Banks will still veer towards cheap money

Governments need to use their balance sheets to build productive assets


High-income economies have had ultra-cheap money for more than five years. Japan has lived with it for almost 20. This has been policymakers’ principal response to the crises they have confronted. Inevitably, a policy of cheap money is controversial. Nonetheless, as Japan’s experience shows, the predicament may last a long time.

The highest interest rate charged by any of the four most important central banks in the high-income economies is 0.5 per cent at the Bank of England. Never before this period had the rate been below 2 per cent. In the US, the euro zone and the UK, the central bank’s balance sheet is now close to a quarter of gross domestic product. In Japan, it is already close to half, and rising.

True, the Federal Reserve is tapering its programme of asset purchases, and there is talk that the Bank of England will soon tighten policy. Yet in the euro zone and Japan the question is whether further easing might be needed.

These unprecedented policies are needed because of the chronic deficiency of global aggregate demand. Before the wave of post-2007 crises hit the world economy, this deficiency was met by unsustainable credit booms in a number of economies. After the crises, it led to large fiscal deficits and a desperate attempt by central banks to stabilise private balance sheets, mend broken credit markets, raise asset prices and ultimately reignite credit growth.

These policies have succeeded in lowering the cost of borrowing. This has made it easier to bear both the huge quantities of private debt inherited from before the crisis, and the public debt that has been accumulated in its aftermath. A report from the International Monetary Fund, published in October 2013, concluded that the bond purchase programmes from November 2008 lowered US 10-year bond yields by between 90 and 200 basis points. In the UK, bond-buying that began in 2008 lowered them by between 45 and 160 basis points. In Japan, similar interventions from October 2010 lowered rates by about 30 basis points, although Japanese yields started from a lower level.

Lower interest rates have also had a significant effect on the distribution of income. A study by McKinsey Global Institute published at the end of last year shows large shifts in income from net creditors to net debtors. In general, governments and non-financial corporations have gained. Insurance companies, pensions providers and households have been among the losers.

Banks are in an intermediate position. US banks have gained because their interest margins have risen. Euro zone banks have lost because their interest margins have been squeezed. UK banks have also suffered small losses.

Some of the details are significant. Governments are winners not only because the interest rates they pay are lower than before the crisis, but because quantitative easing has monetised a substantial portion of government long-term debt. Thus, in the case of the US, the Federal Reserve transferred $145 billion in gains from quantitative easing to the government between 2007 and 2012.

This is in addition to the $900 billion the government saved over the same period through lower interest payments. In the UK, quantitative easing produced gains of $50 billion for the exchequer in addition to $120 billion in interest savings.

Again, in the case of the US, sharply lower interest rates accounted for 20 per cent of the growth of profits of non-financial corporations between 2007 and 2012. But there have been adverse effects on pension funds that must honour the promises they have made to members in defined-benefit schemes, and on insurance companies – particularly those that offered guaranteed nominal returns.

In the case of pension funds, reduced long-term yields are particularly unwelcome because they both lower returns and raise the present value of future liabilities. Many life insurers might be forced out of business if these rates persist. This is a crisis on a long fuse.

For households, the distributional consequences of ultra-low interest rates are more important than their aggregate effects. In the US, households with heads aged 35 to 44 are gainers from lower interest rates, while older households are losers. On average, the younger group gained $1,700 in annual net interest, while those over 75 lost $2,700.

Above all, the richest 10 per cent of Americans own about 90 per cent of all financial assets. Thus the main losers are relatively prosperous people who depend on interest income. At the same time, such people have also gained from huge rises in bond prices and strong equity markets, although McKinsey argues that low interest rates are not the most important factor behind equity gains.

This policy, however unpopular with some, is better than the available alternatives. Keynes even had a phrase for it – the “euthanasia of the rentier”. In a world of abundant savings, the available returns ought to be low; this is a consequence of market forces to which central banks are responding.

At present the world’s high propensity to save is not matched by a desire to invest. This is why fiscal deficits remain large and interest rates ultra-low. At the margin, additional savings are now useless.

Returns are being pushed even lower by the fact that central banks are seeking to prevent the bloated balance sheets created before the crisis from collapsing in an episode of mass insolvency.

There is, however, a puzzle. Why is private investment not stronger, given that the non-financial corporate sector is apparently so profitable?

Perverse managerial incentives are one explanation. The weakness of the financial sector is another. Then there is the vicious circle from weak demand, to sluggish investment, and back to weak demand. And to many, it seems sensible to postpone investment until the world is more predictable.

Low interest rates are certainly unpopular, particularly with cautious rentiers. But cautious rentiers no longer serve a useful economic purpose. What is needed instead are genuinely risk-taking investors.

In their absence, governments need to use their balance sheets to build productive assets. There is little sign that they will. If so, central banks will be driven towards cheap money. Get used to it: this will endure.

– Copyright The Financial Times Limited 2014

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