Friday, June 17, 2016

Some thoughts on very low interest rates

I have been having twitter arguments with people I usually respect who think that it is self-evident that very low rates (even negative rates) are a function of Fed intervention - and not a function of the supply and demand for funds.

I don't normally blog about macroeconomic issues because I know enough to know that I will be wrong most the time. However I feel I need more than the 140 characters on twitter to explain why I am unconvinced that negative rates are that unnatural.

Alas you are going to have to go through a fairly long-winded argument. And I am far from sure of all this - so I really want the comments to criticise my thesis. I am apt to change my mind.

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Step 1: the impossibility of collectively deferring consumption

Very roughly almost everything I have consumed this year was made this year. The restaurant meal, the haircut, even the flight I took. There are a few exceptions. The plane trip that I made was made in a seven year old plane (but it wasn't made in a 20 year old plane).

Very few services I consume at all are produced in any way more than say a decade ago (or with capital equipment more than a decade old).

There are a few exceptions.

  • I snitched a 15 year old bottle of wine from the cellar last week (it was very nice).
  • And much more importantly the housing services I consume are in a house that was built 30 or 40 years ago.

But with those exceptions what I consume in this decade is almost entirely produced in this decade.

And for that matter what I consume in the five years from 2030 to 2035 will almost entirely be produced in those five years.

I can inter-temporarily move consumption around (saving money/capital now) and consume a little more than I earn in 2035.

Everyone individually can do that. That is what capital markets are for in part.

But collectively we can't.

You see everything that everyone consumes in the years 2030-2035 will roughly be made in the years 2030-2035.

We can all save individually saving money, deferring consumption, but collectively we do not defer consumption. We just rearrange claims on that consumption.

Step 2: ageing populations

In every country that matters economically populations are ageing - very sharply. Indeed this is the most rapidly ageing population in human history.

And ageing people want to defer consumption. Individually we have huge populations wanting to defer consumption.

Step 3: the problem - we cannot collectively defer consumption

And now you see where I am going. Individually we all want to defer consumption. Collectively we cannot because what is consumed in 2030-2035 will roughly what is produced in those years.

So I am going to assert that collectively we are very likely to be disappointed. People will not get (in returns) what they expect to get.

Step 4: How is this disappointment to be settled on people?

Since I am asserting that collectively we are going to be disappointed (as we can't collectively defer consumption) the next twenty to thirty years will be in large part trying to work out how to settle that disappointment on people.

And if you can work out all the ways (and timing) that settlement is disappointed on people you should be able to make money (trading the other side). I would love to be able to do this. But here are a few suggestions.


  1. Pensions default. We all think by working hard and earning a pension we are looking after ourselves - but collectively we are disappointed.
  2. Inflation takes away our savings
  3. Interest rates don't keep up with inflation - we have 20 years of negative real rates - maybe sharply negative after taxes,
  4. Asset prices in real terms fall for decades - so your Singapore apartment isn't going to be worth what you think it is - nor is that Sydney or London place, and equities are destined to disappoint.
And it won't matter if you used socialised methods of savings (pensions) or capital-market measures of savings (equity accumulation funds) you can't in aggregate escape the disappointment. Returns are negative. Get used to it.

Is there any out?

There are a few outs. The first one is such large productivity growth that you don't disappoint anyone because just so much more is produced in 2030 than now that you can give the then dissavers a low share and still not disappoint them. I know my Silicon Valley friends are optimistic enough to believe that is possible but I doubt it.

I doubt it for a good reason. Economic growth has to be faster than the ageing population - but the main innovation is likely to be in life-extending medicine - thus exacerbating the ageing population issue.

The second out can be done for some countries but may not be done globally. And that is to muck around with the age profile of your population. Age profile for a country is a choice. Our former finance minister Peter Costello used to argue that mothers should have three kids, one for him, one for her and one for the country. But that was what you did (as Australians) if you wanted to solve the population age-profile issue and you still wanted a white Australia. You can have any population profile you want if you take immigrants. And if you want your welfare/retirement-savings systems not to collapse you are probably going to have to do it. (Nigel Farage and his ilk want a population profile that makes your pension default. But I doubt UKIP will tell that to the voters.)

But beyond that I see no outs.

Implications

There are dozens of implications - and I am far from sure of any of them.

But one is pretty obvious to me. The market clearing real interest rate is negative and should be for some time.

There is nothing in capitalism that guarantees you a positive rate of return and the legion of people who argue that the Fed should raise interest rates just because they believe returns should be positive should be labelled for what they are: ideological capitalists against market clearing. (Okay - now I teasing a little - but I am surprised that people think they are entitled to positive returns.)

I am happy to be argued with here. I am very uncertain of all this stuff. Much less certain than many of the twitterati who prompted this post.







John

76 comments:

Mark B. Spiegel said...

If you really think the market clearing interest rate is negative, then what do you suppose it would be if the BOJ & ECB weren't combining to buy approximately $140 billion worth of bonds every month, many of which are from essentially insolvent countries?

John Hempton said...

And anything else they do will also have negative real returns.

I am not sure the central banks could raise interest rates much even if they tried... they do not seem to need to try hard to keep them at zero.

Michael M said...

I'm sure you're right that "ageing people want to defer consumption", but it doesn't jive with what I see personally, so just curious if you have data to support this? I see no evidence of this among people I know (they're European middle class boomers and never deferred anything). The retirees I know spend more on travel (while they can), dining out, gardening and cleaning (rather than downsizing their home), medicine and personal care than they did before retiring. I'm really not seeing a deferral mindset, only that they may eventually defer if they run out of funds or more likely appetite.

Frenchguy said...

This is the Fisherian critique: real rates are determined by fundamentals and not monetary policy. The corollary is that, in the long run, to have higher inflation you need higher rates. So yes, I agree real rates may very well stay negative for a long time but this is not a good excuse to keep nominal rates close to zero.

John Hempton said...

Yeah - I am sure the biggest population group in the world want to defer consumption - its the Chinese. They have a HUGE savings rate with negative returns, and no social security to rely on.

