doing, these central banks are acting in desperation like apprentice sorcerers, setting in motion events that they may not be able to control.
However, they face a problem, and it comes from the Bank for International Settlements (BIS), an organisation that regroups 60 global central banks. Indeed, the BIS is opposed23 to this risky policy of negative interest rates because such a policy may force private banks to raise their lending rates, and not lower them, and to contract lending and not increase it.
Therefore, it may be appropriate to look at the rationale behind the unconventional idea of pushing interest rates into negative territory and forcing lenders to pay for lending, instead of charging for that service, as is usually the case.
A question begs to be answered: Can the kill-or-cure remedy of negative interest rates really increase banks’ lending and corporations’ and consumers’ borrowings? Nothing is less certain.
For example, in Switzerland, the central bank has imposed an interest rate of minus 75 basis points on some bank deposits. However, in that country, private banks have actually raised their mortgage rates to mitigate the losses incurred when their reserves at the central bank generated negative returns. When and if this becomes a general practice, then negative interest rates are bound to hurt lending, because such a policy lowers bank profit margins, and banks try to compensate for the losses by charging higher borrowing rates.
In Japan,24 the policy has nearly destroyed the money market, as people have rushed to buy safes and have begun resorting to hoarding. Moreover, there are indications that the negative rate policy may have hurt consumers’ and corporations’ sentiment, and this may have reduced the demand for loans. If so, this result would be the exact opposite of what the ‘innovating’ central bankers wished to accomplish.
More generally, by offering negative interest rates25 on the balances private banks hold at the central bank, central banks profess to pursue three goals: First, they hope to depreciate their currency and boost their country’s exports. But, this is a self-defeating policy when all central banks try to debase their currency in tandem; it’s reminiscent of the 1930’s “beggar-thy-neighbour” policies. Secondly, they believe that such a tax on the banks’ cash reserves would motivate private banks to lend more to corporations and consumers, and thus stimulate spending and raise the inflation rate. Thirdly, a reliance on negative interest rates on banking deposits is designed to tax saving and to subsidise borrowing and spending.
Maybe there are two other less obvious objectives that motivate central banks to push nominal interest rates into negative territory. First, faced with over-leveraged economies, and with governments somewhat paralysed by their own huge public debts or by political gridlock, central bankers are trying desperately to avoid what I have called elsewhere the danger of a deflation of debt, i.e. the danger of the world economy plunging into a downward deflationary tailspin.26
They may think that by pushing nominal interest rates as low as possible, even into negative territory, they will help over-indebted governments, corporations and consumers to refinance and service their huge debts at subsidised rates.
And, secondly, central bankers would like to hit two objectives with the same policy, i.e. they may aim at keeping banks’, insurance companies’ and pension funds’ stock and bond portfolios at a high level in order to keep the appearance of balance sheet solvency.
If so, a negative interest rate policy would only be a continuation, under a different name, of what many central bankers have been doing since 2008, i.e. recapitalising large private banks and other financial institutions. They did it by boosting the value of these institutions’ portfolios of financial assets, through an exchange of private banks’ bad assets for newly created cash money and through cumulative rounds of so-called quantitative easing (QE1, QE2, QE3), when the central bank bought huge amounts of government bonds with newly created money. This would be another example of “save the banks and kill the economy”!
Since negative interest rates punish savers and especially retirees, the drop in incomes for these groups is bound to reduce their spending further. The question is whether a policy of negative interest rates will raise aggregate demand or not. Even if central banks, in the best case scenario, do make borrowing cheaper, if viable economic projects are not forthcoming, banks will not increase their lending for fear of losing money or for lack of demand for new loans. They will continue to lend to brokers and buy secured government bonds. That would boost the stock market and the bond market, but this will do little to stimulate spending in the real economy. The European Central Bank27 (ECB) is doing precisely that these days, with its intention to save the eurozone at all costs.
The idea of taxing savings may bring down planned saving in line with planned investments, but this could also have very negative effects in the long run and cause a phenomenon of disintermediation28 and of financial repression.29
In such an artificial context, indeed, savers will attempt to avoid punishing negative rates on their deposits by withdrawing their funds from banks and savings institutions, and by investing instead in cash, in gold, in real estate or any other assets such as stocks in companies, which have a positive rate of return, be it in income or in capital appreciation. Again, the central banks’ gimmick of negative nominal interest rates will enrich the banks, the insurance companies and the pension funds, by boosting the value of their stock and bond portfolios, but this could end up impoverishing the real economy by lowering productive investments.
By pushing nominal interest rates lower than they would be in a more competitive market, especially if nominal rates are pushed below the inflation rate and result in negative real interest rates, central bankers are de facto assuming a fiscal role: they subsidise debtors and tax savers.
And considering that governments in general are the largest debtors of them all, central bankers are then simply doing the heavy lifting for their respective government. Such a policy is tantamount to taxing the general public to help the more heavily indebted borrowers.
