Interest Rates – low but not low enough

Interest rates may not be low enough to get us on the road to recovery but falling prices should help

Something strange is afoot in the economy.  With interest rates at record lows in many countries, borrowing should be booming and saving on the decline but the opposite is true.  This suggests that the economy remains out of kilter without interest rates being able to set the right balance between savings and investment.  Instead, the shortfall in demand due to limited investment and weak spending may be dragging down prices as a means to put the economy back to health.  

Not so free market

The self-healing ability of any economy is one of the central tenants of economic theory.  Prices adjust as a means for the economy adapting to any changes.  For example, an increase in the supply of bananas will trigger a fall in prices and more people eating bananas.  A rise in companies looking for software experts would drive up their wages (the price for labour) and the number of people wanting to learn more about computers.  Through changes in these prices, the economy moves toward an equilibrium where everything is at appropriate levels.

Interest rates act in the same way acting as the “price of money” to make sure that there is neither too much nor too little savings or investment.  Lower interest rates are used to make borrowing cheaper and savings less worthwhile.  This was the course of action taken by central banks in order to stimulate the economy by attempting to boost investment (funded by lending) and spur on more consumption (due to lower savings).  Quantitative easing adds to this by giving banks more money to lend and less need to entice people to leave money in the bank.

Still waiting

The continued wait for a robust recovery suggests that something remains amiss.  The lack of appetite among companies to expand their operations by borrowing is both a cause of and caused by weak demand in the overall economy.  Spending by consumers is also faltering with people happy to let money mount up in the bank despite the low returns on savings.  The high levels of household debt that still persist are another reason for consumers to hold back from spending.

The persistence of the state of low investment and high savings suggests that monetary policy has not been enough to get the economy back on the right track (although it has helped to prevent a financial collapse).  A further loosening of monetary policy is not on the books for most central banks.  Interest rates cannot be lowered much further considering that negative interest rates are difficult to implement.  Quantitative easing also seems to have run its course while increasing creating negative side effects. 

Where to next?

The inability of interest rates to adjust is hampering a return to economic growth.  With interest rates not able to go any lower, it may be the case that it is prices which are instead moving to get the economy back to equilibrium.  That is, rather than interest rates falling to balance out weak lending and growing savings, prices are being depressed by the lacklustre economy.  The hopes for economic recovery rely on cheaper prices spurring on more spending thanks to consumers felling richer.  Further impetus would result from the extra spending helping to push up investment and lift the economy to better match the current level of interest rates.

This route back to recovery may take time considering that any decline in prices will be limited and wage gains have yet to take off.  There are ways to push this along of which easiest way would be for governments to temporarily increase spending.  Money used for investments in infrastructure or training and R&D in new technologies would be worthwhile at a time of low interest rates.  Another alternative would be for central banks to use their money-printing capabilities to transfer cash to consumers.  This more radical option would provide a short-term boost to spending.  Sometimes we all need a little bit extra to get us back on track and the economy is no different.

Inflation – Hard to ignore again

Low inflation is a nuisance for central banks looking to increase interest rates but they would be wrong to dismiss it

Family get-togethers over Christmas often involve naughty children but it is inflation that is making trouble for central banks.  Inflation unexpectedly shot up in the aftermath of the global financial crisis but is now surprisingly falling despite a burgeoning economic recovery.  Central banks ignored the jump in inflation in 2011 and are now stuck figuring out how to deal with persistently low inflation.  The antics of inflation will be difficult to disregard a second time around considering that the causes for static prices are not all external.

Inflation acting up

The level of inflation is used as a measure to check whether all is well with the economy.  There should neither be too much inflation (suggesting an overheating economy) nor too little (which is a sign of weak overall demand).  With countries increasing sourcing goods from overseas, prices levels in any country can be influenced by prices of commodities on global markets.  This can push inflation in a different direction to the particular circumstances of any economy.

The best recent example of this was a plague of high inflation in 2011 when the economies of many countries were still in the doldrums.  The Chinese economy was still humming along despite financial turmoil elsewhere and China continued to buy up commodities on the global markets.  The result higher prices were most prominent in the UK where inflation topped five percent in 2011.  This bout of inflation was not just a brief spike with prices rising by more than four percent for over a year.  Despite inflation being well above its target of two percent, the Bank of England maintained its loose monetary policy to support the weak economy.  The argument behind this was that the inflation was temporary and not related to the underlying economy. 

Behaving badly again

Inflation is currently misbehaving in a different way and is causing concern due to being too low.  Prices are not rising by much due to lower commodity prices with the spurt of growth in emerging countries having run its course.  While this is a positive for consumers who benefit from a boost in spending power, low inflation is a source of anxiety for central banks.  The Federal Reserve and the Bank of England are getting set to increase interest rates to more normal levels.  Even the prospect of the economic recovery gaining further momentum would not provide central banks with enough of a reason for higher interest rates when inflation is around one percent. 