The negative returns they are getting is the disappointment being delivered to them.

The Europeans want to save for retirement too. They just do it through pensions.

The disappointment will get delivered to them too.


J

Fritz said...

I believe you are right about the market clearing interest rate being very low. Demographics, overleveraged corporates and households probably both play a part? If ECB raised interest rates to say 2-3% it's hard to believe it would benefit economic growth. Carry trades would unwind and credit would contract, directly impacting spending. The positive impact on bank balance sheets would not be seen until years later.

Instead I think there are a few other solutions:

1) helicopter money to ensure a certain rate of nominal GDP growth so that deleveraging takes place over the next few decades. Why aren't we handing out more subsidies to people having kids. That would solve the spending problem and the demographic problem at the same time.

2) use price regulation to ensure bank profitability, eg via regulated credit card fees etc. Banks cannot lend as long as they are capital constrained

3) longer-term, free up the legal tender monopoly and let market forces determine which currency is most convenient/trustworthy/etc. Is Bitcoin the ideal currency, or gold? Let people themselves decide where to put their savings. If borrowers knew that they would have to pay back their amount in gold, perhaps they would think twice before leveraging up 90% on their mortgage. The current system leads to unnecessary and unfair wealth distribution in my opinion.

Have you read what Charles Gave has written about negative interest rate? Thoughts?

Tom L said...

Brilliant thinking John! You make a very logical argument that I'd never heard articulated so clearly.

Erikwim During said...

Following your own logic the Chinese do not have negative returns but highly positive ones. The economy they live in while retiring is vastly different from the economy they came from a few decades ago. Their monetary teruns may very well be negative, but the real life they lead is going to be spectacularly different from the deep poverty most of that billion came from.

Cheryl Frances said...

Just a thought..being a woman and threat of Zika Virus out there would think twice before planning on having a child this year or next until issue is resolved....thus no spending on family growth things and no increasing of demographics?

globalmacrotrading said...

Here is a US centric response.
Deferring consumption = saving, by definition, since income = consumption + saving.
So when you are saying there will be an excess of deferred consumption, you're saying there will be an excess of savings. This is the global savings glut hypothesis that many central bankers have posited, including Bernanke:
http://www.federalreserve.gov/boardDocs/Speeches/2005/200503102/default.htm
http://www.brookings.edu/blogs/ben-bernanke/posts/2015/04/01-why-interest-rates-low-global-savings-glut
As you can see for yourself, some of your ideas are in his thoughts also. You should read those pages, especially the 2nd one, before you go on.

A major point to note, however, is that the savings glut originates from overseas and not the US. This is key because the way the overseas savings glut affects the US is via net foreign trade surpluses to the US. This is distortive because in effect, foreign savings in USD assets tend to be much more risk averse. I.e. a German corporation will have only limited appetite to buy US stocks because they may need to repatriate their USD profits quickly.
Currently, the US trade deficit is massive. The non-petroleum deficit in particular is quite extreme. The offshoot of that is that the global purchases of safe USD assets is extreme.
Along those lines, disappointment will (likely) be settled on non-US entities (Chinese, Japanese, Germans) via a weaker USD vs the trade surplus countries. You are seeing that with Japan now. With the BoJ impotent, JPY could keep strengthening vs the US and force losses on the Japanese who saved by buying USD assets.

In general, the orthodoxy is that rates cannot be disconnected from economic fundamentals forever. The reasoning is that economic agents will be able to ‘arb’ the disconnect, and continue to do so until the disconnect is corrected. US corporate repurchases of equity by raising debt is one such example. So one reason for the disconnect is that the US is not using fiscal stimulus efficiently. US nominal GDP is 4%, and it can borrow for 10y at 1.5%. The Treasury is by far the largest debt issuer, and is the only issuer of size that can offset the overseas savings. In the last cycle, it was US households, using housing debt, that offset the overseas savings. But the tightening of mortgage standards post crisis along with higher px/income ratios have dented that channel sharply. So the idea there is that until either there is fiscal stimulus or a reduction in foreign savings here, the disconnect can continue.

Anonymous said...

> but the main innovation is likely to be in
> life-extending medicine - thus exacerbating the
> ageing population issue.

I may be completely wrong, but I think this may be mistaken.

Surely life-extending medicine *ameilorates* the aging population issue.

A population which lives longer is a *larger* population - for a given birth rate, the longer people live, the more people are alive at any given time.

If we imagine a one-off advance and so everyone alive lives (say) 20 years longer, then we have a one-off population demographic adjustment - like the baby-boomers.

But it won't be like that. It will be a steady series of longevity increases. They'll keep coming. Retirees may be reduced consumers, but they are still consumers, and there will be more and more of them (but there are big questions in my mind about how the macroeconomics play out - if people accumulate wealth when they work, then invest and retire and live from the interest, that can't work if *everyone* is doing it, because there's no one to do actual work).

It might even be that the pace of invention is such that once the first advances start coming out, you've made it - the first one will give you time for what comes next, which will give you time for the second, and so on.

To the extent his happens, we see the population growing, simply because poeple stop dying. So the demographic is getting older and older - but these "older" people are becoming younger and younger, physiologically - the whole effect of longevity medicine is to reverse age-related decline.

It's not like you hit 80 and live as a old man forever; what happens is you become more and more like 25.

Then at some point what happens is that women are permently fertile; menopause is reversed. Now all bets are off - men and women find themselves with the prospect of extremely long lives and the ability to have babes at any time.

What happens then to the birth rate? I think people will defer having kids, but will end up having - over time - MANY more kids than they would have had in a single life-time (however, strict birth controls must occur in the end).

Then eventually these advances lead to immortality. Death only occurs through illness and accident.

The endgame demographic ends up with a huge bump of really old people (the mass of people who were around when immortality hit) and then a very slow trickle of younger people, because there will have to be strict birth control, at the replacement rate, at least while we're still on one planet.

That's actually an important point. Currently we look at whether populations are growing or declining, for their demographic impact - in the end-game, populations are stable.

