From QE to communism

Zero interest rate policy and quantitative easing is not working to stimulate the real economy.  No country has succeeded.  The pioneer of quantitative easing, the Bank of Japan, failed (and Japanese yen is uber-strong).  The Federal Reserve has failed, and the Bank of England has failed.

Before going to quantitative easing, let’s consider whether zero interest rate policy (ZIRP) works.  Michael Pettis offered some interesting observations recently in his newsletter.  He says that even though theory reckons that lowering interest rates should make people less likely to save, and to consume more, empirical data suggest the otherwise.  In fact, people save more when rates are low, not less:

In China, for example, deposit rates are seriously negative and have been negative for many years, and yet the household savings rate is nonetheless very high. In fact it seems that, as a rule, countries with repressed interest rates have higher, not lower savings rates.

What’s more, I have seen US historical data that suggests that when interest-rate declines have coincided with falling, not rising, stock and real estate markets (as they have recently), the savings rate usually rises rather than declines. In other words households care mainly about their wealth, not about the reward for postponing consumption.

So in an environment where the asset side of household’s balance sheet is falling in value (as in recent years in the US), it makes sense for households to save more, regardless of the interest rates.  That’s debt deleveraging or balance sheet recession as we know it.

Now let’s consider Japan.  It underwent debt deleveraging or a balance sheet recession for two decades.  As corporate balance sheets were underwater because the asset side was falling in value, corporates increased their saving level.  Thus there plenty of demand for holding Japanese yen (and for that matter, Japanese Government bonds as a vehicles for savings).  That’s why JGBs yields are so low, because the saving level in the corporate sector has increased.

Of course, when everyone is saving and not spending and borrowing, asset prices will be under even more pressure, and that encourages even more debt deleveraging as that pushes everyone’s balance sheet even deeper under water.  So we have a vicious circle of falling asset prices, increasing saving level, and deflation.

If central banks can’t break this deflationary vicious circle even as they are getting bigger and bigger, Prof. Nick Rowe considers the following somewhat bizarre endgame in his terrific post:

What happens as we push this process to the limit, and keep on reducing the long run inflation rate, down to zero, and then into deflation? The central bank keeps on getting bigger and bigger, and owns a larger and larger share of the total assets in the economy. It buys all the short-term government bonds, then all the long-term government bonds, then all the commercial bonds, then all the shares, then all the land, then all the houses….Because as the rate of inflation falls, falls to zero, and keeps on falling into negative territory, people will want to hold more and more of their wealth in the form of central bank money. And unless the central bank satisfies that demand, by selling them money and buying their other assets, the result will be an excess demand for money and recession.

Where does it end? Do we ever hit some absolute liquidity trap where people want to hold money rather than any other asset? Well, not really. Because the central bank has to keep on buying assets that people do not want to hold because they want to hold money instead.

It doesn’t end in a liquidity trap. It ends when the central bank runs out of things to buy, because it already owns everything, right down to your house, furniture, and toothbrush, which it rents back to you. It ends in communism.

Karl Marx certainly did not say that quantitative easing can achieve his goal, although he did want to see the following according to the Communist Manifesto:

Centralisation of credit in the hands of the State, by means of a national bank with State capital and an exclusive monopoly.

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Comments

  1. I never thought of it like that, but its true.

    If you define deflation as unmet demand for money as a store of value (something only the state can provide); a QE program which fails to create inflation is really just another step closer to Communism. Because money creation and deflation together mean the State is taking a greater and greater share of the real economy.

    Inflation hawks should think about that. Do you really want Communism?

  2. Zarathrustra

    I’d make a few observations
    1. I think teh data is being cheery-picked and generally being interpreted over too short a time frame.

    2. Is it surprising that lower interest rates are associated with higher saving when, with the current policy settings, lower interest rates are associated with reasonably severe downturns in the economy. As you then state fear outweighs the lower interest rate effect. As soon a spending picks up we get higher rates because of fear of inflation.

    3. Are we talking nominal interest
    rates or real after-tax (marginal rate)interest rates? The Western World has bbeen running negative real after-tax interest rates pretty much continuously for 50 years. Are we now claiming we have too much savings or too much debt? I think the long term effects of NRATIR are all too apparent.