This irritation is not likely to go away anytime soon if the high inflation in 2011 is any guide.  Inflation is likely to slip even lower in 2015 as the effects of the plunging price for oil feeds through into the economy.  On top of this, swings in commodity prices tend to last for a few years so that inflation is unlikely to pick up for the next couple of years.  This would suggest that inflation will be below target for 2015 and 2016 which is the two-year time frame that central banks look at when deciding interest rates. 

Ignoring inflation would be naughty

Low inflation should imply low interest rates but central banks could choose to ignore this and raise interest rates away.  This is because the same argument as in 2011 could be applied – disregarding trends in inflation that are attributed to outside sources.  It is a convenient strategy for central banks worried about the economic recovery triggering a jump in inflation due to the potential for wages to rise as unemployment falls.  Such an outcome does seem optimistic considering that wages are not budging by much even as the economy picks up steam.

A further problem with turning a blind eye to inflation is that it is tough to gauge what the inflation level would be without the fall in commodity prices.  It is not as if consumers have money to spurge having been stuck with stagnating wages and considerable debts from the pre-financial crisis spend-up.  Sluggish prices are harder to dismiss considering that low inflation is also caused by weak domestic demand.  With inflation likely to continue to play up for a while yet, central banks will need to be patient and bide their time before raising interest rates or else it will be the central banks that may be the ones getting into trouble.

Economic Recovery and the Politics of Slow Growth

When the economic pie stops expanding, everyone wants their fair share and politicians are unfortunately only to keen to oblige

Slow economic growth is like hot weather – people become easily irritable and argue a lot.  This because, while economic growth makes it easier for everyone to feel better off, the opposite is true when the economy stagnates.  A sluggish economy leads to a shift in focus from creating more wealth to dividing up whatever is already there.  This creates fights over resources with people mostly looking out for themselves. 

Politicians pander to such self-interest among voters and constructive policy making goes out the window.  Voters are get all hot and flustered as the economic recovery since the global financial crisis has proven anything but balmy.  With the outlook for the economy not looking so bright for years to come, politics may continue to get people steamy under the collar.

Politics turns cold

Democracy is the best political system we have for ensuring the implementing of policies for the common good.  Politicians get elected by pushing a package of measures that the majority of voters believe will make them better off.  When times are good, policies tend to be aspiration in promoting economic growth with some resources also going to the less well off.  But things are not going so well, the focus of voters narrows to their own specific well-being.  As such, voters become less generous in terms of social spending and immigration while wanting the government to do more for them. 

The result is that politics become short-sighted and politicians pick more policies that target their own particular support base.  Honest assessment of the economic ills are typically in short supply while voters grow increasing frustrated as timid government policies can only provide limited relief.  Many voters have been tempted with the false hopes of more extreme policies offered by populist politicians.  However, turning back time with less government or less globalization will only create bigger problems rather than providing answers. 

The political infighting comes at a bad time for many developed countries who are increasingly feeling the heat of global competition.  This process was already underway with the rise of China and other emerging economies and the global financial crisis has been a further setback.  The narrow-minded politics currently prevailing in many countries will further hasten the relative decline of the West.  On top of this, government action is also hampered by economic theory that argues for less intervention in the economy. 

Still sweating it out

It is more than a tad ironic that it is now more than ever that positive and proactive government measures are needed more than ever.  This is because government has traditionally been the guardian of the long-term health of society.  The government has even more to offer at a time when businesses are not investing and gains in productivity (output per worker) are proving hard to come by.  Higher productivity is the main route to increases in wages and consumer spending at a time when low skilled work is carried out in developing countries.   

Yet, as described above, governments have been more of a hindrance rather than helpful with regard to the economy.  A push for austerity has dominated in many countries such as the UK despite going against the grain of economic theory.  In the place of increasingly distracted politicians, central banks have take centre stage in reviving the economy (which comes with its own problems).  With minor squabbles often dominating politics, it may take time before governments and voters are ready to sweat over the big issues.  Like a muggy summer that never seems to end, the combination of economic and politic malaise is not a problem that will go away any time soon.

Animal Spirits – Caging our Wild Side

Money can bring out the worst in people so it might be time to rein in the finance sector which offers ways for us to get into trouble

Economists tend to assume that we are all boring (and the feeling is likely mutual).  According to economic theory, we are thought to act in a rational manner, assessing how best to spend our cash like calculators with legs.  Not only is this an overly simplistic view but it has resulted in economists ignoring how our emotional sides affect the economy.  The global financial crisis is an example of what can happen when animal instincts such as greed and fear take over.  Economists need to take a closer look at how our emotions can drive the economy and how we can be saved from ourselves. 

Reality is messy

Economics is the study of allocating scarce resources.  It focuses on how consumers make the most from what they have.  At the same time, competition between firms ensures that products are priced efficiently so that as much output as possible can be generated from limited input.  Economists would like to think that our sober side helps keep everything running as it should.  But when money (and everything that money brings with it) is involved, our primal nature can take over with ugly consequences.

The worst of our traits kick in over booms and busts.  When times are good, we hear stories of people making easy money and we want in too.  Like greedy kids in a candy store, we buy a second or get shares in the latest stock market fad in the belief that prices are sure to rise further.  Prices will climb as the lust for more wealth attracts more and more victims.  But with gains in asset prices typically outpacing the rest of the economy, this can only last for so long. 