Anonymous said...

Nice analysis John.
You should ask your twitter opponents how they explain the low inflation rate - if central banks were grossly manipulating interest rates then you would see high inflation.
In fact, over the last 6+ years many people did predict 'runaway' inflation - the honest ones will have changed their opinion now that they see it hasn't happened. Maybe look at your 'opponents' statements over the last few years?

Michael M said...

EU household consumption is almost 3X China's, and China is only 9% of global household consumption (2014): http://data.worldbank.org/indicator/NE.CON.PRVT.CD/countries?display=default

Anonymous said...

The weak link is in the assumption that a particular group will defer consumption. If that pent up opportunity exists, there are all the motivations in the world to provide the services and goods that will cause that money to flow. They may not buy cars, but they will buy because in the model you provide the payoff will be enormous. So....what would they buy? ;)

Anonymous said...

Seems like this would argue for a fairly large allocation to TIPs. 30yr still offers 85bp real.

Ben said...

Not sure why anyone would rationally buy bonds at a negative interest rate. You are guaranteed to lose money unless in the short term a bigger fool comes to bail you out. I guess in theory your arguments make sense for low interest rates, but not negative ones. Hard for me to believe that Central Banks buying 100%+ of bond issuance aren't having an impact on supply/demand for bonds.

Central banks are doing their best to drive people into equities and other assets. They think it will drive people to invest more in productive assets, but if that was happening wouldn't it really just drive low return investments that people shouldn't make? Already occurred in energy and mining. Also, why won't it work for some time (drive people into equities)? The logical outcome of this is any equity with a decent dividend yield is going to go up a lot, which has happened to some degree in staples and utilities, but the logical next step would be riskier equities.

Joe Lucid said...

A system in which central banks target 2% inflation via interest levels must necessarily be unstable and lead to deflation and negative interest rates in the long term: Productivity and population growth inherently lower price levels unless countered by perpetual stimulation by central banks (more goods, same money stock -> lower prices). And income concentration reduces spending propensity. CB's lower interest rates to provide the stimulation which boosts debt and gdp growth and keeps price levels going up.

Initially this works well as low levels of private debt allow ample stimulation over a couple of decades. But the debt stock becomes an anchor on growth and thus price level because of interest expenses (this applies esp to unproductive debt like consumer loans which doesn't lead to ongoing gdp growth). The necessary consequences are falling interest rates from cycle to cycle and an ever accelerating debt stock.

I think that is the story of the last 40 years. Demographics will certainly influence growth rates going forward. But who knows what kind of breakthrough technologies will become available so I'm not ready to forecast low returns based on demographics alone.

Unless the central banks and government own up to the problems in the current setup they will make the world a less and less enjoyable place. Each step they undertake is self-defeating as all they can currently do is increase debt levels and lower returns, thus simultaneously decreasing (long term) spending by debtors and (short term) expenditures of savers.

I think the long term solution is helicopter money to maintain a 0% inflation rate. That's a level that is more achievable especially given the growth headwinds you cite. And money creation without loan backing doesn't increase the debt level so this is more stable. Short term employment management should NOT be an objective of a central bank as the short term fix has abundant long term costs. Instead private debt to GDP should be a target for a central bank to monitor as it reflects the degree to which consumption has been brought forward.

Of course in the short term you need to fix the debt overhang. So add a one time money drop in the form of tax reduction that has to be applied to loan repayment by indebted citizens.

Joe

Mark said...

I think the biggest flaw in your argument is step 2 and moving from there to steps 3 and 4. It is true that not everyone can save at the same time and there seems to be a superabundance of savers in the world right now. It is also true rich world population is declining (your point 2). However, the link between 2 and 3-4 is not obvious to me.
I think low rGDP growth is a necessary condition for points 3 and 4 to hold in addition to the demographic reality. I say this because if the economy is growing, saving should provide returns to the savers in real terms if capital grows in productivity at least as fast as labor.

Incidentally, low to negative GDP growth is probably the best reason to accept a negative nominal yield on bonds in a free market, so the point is probably relevant to the broader debate as well. That is, the only way to rationalize negative 10 year nominal yields on Bunds from a free market perspective is to assume other investment options will have significant risk of generating negative returns as well (which in aggregate implies either reduction in the productivity of capital or a decline in overall economic activity).

I think you agree that your logic implies negative GDP growth, but are somewhat dismissive of this implication ("... such large productivity growth that you don't disappoint anyone because just so much more is produced in 2030 than now that you can give the then dissavers a low share and still not disappoint them"). I have one good data driven argument for why GDP growth can be positive for the next 20 years and one very speculative one.

The data argument is that since 1960 world rGDP has compounded at about 7.77% and GDP per capita at about 2% according to the World Bank (WGDPWRLD Index & WBGDPUS Index on Bloomberg). It is somewhat difficult to locate a longer time series and I devoted little time to it, but a belief that the next 20 years will be radically different from the past 55 is at least suspect. I suspect that over a longer time period the GDP growth rate might be lower thant it was over the past 55 years but it is unquestionably true we are better off today than we were in, say, the 1700s in aggregate and individually. So your hypothesis that we are in a period of sort of reverse Malthusian constraints from a declining population does seem to imply a very dramatic break with history on growth. It is of course possible that a growing population is a necessary ingredient for economic progress, but I think there are good reasons to believe that is less true now than it used to be which is where I resort to speculation.

Mark said...

(Part 2) Basically, I believe capital can be substituted for labor in the future. Automation is increasing across the developed world and this is exactly what you would expect in a world where capital is plentiful and productive. For example, Uber and Google are working on automating the personal transit industry with a driverless car. If these companies are successful, they have the potential to revolutionize trucking, taxis and other reasonably sizeable areas of current endeavor. If you consider, additionally, that an increasing share of income seems to be going towards unusually productive individuals (“superstars”) then the picture looks even better. In that world, what matters is not aggregate population per se it’s how many superstars we have and how effectively we utilize them. It may be that superstars are even more productive if they have more abundant capital, which does sort of seem to be true to me.