My general conclusion is that it is high time for elected governments to assume their responsibility for designing and implementing sensible economic, industrial and financial policies to correct structural problems in their economy, as they used to do in the past, and to stop asking unelected central bankers to try to do the job30 in their place. Central banks are not equipped to steer an economy to prosperity. They cannot create jobs, raise the education level of workers, raise productivity and wages, stimulate entrepreneurship or increase productive investments.
While central bankers can hold inflation in check and make credit available to finance inventories, their “unorthodox” monetary policies of ultra low or negative interest rates only create financial bubbles and financial crises, which, in the end, hurt the real economy of production and employment. It is a recipe for more disasters to come.
About the Author
Dr. Rodrigue Tremblay is a graduate of Stanford University where he obtained an M.A. in Economics (1965) and a Ph.D. in Economics (1968). He is a former chairman of the Department of Economics at the University of Montreal. He is also a former president of the North American Economics and Finance Association, a former president of the Canadian Economics Society and a former vice-president of the International Association of French-speaking economists. Dr. Tremblay served as Minister of Industry and Trade in the Government of Quebec, from 1976 to 1979. He has also served as a member of the Committee of Dispute Settlements of the North American Free Trade Agreement (NAFTA).
Dr. Tremblay has published 30 books. His most recent book is “Le Code pour une éthique globale”, Les Éditions Liber (French, 2009) and “The Code for Global Ethics” Prometheus Books (English, 2010). In 2004, Dr. Tremblay was awarded the prestigious Condorcet Prize as Humanist of the Year.
1. The Glass-Steagall Legislation. https://en.wikipedia.org/wiki/Glass–Steagall_Legislation
2. The Liquidity Trap. https://en.wikipedia.org/wiki/Liquidity_trap
3. The monetary base. https://en.wikipedia.org/wiki/Monetary_base
4. The money supply. https://en.wikipedia.org/wiki/Money_supply
5. Real interest rates. http://www.investopedia.com/terms/r/realinterestrate.asp
6. Deflation https://en.wikipedia.org/wiki/Deflation
7. Excess reserves. http://www.investopedia.com/terms/e/excess_reserves.asp
8. The yield curve. http://www.investopedia.com/terms/y/yieldcurve.asp
9. The Yield Curve as an indicator of recessions. https://www.newyorkfed.org/research/current_issues/ci2-7.html
10. Stock market bubbles. http://www.investopedia.com/articles/06/interestaffectsmarket.asp
11. The demand for loans. http://www.cnbc.com/2016/02/02/banks-report-drop-in-demand-for-loans.html
12. The 2007-08 financial crisis. http://www.investopedia.com/articles/economics/09/financial-crisis-review.asp
13. Economic and financial globalization http://www.globalresearch.ca/pitfalls-of-economic-globalization/5458460
14. Excess of production capacity. http://www.investopedia.com/terms/e/excesscapacity.asp
15. The expected return on capital. http://www.investopedia.com/terms/e/excesscapacity.asp
16. Consumer debt at a record high. http://www.moneytalksnews.com/consumer-debt-hits-record-high-and-thats-good-thing/
17. Baby-boomer retirees suffer from low interest rates. http://money.usnews.com/money/blogs/on-retirement/2015/09/21/raise-our-interest-rates-please
18. Self-fulfilling prophesy. http://www.businessdictionary.com/definition/self-fulfilling-prophecy.html
19. Quantitative easing. http://www.investopedia.com/terms/q/quantitative-easing.asp
20. “Save Banks and Kill the Economy.“ http://www.thenewamericanempire.com/tremblay=1129.htm
21. The total world financial debt.http://www.iii.co.uk/articles/223331/what-worlds-financial-markets-are-worth
22. “Economic Bubbles and Financial Crises, Past and Present.“ http://www.globalresearch.ca/economic-bubbles-and-financial-crises-past-and-present/18202
23. “The risks from negative interest rates.“ http://money.cnn.com/2016/03/07/news/economy/negative-rates-central-banks-bis-report/
24. “The Effects of a Month of Negative Rates in Japan.“ http://www.bloomberg.com/news/articles/2016-03-13/the-effects-of-a-month-of-negative-rates-in-japan
25. The Negative Interest Rate Policy (NIRP) http://www.investopedia.com/terms/n/negative-interest-rate-policy-nirp.asp
26. “Debt Deflation: A Long Economic Winter Ahead.“ http://www.globalresearch.ca/debt-deflation-a-long-economic-winter-ahead/20040
27. “ECB pulls out all the stops, cuts rates and expands QE“ http://www.cnbc.com/2016/03/10/will-super-mario-deliver-high-hopes-for-robust-ecb-easing.html
28. Disintermediation. http://www.businessdictionary.com/definition/disintermediation.html
29. Financial répression. http://lexicon.ft.com/Term?term=financial-repression
30. “Osborne Looks to Carney to Do the Heavy Economic Lifting.“ http://www.bloomberg.com/news/articles/2016-03-14/osborne-looks-to-carney-to-do-the-heavy-economic-lifting