When asset prices start heading downwards, fear is the overriding response.  Companies slash plans for investment and lay off staff in order to stay in business.  Consumers also retrench by cutting back on spending and asset prices slide downwards as higher prices no longer seem sensible.  Assets often end up being sold off at bargain prices as cash is needed to pay off debt taken on during better times.  Fear also reached chronic levels among banks who would not even lend to each other in the aftermath of the global financial crisis.

How we get ourselves in trouble

Change is a necessary part of an economy developing over time as certain sectors expand while others wither away.  But what Keynes labelled our “animal spirits” result in periodic bouts of instability that can hamper the expansion of any economy over time.  Rather than dealing with our insecurities, most economists choose to ignore them.  A common argument used by economists is that financial markets constantly adjust to new information and reflect the true value of any assets.  Yet, sharp drops in stocks or house prices cannot be reasonably explained away with this line of thought.

The devastating effects of our emotions getting the best of us are evident in the wake of the global financial crisis.  Instead of ignoring base instincts, economists should be thinking of ways to rein them in.  One of the key ways for greed and fear to influence the economy is through the finance sector.   Banks are geared to generate as much borrowing as possible but their loans more often than not go toward speculative investments in property or stocks.  Such lending creates unnecessary instability with the economy as a whole suffering as boom turns to bust.

It is no coincidence that the worst recession of a generation comes at a time when the finance sector has grown to dominate many developed economies.  Limiting the scope of banks, with more rules following decades of deregulation, would be a good place to start improving the system.  Measures such as taxes on financial transactions would also take out some of the volatility from markets for stocks and bonds by pushing investors to take a more long term view.  Such policies may lead to higher fees for loans and lower returns from investing but the costs of continuing with the status quo will only mount up.  Better to save us from ourselves than to let our passions run wild and cause even more havoc.

Quantitative Easing – Get to the chopper!

What do you do when the economy needs a fiscal stimulus but there is no money for it?

Central banks have an ever expanding range in their toolkit to choose from to fix their individual economies but none of them seem to have worked so far.  This may be because they lack the right tool for the job.  In this case, the right tool is likely to be a large hammer in the form of a substantial fiscal stimulus but this is the preserve of governments who, at this point in time, are saddled with too much debt.  Yet, there is a way in which central banks could use monetary policy to act like a fiscal stimulus and generate the boost to demand that the global economy desperately needs.

Even new monetary policies are falling short

Economists thought we had it figured out.  Simply control the money supply by setting interest rates and it will be possible to ride out any booms and busts.  However, the weak recovery following the global financial crisis has shattered this belief.  Even manipulating the money supply using newly contrived measures such as quantitative easing has been less fruitful than hoped as well as creating unexpected problems. 

Quantitative easing has relied on a convoluted process where central banks create cash in order to buy bonds which frees up money for use elsewhere.  The problem has been that there is little demand for money in the actual economy as businesses are not keen to borrow as a result of the weak underlying economy.  Instead, what is needed is an instrument for inserting money straight into the economy.  This is because, rather than just cheap credit, companies need greater revenues from stronger sales in order to encourage investment and jump-start the economy again.

A fiscal stimulus fits the bill and has been tried already but only in small doses.  The key spanner in the works in this case has been high levels of government debt.  Before the crisis, politicians everywhere were almost as amped up as bankers and government finances were managed as if the boom time would continue forever.  The results have left us short of workable options to bolster the sluggish global economy.

Using Monetary Policy like a Fiscal Stimulus 

It may sound like a strange solution, but if monetary policy is not working and higher government spending is not possible, central banks could use their money-printing capacities to engineer a fiscal stimulus.  Rather than using freshly printed cash to buy bonds, central banks could just give it away.  Or, to use an analogy that economists like to use, drop money from a helicopter. 

Central banks operate the valves which control the supply of money, which is already being expanded on a temporary basis using quantitative easing.  The helicopter idea is a much more direct approach than shovelling money at the bond market.  Recipients of the cash would be free to spend it as they please, thus injecting money into the actual economy and creating a bonus for firms.  

The cash would not actually be in in the form of notes or coins but could be paid as a cheque or straight into the bank accounts of tax payers.  It strikes at the core of the main problem in the economy, a shortage of demand, allowing for more rapid results and less distortion compared to having surplus cash in the financial system.

The main drawback of this seemingly too-good-to-be-true policy is worries about inflation.  This is also the biggest obstacle as inflation is the primary concern of the central banks that would need to print the cash to be distributed.  It is the belief of many economists that it is the discipline of central banks which has kept inflation down over the past few decades.  Any sign that central banks might allow for more inflation is thought to push prices into a perilous upward spiral.  Yet, inflation is no longer the threat it once was and would not become an issue until the economic recovery was well under way.

Just like any handyman, economists have their favourite tools and are sometimes loath to admit that there might be a better option.  Unfortunately, it may just be a step too far for central banks to overcome their fear of inflation and leave the safety of familiar ground despite the extra firepower on offer.