All of this implies that the world could have a positive equilibrium rate of growth and thus a positive equilibrium rate of return on saving over the next 20 years in my view. That we observe equity prices high enough that there must be some aggregate growth at the same time we observe bond prices high enough people are clearly worried there will be negative growth is a puzzle. One solution to the puzzle, which may not be complete, is central bank policies and actions designed to reduce unemployment reduce interest rates below their otherwise natural level.

James said...

Maybe it is a natural outcome in a FED regulated economy. But this is not capitalism - only pseudo-capitalism. The same argument could be made for booms and busts in the economy, again, natural outcomes for a controlled economy, but not of a free-market. There is no good reason for the (private)FED to exist, other than to control the economy for their own benefit and to make interest off the loans they provide governments, (which are wholly unnecessary). Audit them, then abolish them, you'll see these problems disappear quickly, albeit with some painful corrections form the bubbles they have propped up along the way.

Anonymous said...

I don't agree with your premise that by not spending today you are not really deferring consumption. I agree that if you consume something in year 2035, most likely that service was created in between 2030-2035 but you are not taking into account the resources/(raw materials) that were used in creation of that service. For e.g. if collectively people defer to buy cars till 2030-2035, you effectively deferred the consumption of steel to year 2030-2035.

Anonymous said...

It can't be a surprise to people (i.e. the Twitterati) that an oversupply of capital leads to low interest rates, can it? It's another effect of the massive capital accumulation (especially in the hands of a few) and it's happening globally. Higher taxes to make that capital productive in the real economy? Higher government spending while rates are low? Why not both? Infrastructure projects are tremendously long-lived, and aren't you discounting those projects when you discuss your consumption being fixed within a time frame? Whatever way you go, don't you have to move money away from capitalists (those "morally virtuous savers") to spenders (those "morally degenerate spenders")?

Sean DiTullio said...

The only issue I have with your analysis is equities still look fairly cheap across the board compared to the bond market. Maybe pricey compared to history (which agrees with your thesis), but really cheap compared to bonds.

I mean US P/E the most expensive market in the world is in the 18 range. Which should offer long-term a 7 or 8% return. Europe is even cheaper.

Point being negative rates are not just a function of deferred consumption, but also of lack of risks taking and in my opinion the results of those arguing for higher rates holding central banks back and hurting growth.

theambler said...

Currently in the UK we are having a referendum on staying in the EU. The big reason for voting Leave is to stop immigration from eastern Europe. I accept that on a local level, this immigration might cause problems. But the simple fact is that your analysis of the problem of pensions is correct. We either increase productivity (it's currently flatlining), accept increased immigration, or accept worse pensions. There is no evidence of any of these things happening.

Leaving the EU is the black hole of reason. The UK Treasury believes it will have a catastrophic effect on the economy. The politicians it will empower are horrific. The secondary repercussions (strife in Ulster, a renewed pull for Scottish independence etc.) are terrible. I am stunned this vote can attract 10% of opinion polls let alone a majority.

AG said...

I respectfully think that the flaw in the reasoning starts with step 1, with the idea of deferring consumption.

Very simply, aggregate spending can be reduced when individuals decide not to spend their disposable income: use their cars a few more years, skip an iphone upgrade, not move to a slightly more expensive rental, not get a massage, cut their hair themselves...

Most of the spending is beyond what can be categorized as strictly necessary, so we can definitely collectively reduce spending, and therefore make a lot of the productive capacity temporarily useless.

However I am surprised you would not consider that, so perhaps I misunderstand the argument.

As far as interest rates are concerned, central banks intervenes directly on clearing prices via QE, but they also control money supply, i.e. availability of money to be lent. A large money supply vs. GDP without QE, without inflation (too much productive capacity), without credit demand (again, already existing large productive capacity), would lead to lower interest rates cleared in a market too.

It is almost tautological that without profit insensitive market participants such as central banks, and banks constrained with regulations, which both enable "greater fool" buying from normal participants, negative interest rates would not exist.

Overwhelming demand for AAA CDO tranches in 2006-07 lead to risky assets yielding a mere few bps over risk-free, but not negative.

bodenby said...

Finally someone not glorifying central banks...the idea that central banks control ANYTHING is debatable. Another angle to approach this is what would global GDP growth/inflation look like if central banks weren't doing what they're doing? Low bond yields equate to expectations on returns/inflation....or deflation. The 30 year yield on Swiss bonds at 0% tells you more about what expectations are for the currency as much as anything. OK, I'll accept 0 returns on my bond if I expect the value of the currency attached to that bond to be worth significantly more in 30 years. In other words...deflation.

Anonymous said...

Totally disagree!!!! Obviously, entire populations can lower (defer) consumption. Why is it relevant when something was produced? Can't producers lower their output? What does deferred consumption have to do with asset prices!? (data please?) arghh.

Michael Fu said...

pretty interesting logic, two questions:

wealth distribution: does income inequality/wealth distribution (top 5-10% owns 80% of wealth) cause the lack of current consumption? if you earn say $10mm/yr, you are unlikely to "consume" that entire amount in a given year and will continue to save / defer consumption. My wife and I make ~$450k / year, live in SF (high cost of living), and still end up saving / not consuming our entire income each year. On the other extreme, Warren Buffet worth $50bn spends barely any of his wealth, living in the same house in Omaha and eating burgers and coke. would Buffet help the future generation better by just spending all his money currently, versus donating into non-profit (that will defer most of current consumption as well)? guess it depends on the eventual productivity of the people that receives his wealth.

relativity: isn't wealth at the end of the day all relative? meaning, if I had $1mm today (but average people had only $100K), but in 30 years, mine is only worth $500K, but others are worth only $50K, we are all worst off, but i still feel relatively wealthier than rest. we are all worst off, but i'm still relatively weathier than average by 10x, so i go with the flow. it's fine if all suffers (everyone gets negative interest rates), it's not fine if only i suffer (maybe that's why all developed world governments seem to set interest rate trends in tandem).

thx.