    4 We have just lived through 50 years of some of the most unusual times in history. To base assumptions re inflation and interest rates

    • “We have just lived through 50 years of some of the most unusual times in history. To base assumptions re inflation and interest rates”

      Excellent point flawse. I fully expect the next 50 years to return to the ‘normal’ state of pre-WW2 economics so that when I retire at the age of 112 I will be able to… wait… what the hell was your point?

      • Sorry inter…I was interrupted in the real world!

        The western world has enjoyed low inflation over the past 50 years, admittedly with a couple of gaps,as a result of bei8ng able to import cheap goods from Asia. First, in the 50’s it was Japan. By the 80’s it was Taiwan and then Korea. For the last 20 odd years it has been China.
        So we have been able run up large debts without causing high inflation (of the CPI type)and have been able to run a negative interest rate policy for pretty well the whole 50 years.
        That period is now about finished and IMO that will be very apparent to the average Bob sometime in the next few years. Those of us in the front line are already being shot at!
        Prosperity and demographics in China are currently causing a watershed of change. I see it and constantly hear about it from factory owners.
        Just one other important point – There is NOT another China anywhere in the world.

          • Rubbish! 🙂
            Have you ever tried to get things manufactured in India? It’s a totally different culture.

          • Steve you miss the point. This is not about a substitute for Australia.
            What country (countries)in Africa have the work culture, the nouse, the saving culture etc etc to replace China?

        • Janet, SteveB – both true, however I think flawse’s point still stands.

          The remaining developing regions will only buy us a little extra time because the now developed regions are so much larger. Japan, Taiwan, Korea, China bought the USA and Europe (and periphery such as Aus) 50 years. It is unlikely India and Africa will buy the combination of the USA, Europe, Japan, Korea, China, etc., the same period again.

          Or perhaps I have misunderstood.

          • I don’t think I have misunderstood.

            Minerals and oil are the beachhead into Africa, fundamentaly low wages (compared to China) are the reason that they will stay.

            China has been on the receiving end of the biggest IP and capital investment in living memory. It’s now theirs to reinvest wherever the mood takes them.

            The aspect of China that I think is least likely to be replaced by other nations is their dominance in materials purchasing, not Labour.

            Work culture and Nous? If you had said “education” I would have agreed but starvation and squalor are serious motivation.

            We are talking about a nation that can think strategically 3, 6 or 12 years into the future. They need cheap minerals and they will develop Africa to get them.

  3. The Austrian explanation of why QE doesn’t work actually makes a lot of sense to me personally.

    I think the USA would have been far better off letting the economy completely implode on itself. It no doubt would have recovered very strongly. QE will just drag out this malaise for a decade (we are half way there) or two. I’d rather speed the process up. Short term pain for long term gain comes to mind. As does, you gotta be cruel to be kind.

  4. P.S. I wasn’t trying to argue with your basic line of thinking re the outcome of current policies. It’s a trend that’s all too obvious.

  5. There can be lots of reasons to save (hold cash) even if nominal interest rates near zero. Take the case of US Treasuries. First, liquidity is assured, which is not necessarily the case in relation to other asset classes. Second, if prices of goods, services and other assets are likely to fall, the real interest rate may be positive in any case. Third, if it appears that markets for non-cash assets will be dislocated or (say, for example, in the case of Euro-denominated assets) possibly subject to extreme dysfunction, then at the worst US denominated assets offer durability. Fourth, consider the very high volatility that non-dollar asset markets have been exhibiting in recent months (or even years). For risk averse savers, this volatility itself is a cost. Since nearly all non-dollar assets are highly correlated with each other, the surest way to eliminate volatility-costs – which are a form of opportunity cost – is to hold “pure” dollars – Treasuries.

    These reasons for holding dollars are very similar to the reasons for holding gold. In fact, they are a better cluster of reasons than can be advanced in favour of gold.

    Can the process of swapping physical assets for dollars continue until the central bank owns everything? Not unless the rental charged by the central bank for the use of the assets is less than the nominal rate of interest. (This is the only case in which it would be logical to accept cash for your house, which has some inherent utility – itself a proxy for income). Since interest rates are already near zero, this would only be possible if the central bank, having purchased your house, then paid you to live in it – or, more likely – was willing to sell it back to you for less than it had paid. In this cycle, every asset would be quickly short-sold until prices reached zero. At this point, the opportunity cost of holding a house would be zero, and the central bank would have to begin to pay house-sellers not to become house-buyers. And yet the cash paid would be completely worthless since it could not be used for any purpose at all.

