Monday, March 14, 2016

The Folly of Easy Monetary Policy and Negative Interest Rates

Last week, the European Central Bank announced new and aggressive efforts to try to stimulate the lagging economy of Europe. To this end, the ECB increased the rate of monetary stimulus (i.e. creating money) by 33% to 80 billion euros per month and further reduced the deposit rate to negative 0.40%. We'll explain how negative interest rates work in a minute, but know that all of it is done in the name of trying to increase economic activity. Central bankers around the world are pulling out all the stops to try and prevent the collapse of the latest financial bubble. In reality, the policies being implemented today only serve to delay the inevitable crash.

At the heart of the problem lies a deceptively simple view of the economy and what really matters. To see this in action, let's begin with the case of GDP. 

GDP is not the only thing that matters
Gross domestic product, or GDP, is one of the key metrics used to gauge economic health. The technical details of how it's measured are not critical, but it basically captures the value of all products and services produced by an economy. And since things that are produced must also be purchased / paid for, GDP is often thought of in demand terms--where the money is coming from. In particular, economists often focus on three major components: consumer spending, investment spending (spending by businesses), and government spending.

GDP is a useful measurement of economic activity. But that's all it is. It does not tell us whether the economic activity itself was productive, useless, or somewhere in the middle. For instance, the economy could have $10B of GDP related to the production of cars that provide value to customers. Alternatively, there could be $10B of GDP related to government spending on a fighter plane that can't fly through clouds. They'd get counted the same in GDP, but they clearly would not be equal in terms of benefits provided to the economy (and the people in it). One provides value; the other is just an acceptable form of graft.

You might think this would be an obvious point. But you would be wrong. To this day, it is very common for Keynesians (the dominant school of thought in economics) to claim that war is good for the economy. Which explains why New York Times columnist Paul Krugman could be found in recent years wishing for a credible threat of an alien invasion that would get the government to spend the money needed to get the economy going again. (And no, I didn't make that up.)

A related problem to this one is the idea of idle resources. If unemployment is high or factories are lying idle, you will sometimes hear people assume the solution is for the government to take action and get these resources and people back to work. Here again, there's often a confusion between mere economic activity and useful economic activity. Imagine a ski resort during the summer. Most ski resorts are largely vacant during the summer, for the obvious reason that there's no snow on which to ski. In some sense, the lodge, the chairlifts, restaurants on the mountain, etc. are idle during this period. But if the government somehow managed to pass a stimulus to get the ski lodge working year-round to create jobs, this would obviously not be preferable. There might be more jobs and activity in the short-run (and GDP would go up), but if no one wants to use the ski resort, then this is really a waste of resources.

It's an extreme example, but the same logic can be applied to a factory that is idle because the product it produces is no longer in demand (or the prevailing price is too low for the factory to break-even). A healthy economy needs activity, but it needs activity that is sustainable and creates value. Activity alone is not enough.

Unfortunately, this is not the dominant view among mainstream economists. A recession is defined as a decline in GDP in two consecutive quarters, and they are determined to prevent a recession at all costs. And that's where the negative interest rates come into play.

How could negative interest rates help?
Negative interest rates should be viewed as an extension of the historically low interest rates that were initially embraced during 2008 Crisis. For US rates, this chart from the St. Louis Fed shows the progression of the key interest rate over time. This interest rate is known as the Federal Funds Rate, and it has a cascading effect on other interest rates in the economy. Here's the chart:

There is a slightly complicated technical definition of the Federal Funds Rate, but basically you can think of it as the interest rate banks earn for storing extra funds with the Federal Reserve. If you have extra money, you might put it in a savings account and earn a small interest rate on your deposit. If you're a bank and have extra money, you will likely deposit it at the Federal Reserve and earn interest at the Federal Funds Rate.