Sean said...

Replying to James:

I'd argue the FED isn't manipulating rates. The market is saying they are not. When they first announced massive QE the 30 year yield rose (on expected higher inflation). For 2 years now they have ended QE and been talking about hiking rates (which expectations as important as actual hikes), and they have done 1 rate hike. What has the 30 year yield done since the FED started tightening - it has rallied from a 3.5/4% range to a 2.4/3% range. Also the FED was far more aggressive in the early days since 2008 than Europe/Japan. Who has higher rates today? Theres an old saying in monetary policy if you want higher rates then cut rates...if you want lower rates then hike rates. Over the medium term its proven true. Volker hiked to 20% + and since Volker the Bond has rallied from 20% to 2.4%. The effects of short-term monetary policy to effect inflation is intact and that is the main driver of long term interest rates.

sean said...

"It can't be a surprise to people (i.e. the Twitterati) that an oversupply of capital leads to low interest rates, can it? It's another effect of the massive capital accumulation (especially in the hands of a few) and it's happening globally. Higher taxes to make that capital productive in the real economy? Higher government spending while rates are low? Why not both? Infrastructure projects are tremendously long-lived, and aren't you discounting those projects when you discuss your consumption being fixed within a time frame? Whatever way you go, don't you have to move money away from capitalists (those "morally virtuous savers") to spenders (those "morally degenerate spenders")?"

You actually can't tax accumulated wealth. You think you can but you really can not. Take Buffet for example. He has tons of wealth but doesn't spend a lot. When you break down GDP = Consumption + Investment + Government

Buffett isn't consuming anything. So there is nothing to tax. If you tax his wealth and lower his net worth you set off a string of actions that actually cause the tax to fall on someone else. Since to boost government or someone elses consumption you need someones consumption to fall. The end result if you taxes away a lot of wealth then a lot of wealthy people would need to sell their equities and bond holdings. This would cause the price of these assets to fall. The end result would be interest rates would rise. Which then means some middle class consumers mortgage rate increases. Thus lower that middle class homeowners income to fall leading to lower consumption from that person. And with lower equity prices companies would be able to raise less money. Which means many companies in need of capital for growth wouldn't be able to make those investments.

So would the middle class borrower prefer to have the government tax Buffett more and then get a check from the government or would they prefer that interest rates are lower and they pay a lower rate on their mortgage. Either way Buffett isn't taxed. And in the process you have distorted a lot of price signals within the economy.

Davey said...

The supply and demand for funds is the most logical argument for negative nominal long-term rates. Fama's research into Fed control concluded that the Fed has little control over rates, short or long-term (http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2124039).

Also, keep in mind that investing in government bills or bonds is a voluntary transaction. So considering that bondholders entered this transaction voluntarily, why would they accept negative nominal long-term rates? (Japan 10y: -15 bps, Swiss 10y: -50 bps, Germany 10y: 0 bps)

Two reasons: 1) Deflation expectations and 2) Large scale storage.

Deflation expectations: I agree that positive returns are not a guarantee in capital markets. However, a rational justification for paying to lend money to a government is that you expect deflation in the future such that your real returns are positive or zero. Hence demand to invest in long-term bonds. Helicopter money is a potential solution to continual deflation yet the market may view this as an unlikely outcome.

Large scale storage: Even if you expect moderate inflation, there still is a rational justification for paying to lend money to a government. If you have $100 that you need in the future with certainty and the bond market is charging you to lend to them, you would just park the money in a mattress. Now imagine you have $1B that you need in the future, well storing this money under a mattress isn't easy. Therefore, you accept negative nominal interest rates as a fee for storing your investment.

Ageing, less productive societies can lead to deflationary pressures and hence, negative nominal rates. This supports your argument John (https://www.imf.org/external/pubs/ft/wp/2014/wp14139.pdf). Further, these expectations will lead to savers desiring large scale storage, pushing rates further negative.

All these reasons lead to rational, market justifications for negative nominal rates. Demand for safe keeping and demand for saving as deflation expectations increase. Hence prices will increase and yields will fall unless there is a supply increase (helicopter money).

Anonymous said...

I am in the camp that interest rates are determined by supply and demand of funds too

However, what determines the supply and demand of funds?

Money is a human creation is so by implication so is its supply and demand
And so interest rates are determined by how we've constructed the system
And Fed's control over short term rates and funds is one input into this system

I see no fundamental problem with negative rates too but ya, what is optimal and how can we balance the system toward what we believe is best?

But if it is not optimal now, we can't say that the Fed and it's interest rate policy is just a passive output.
Our monetary and fiscal choices have led to the current supply and demand of funds

We could tax the supply and move it to the people with more demand (more in the numerator less in the denominator means higher returns and rates)
Or if Fed raised rates and let asset prices fall (instead of the other other way around for the last 40 years), this will destroy some of the funds on the supply side as well

In conclusion, I believe both are right. Interest rates are determined by supply and demand of funds but how we’ve constructed the system and our policies help to shape this balance.

Anonymous said...

I am in the camp that interest rates are determined by supply and demand of funds too

However, what determines the supply and demand of funds?

Money is a human creation is so by implication so is its supply and demand
And so interest rates are determined by how we've constructed the system
And Fed's control over short term rates and funds is one input into this system

I see no fundamental problem with negative rates too but ya, what is optimal and how can we balance the system toward what we believe is best?

But if it is not optimal now, we can't say that the Fed and it's interest rate policy is just a passive output.
Our monetary and fiscal choices have led to the current supply and demand of funds

We could tax the supply and move it to the people with more demand (more in the numerator less in the denominator means higher returns and rates)
Or if Fed raised rates and let asset prices fall (instead of the other other way around for the last 40 years), this will destroy some of the funds on the supply side as well

Interest rates are determined by supply and demand of funds but how we’ve constructed the system and our policies help to shape this balance.

Nemo Incognito said...

A few questions / comments.