    The point of all this is that while it can make sense for savers to accept very low interest for very highly liquid cash, it can make no sense to exchange useful physical assets for cash unless equivalent assets can be re-purchased later on at cheaper prices – that is, the central bank would have to offer an indefinite option to re-sell houses. Since such options could be instantly converted to cash, such a cycle would fail before it got off the ground. Putative sellers would just take their cash and hold their property too.

    This is a self-contradictory idea.

    However, it does suggest how negative interest rates can work. That is, central banks can pay bank account holders to borrow. The deal would be, say, “We will lend you $1.00 today, providing you repay us $0.95 in 12 months.”

    This would be a lot more effective than Q-E as we have experienced it in the past.

    • “We will lend you $1.00 today, providing you repay us $0.95 in 12 months.”

      One problem: anyone with any sense will respond to that by borrowing more than the entire world’s GDP for the next million years. Welcome hyper-hyper-hyperinflation.

  6. Be interesting to see what happens to US bonds when international holders (50% alone from Japan and China) decide to look elsewhere.

    Nearly half of JGBs are owned by Japanese banks. Do we think the US banks will take up the slack and in years to come and will we see the end of the secular bull market in US bonds? I think this needs to be covered and discussed more on MB. Also, endogenous money creation (or lack thereof) and how it negates QE.

  7. Briefly “pure” dollars – Treasuries.

    I agree with your prognosis re Treasuries in the near future. For reasons of my own I think that investment in USD denominated assets of other types are a very good idea sometime shortly. However I think this ‘Treasury’ fad is a knife edge thing. A tipping point may well occur.
    There are a few relevant ideas I think.

    The world media now seems to be almost totally in sync. The Stock Markets all follow each other almost perfectly. Money flows seem to be much the same. Treasuries would become much less ‘pure’ if their worth in terms of physical assets starts to decline more rapidly. I think Bernank et al must have nightmares about a rising Gold price. I don’t much doubt that the PPT are active in this area.

    As I described earlier I think our ideas on future inflation are way off the beam and totally out of kilter with what is happening in the real world rather than in the brains of academic economists. So again there is a danger of a tipping point.

    I have some contact with large Chinese Government and semi-Govt owned companies wanting to invest in Australia. They are looking to make investments of half a billion dollars and above. Their basic attitude is ‘We have all these USD and UST that are basically worth nothing. So short term returns are not an issue’ Essentially they are just wanting to get rid of the money into something physical that has worth in the long term. If that idea starts to spread then the UST will be in quite a bit of trouble. Further I think at the moment it is just a ‘creeping’ idea that will, in time, become a tipping point.
    Don’t ask me for a specific definition of ‘in time’. My life is highlighted by being proved correct about a lot of things but my timing, with a few notable exceptions, is often lousy.

    Re negative interest rates. They DO work. You just have to look at a sufficiently long term and consider the other factors at work.

  8. Australian small business and manufacturing would be far better off with lower interest rates. How can one argue that the Australian economy would be worse off with lower interest rates. The RBA forecasts have proven to be wrong and ignore the global reality of low rates and inevitably energy driven inflation.
    The OZ$ is to high because the RBA are getting it wrong and hurting the economy as a whole. Hillary Clinton has just come out and said that the US needs to implement protectionism to protect its economy. Why not Australia?

    • Its not just about easy credit fueling our economy.

      I’ll tell you what fuels small business and manufacturing growth … savings !

      Cheap credit creates bad investments and fuels the boom-bust cycle. Subprime, dot-com, all fueled by loose monetary policies.

      And besides, once you’ve entered a debt-deflationary period, lowering interest rates is like pushing on a string. It didn’t work in Japan, its not working in the US now.

  9. Yep Web. The trouble with it is that, with permanent negative real interest rates we are always boosting our income with more debt. Then we cover the debt by selling more of the country off.
    As to the problems with the A$ this has been hotly debated already in these pages. You should read both the blog and the comments in these threads in order to frame the idea properly.

    http://www.macrobusiness.com.au/2011/09/fighting-australias-hot-money-problem/

    http://www.macrobusiness.com.au/2011/09/our-economy-is-fundamentally-broken-2/

    There are a lot of very worthwhile discussions going back a few weeks.

    Web then you speak of low rates and energy driven inflation? Inflation will be more than energy driven and if you are saying inflation is headed our way then I don’t quite understand your comment?