Based on this definition, you can see how it would have an impact on interest rates in the broader economy. Since the bank's deposits at the Federal Reserve are thought to be virtually risk-free, the rate they can earn on these deposits is essentially the floor for any interest rate they might charge a potential borrower. If the bank could earn a guaranteed 6% at the Fed with no risk, as was the case around 2000, then it would have to charge a borrower several percentage points higher to account for the risk of loss. (Again, though this might not be intuitive, considering a personal example makes it clear. If you could 6% interest on a savings account, you would have to be promised a much higher rate of return in, say, the stock market to be willing to accept the risk that goes with it.)

Thus, if you lower the Federal Funds Rate, you lower interest rates in the overall economy. And if you have lower interest rates, people will borrow more money, and spend more money. And if they spend more money, that means higher GDP in the short-run. In turn, this is why lowering interest rates is often the first tool deployed when a recession seems near; the central banks are doing whatever they can to get people borrowing again to drive up GDP.

The problem this time around is that the Federal Reserve, and many other central banks, already drove the interest rates to effectively zero in the last crisis. And during the much-hyped recovery, they were afraid raising interest rates would send the economy back into a downward spiral, so for the most part they didn't. The major exception to this is the Fed's rate increase in December 2015, which was promptly followed by a large decline in the stock markets during the first two months of the year. In other words, it appears that central banks were correct in their fears that raising rates could destroy the recovery--but one must question the robustness of a recovery if the prospect of raising interest rates by merely 0.25% is enough to derail the entire project.

Outside the US, other banks have not been showing nearly the level of optimism that was present at the Fed. Europe and Japan, especially, have been trying desperate measures to try to bolster lagging economies. And since they also drove their interest rates to zero during the previous crisis, sending interest rates negative was the only option left available. They now exist in several countries.

Unfortunately, this experiment is nearly certain to end in disaster. Because think about what it means. It effectively means punishing banks to keep excess reserves on-hand. If your savings account charged you a fee just for the privilege of depositing your money, you probably wouldn't do it. The same is true of banks. A negative interest rate, by design, makes them more eager to give out loans and will presumably lead some to lower their credit quality requirements towards meeting that end.

This could possibly achieve the narrow goal of increasing borrowing and spending in the short-run, but to do so, the banks are taking on more risky loans than they otherwise would. This, in turn, makes the banking system less stable overall.

That's not the only problem though. The fact that banks are also effectively punished for storing extra cash, means they will tend to keep less reserves on-hand, further reducing their stability. And since banks are not likely to charge their depositors a fee for saving money any time soon, they are going to tend to be less profitable overall. In accounting jargon, we would say their margins are being squeezed. Because while the interest rates they can charge borrowers will likely come down to say, 4.25% from 4.5%, the average interest they pay their depositors will stay the same, close to 0%. The fact that banks will be less profitable, all things equal, further destabilizes them.

Summing Up
What we have then is a perfect storm of sorts. Amongst other priorities, central banks have two key goals: mitigating economic recessions (primarily by managing the interest rates) and ensuring that the banking system is stable. But as we have seen, negative interest rates bring these two goals into direct conflict. Central banks can temporarily prop up consumer spending and GDP by cutting interest rates into the negative; but in doing so, they have to make the banking system as a whole more unstable. The GDP effects will show up in the short-run; the instability will only be apparent in the longer term. History clearly suggests that short-term priorities are likely to carry the day.

This means we should expect the Federal Reserve to back away from its previous plans of raising interest rates multiple times this year. Raising rates would probably throw the market into utter turmoil, and that's the last thing they want. Indeed, by the end of the year, it seems likely the Federal Reserve will be considering lowering rates again and contemplating negative rates in the US.

That said, we should also recognize that there are no easy solutions here. At this point, the Fed is choosing between two bad options: short-term economic collapse that will be very painful, or a longer term collapse that will be even worse.

And while no one can predict exactly when the next collapse will strike, there are many different reasons to think that day is quickly approaching.

*Full disclosure: I work for a bank (not one of the infamous ones), but the views expressed here are entirely my own and in no way reflect the public or private views of decision-makers at my institution.

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