1) If you are saving now for future consumption, capex to offset future spending makes sense. Everybody get solar panels and such would seem to be sensible. Hard to do with restaurants, school feels, kindle books and pilates classes.

2) Public sectors globally should pull forward spending during this period without a doubt.

3) Everybody should get used to working longer though if the Productivity Commission is right and a large deflationary impulse is from Uber/Airbnb etc, then maybe they will work later into life but with very flexible hours.

4) There is an offset to the generational inequality of savers of today having little to buy with yield - the scarcest commodity now is labor which is broadly inflating faster than inflation.

5) Pension plans have assumed returns but also claims inflation. Both are coming down, it is not a given that they are bankrupt if they move down by the same quantum. 7% return with 3.5% inflation is 3.5% real - similarly, 5% nominal with 1.5% inflation is 3.5% real. Not that bad, net net.

theambler said...

Anon, entire populations can indeed lower consumption. This is either because of an economic breakdown like the Great Depression, or because the economy switches to war production, or investment. But business owners don't invest in factories or offices when they do not expect profit from that investment. Also note that if everyone deferred consumption, profitability of business falls, so share prices fall, so pension fund values fall...

Anonymous said...

I think we are ignoring the main issue here which is one of moral hazard. The current policies have actually stifled real innovation by not allowing bad actors to go bust and furthermore have rewarded those who have continued to play on the central banks bailing them out. By definition this means that non productive speculations stick around and drain the economy of the energy that's required to get people employed and productive. The fact that housing stock is so highly valued says something about how this is all playing out. It's basically a system that keeps the current power structure and their pals at the top even as everyone else suffers. Helicopter money is not going to solve this problem at all because at the heart of this system is a rot - amorality. There is an unjust inequality and the natural order is to return to a just inequality which is being held up by various machinations but especially by central banks.

Basho said...


John, a few thoughts and comments.

Step 1: the impossibility of collectively deferring consumption

But we do, all the time. If we didn't, productivity and hence living standards would soon collapse. The fact that most items consumed in (say) 2030-2035 will be produced contemporaneously says nothing about the necessary savings (collective deferred consumption) and resulting investment to sustain and improve the existing capital structure in the meantime. This is a rolling, continuous process.

As an aside, I suspect sufficient malinvestments have accumulated during this 3-4 decade credit cycle such that high levels of savings will be required simply to allow for a good chunk of it to be written off.

Step 2: ageing populations

Undoubtedly true but while ageing people may wish to defer consumption, isn't one of the structural effects of a rapidly ageing population heightened consumption relative to income (i.e. production)?

Step 3: the problem - we cannot collectively defer consumption

We are indeed likely to be disappointed but, as suggested above, I think the reasons will be somewhat different to those you suggest.

Step 4: How is this disappointment to be settled on people?

Yes, we will be disappointed. All four of your suggestions as to how this might happen to seem entirely reasonable to me. FWIW, my guess as to the likely mechanisms is as follows:

- First, credit induced malinvestments will be a substantial drag on economic performance for some time to come. In other words, productivity will suffer badly, quite possibly going negative for many years.

- Second, the vast (and still increasing) debt overhang will create a constant and powerful deflationary undertow until debt ratios are somehow returned to more sustainable levels. Getting there is likely to either involve large defaults and/or debt/equity swaps (practically speaking, much the same thing) or the effective nuking of the monetary system so as to wipe out a decent chunk of existing real obligations. I struggle to see the current extend and pretend farce lasting too much longer.

-Stemming from both of the above, current asset prices are likely to produce very low or even negative nominal returns over the next decade or more. Depending on how the monetary gain plays out, real returns may well be lower still.

Returning to your central topic, I don't see how negative interest rates could exist in a genuine market economy. Having something today must surely always carry a premium (however small) over having that same thing tomorrow. That we do have them is I suspect primarily a consequence, as AG suggested, of two things. Namely, price insensitive buying on a massive scale by central banks (with all its knock-on effects), together with bank regulations encouraging the purchase of sovereign debt.

Anonymous said...

What utter nonsense.

Anonymous said...

Can I suggest the following paper as explanation where the rates reducing funds come from? Rather than a "savings glut". http://www.bankofengland.co.uk/research/Documents/workingpapers/2015/wp529.pdf

Michael said...

Hi John,
grat post!
I think you're right on the essence -- if we can't defer consumption in aggregate, real interest must be negative. I'll be more drastic: if demographics go too bad, people will not be able to retire, however much money they have saved.
However, I think you underestimate the possibilities to actually defer consumption -- invest -- in the long term:
1. Human capital. Not the bullshit bingo buzzword, but the actual improvement of people's productivity by
- moving them out of villages into cities
- giving them technical or professional training (and in some cases basic literacy)
- extending their *productive* (not just their biological) life
All this is *not* trading savings between countries. There is a huge untapped potential, mostly in the 3rd world, and it should suffice longer than the market looks now
2. Capital accumulation. More capital = more productivity of labor. More productive labor now = more potential to accumulateneven more capital. Unless capital has decreasing impact on productivity, this creates exponential growth
Note that the life span of capital goods is irrelevant. It wouldn't matter if they had to be replaced yearly. What matters is the split between capital and labor
Is there reason to assume they can not be efficient substitutes? I think history bears out the opposite
3. Endogeneity of demographics. By this I mean that dmographics don't just happen. People used to multiply (afterr a while) whenever they were in demand -- i.e. well-paid, and hence well-fed -- in the past. If there really is a capital glut and a labor shortage, this should happen again
Doesn't recent (last century or so) history refute this? Not necessarily. Domwe know in advance how much capital is enough / too much capital? Maybe modern economies need a strongly increasing proportion? What if state intervention has hobbled capital formation -- all in the name of social justice? What if taxing capital formation actually led to its shortfall (as elementary theory predicts)?
I know it's more sophisticated to see internal contradictions in capitalism, and the twittering classes are vulgar Marxists to a high degree, but maybe, just maybe, there is no miracle to explain here. It's just the state doing well-intentioned harm, as always

Again, I think your post is great, and a big improvement on what's usually said on the topic. And rates can have to be negative for good reasons. I just think that on the grand scheme of things, the ultimate reason is social meddling, not demographics


James B. Shearer said...

We can all save individually saving money, deferring consumption, but collectively we do not defer consumption. We just rearrange claims on that consumption.

This is not true as stated. Society collectively decides how much of current production to allocate towards current consumption and how much to allocate towards enabling future production. By consuming less now you can increase future production allowing you to increase future consumption. Like China or South Korea. Or like Venezuela you can eat your seed corn maximizing current consumption at the expense of the future. So within limits we can collectively move consumption around in time.

I think a more serious problem is that a growing fraction of the population is becoming worthless in economic terms as labor ceases to be an important factor in production. This is stressing our current system for allocating claims on production.

Ryan Morris said...

I think the problem is actually potentially even worse than you frame it and I have a different frame on it.
1) The supply side of capital is 'over supplied' because of the demographic factors / ageing.
2) The demand side you don't really address is also an issue pushing rates negative - 50 years ago you would need large amounts of financial capital in order to build a business (factory, inventory etc). Now with service businesses and automation - many new businesses that were unimaginable 50 or even 30 years ago don't need much tangible capital (Facebook, google, msft, even amazon) to operate. This trend is only accelerating with automation / AI though perhaps arguably robotics will bring back some more demand for capital vs labor. Regardless this trend means that businesses need less capital and the surveys show that at companies. The bottleneck is 'information' in the sense of reorganizing the limited tangible capital there is - i.e. entrepreneurs and smart people are the main bottleneck that there needs to be more of.

SO if all you bring to the party is financial capital: expect negative returns.
Entrepreneurs will capture more of the value going forward than ever before - which means the world will be more of a meritocracy than ever...

dede said...

Interesting thoughts. I believe there is definitely a market downward pressure but the problem is to what extent it is market driven and to what extent is it distortion driven?

I like what Ben said at 2:49 but I think he's got one point wrong: "They think it will drive people to invest more in productive assets"
I do not believe they think what they say. They observe that there is a Capex issue (the buybacks are a symptom) so they say that this is the reason why they print like crazy to push rates down so that companies can afford to invest.

However, is it possible to dismiss all the broke governments who cannot service their debt anymore? Governments running deficits above their debt servicing amount have huge incentives to keep rates as low as possible (or better, negative!) and one way to do that is to ask the Central Banks to flood the market with money and find a plausible argument to explain what they do.

Virgon6 said...

Virgon6

Hi John,

Great work. However, you post seems to have a good, strong, nod at the world of Mathus. On the supply side. Inflation on an historical data has for most of the lived post (pre- 20C) was flat or 1%. The world won't run out of resources, however, you seem to be suggesting that market clearing mechanisms have reached an infection point and the politics of entitlement are no longer.

Olivier said...

As luck would have it Zero Hedge was mulling on the same topic recently: http://www.zerohedge.com/news/2016-03-02/capitalism-requires-world-war. In a nutshell: interest rates have been falling for decades in the West because interest rates must always be below the rate of return on productive investments but the rate of return falls naturally, due to capital accumulation and market competition. How to break the trend and "reset" to high profits? By destroying surplus capital, goods an manpower in a war, hence the title of the posting.

Anonymous said...

I think I only saw one comment that actually addressed deferral of consumption. Respectfully, because I generally find your posts to be well thought out, you are missing something fundamental. Sure it is true that the dinner that I have tonight must be produced concurrently. But that does not mean that I cannot defer nor cannot save.

I can choose to diminish my spending. I need not eat out. Nor eat steak. Instead eat low cost food. Save money. Invest it, though not necessarily in public markets, but in my education or business or children's educations. My current consumption is source from today but I have some level of control over the holistic level of consumption.

Jan Christiansen said...

After the Second World War real interest rates were negative - this is called financial repression.

One of the solutions to the lack of deferred purchasing power is going to be a dramatic increase in suicide among the elderly. Give it five years, ten at the max.

We can defer SOME consumption. It is a tragedy that governments are not using the current low interest rates to build bridges, public buildings, public transit and public utilities that will produce streams of consumption for fifty years.

Two steps would help address the global savings glut:
1) the West cracks down hard on tax havens and wealthy tax avoiders (This is going to happen. Before we let our grand parents commit suicide on mass, starve or live in our basements we are going to seize the assets of the tax avoiders);
2) China introduces a form of social security.

Anonymous said...

John,

Not sure whether this is peripheral to your key issue (interest rates) or peripheral, but I would think that there is a slightly different way of framing it.

The issue you seem to be addressing is not so much the impossibility of trully deferring consumption, but rather the impossibility of preserving purchasing power to a time in the future where the ratio of working population (sellers of production) to consumers (sellers of financial assets) will ve significantly less favourable to the sellers of financial assets (i.e. present "savers" who expect to be "dissavers" in retirement).

Seen from that perspective, your argument is entirely correct, but does leave a few potential "escapes".

1. In a world where innovation significantly improves health, there is the possibility of working longer. (While much of current health innovation is more focused on deferring death for those in a while at a "too fragile to work", there is no reason to believe that we cant do better).

2. The productivity gains that matter in such a situation are not those in "total factor productivity", but only "labor productivity". Given that, we can easily improve labor productivity by loading up on capital (such as education/training, infrastructure, etc). Investment in such capital may be forecast as being uneconomic at present costs of labor ... but when you allow for increase in that cost driven by declines in labor availability, different forecasts emerge.

3. Finally, leaving out any ethical issues, the "retiree" population in a "rich" country can buy production by importing "temporary" labor.

The conclusion is that the current situation is only partly driven by a "savings glut". The other side of the calculation, is that the reason for this "glut" is that there is a massive investment gap in public goods (i.e. education, infrastructure, etc), and the only possible provider of such goods (i.e. the State) is refusing to address it. If they did, they would be able to deploy those savings and the interest rates would go up.

SB.

Dmitry Kozlov said...

I would argue the fundamental #1, because it's pretty straightforwardly wrong.

Not only consumption can be deferred collectively, it has actually been done on multiple occasions on large scales. Using the modern-golden-billion pattern is a poor illustration here.
Deferred consumption is called investment in fixed assets.

If I have an assembly line today which pumps out X, say, cars, and bring me Y in profits, I can consume hookers today (perfect example of produced-on-spot service), or I can buy a second assembly line. This will not realistically give me exactly 2Y, but unless margins fall spectacularly, I will have more then Y to spend on hookers next year.

Want an example of this on larger scale, because it's too "individual"? Well you get the Soviet project. An entire generation of 10'-20's (19xx, that is) basically got their consumption deferred to future generations in order to build railroads and factories. And, not going into the inefficiencies of socialism, on a collective level the root idea worked: factories got built, and consumption rose significantly. The generation of 60's-70's already had universal education, healthcare, housing...

In other words, the "capital use" part of cost structure of goods and services can and does come from saving and investing earlier. The part that seemingly can not be deferred is labor.
And we see a lot of attention going this way: from sophisticated CNC tools all the way up to self-driving cars.

Best regards,
Dmitry.

Ben Kloester said...

I don't see why collective deferral of consumption couldn't increase. Isn't that exactly what a negative demand shock is? Ie aggregate demand drops.

Maybe you're thinking of the hot potato effect? Which is where an increase in the monetary base might lead individuals to individually wish to reduce their holding of money, but the base cannot be reduced in aggregate?

I recommend you read Nick Rowe's blog Worthwhile Canadian Initiative, he has a knack for reducing these sorts of idea to very pure thought experiments that greatly facilitate manipulating the concepts and getting a handle on how things must work.

will said...

Its not to do with aging. If anything old people who have retired consume more than they produce- as they are drawing down savings.
I think the mass of saving is to with developing societies without a welfare state getting rich.

obelix said...

First, what this post by John Hempton is making is essentially a quantitative claim without any quantitative analysis. Sure, you can say that there are factors that point to low natural rate of interest. But once you start talking about negative rates, or whether the Fed should raise the rates or reduce them, then you are implicitly actually putting some parameter values and data into some sort of formula. This post didn't have any computations about it. I doubt I'd see similar "no numbers" analysis about stocks in this blog.

Second, there is a way to collectively defer consumption. It's called real investment. High real investment results in lower consumption today and higher consumption in the future. Of course, the set of investment opportunities is not unlimited, so higher real investment will result in somewhat lower expected return on that investment. The world is not an endowment economy in which consumption is given. John, of course, understands this, but wanted to point it out for completeness as I think it was underemphasized in the post.

Third, central bank policy does influence real interest rates. That's obvious from two observations. One, if you rate the dovishness and hawkishness of the central bankers, I believe you'll see a correlation between real interest rates across currencies controlling for local demographics etc. Two, the market response to news about monetary policy is strong. If monetary policy wouldn't impact real interest rates, it would be difficult to explain the monetary-policy announcement reactions of stocks and inflation linked bonds.

The Fed in the US has a whole staff trying to estimate these things. Those people are not idiots. I think the current Fed estimates for the US are 1.25% natural real rate of interest (lowered based on recent empirical work), 3.25% long-run equilibrium Fed funds rate, 2% inflation target, and about 5.0% natural rate of unemployment. Currently, the core inflation is running at 2% target and unemployment rate below the natural rate. Simple models would predict an appropriate Fed funds rate of 3.25% in this situation. Complex "optimal control" "asymmetric loss" "forward guidance" "liquidity trap" models would predict appropriate Fed funds rate of little over a percent. I am not aware of any quantitative model calibration that would not suggest a higher than current Fed funds rate.

Silicon Valley Farmer said...

Many comments simply citing investment in capital assets without a mechanism, when lack of a mechanism is the whole point! (impossibility of collectively deferring consumption) I'm not much more impressed with self driving cars as a mechanism - transportation is under 14% of 75year old+ expenditures and self driving cars will only make a somewhat small dent in that.

Expenditure source: http://www.bls.gov/cex/2014/combined/age.xlsx

Taking a look at some of the others though, I think we have a lot of room to defer consumption.

•Housing at 36.5%. You've mentioned this as pretty easily deferrable.
•Healthcare at 15.6%. You mention this as a potential negative area. There are a lot of issues in this sector but I think investments in robotic surgical equipment and AI have the potential to defer a significant amount of consumption. (think ISRG, or just for fun, sword wielding robots https://www.youtube.com/watch?v=O3XyDLbaUmU)
•Food at 11.9%. I think there's room here, again primarily through robotics investments (more self driving combines, improved cattle herding drones) but also from capex used for food energy inputs.

I agree we are looking at a future with negative or low real returns but think there enough opportunities to defer income with even Japan's fertility levels. Those solar panels look a lot better with a 0% or -1% discount rate.

I also second Michael's comment on the endogeneity of demographics. Japan's birthrate has ticked up. It's ever so slight, but the cost of living is still high and the population is still close to all time highs. First worlders are demanding a higher standard of living for themselves and their kids before they will have more kids.

Martin H said...

Hi John,
You mention that individuals “can inter-temporarily move consumption around …. But collectively we can’t”. This is better thought of people accumulating wealth with their surplus income (save) during their productive years, so that they can convert that wealth into income (dis-save) when they are aged.
It is because income is perishable that you are right to say much of what you consume “was made this year”. Income is the hairdresser cutting the hair of a client. Income is the milk produced by the diary.
With regard to your comment regarding ageing populations, in countries such as Japan what should be most evident is that the capital base (long-term wealth) is at peak levels. Sadly this is not obvious. Instead, much of the Japanese older population holds fiat monetary claims – essentially only forced claims through taxation over the income of the fewer younger people.
We can collectively defer consumption by redirecting our efforts towards capital goods and away from near term income production – the ‘productivity’ argument you cite – but there is limited evidence that this is taking place, particularly in a manner that will produce more income in future periods. Instead, much current activity seems to be poorly directed.
You argue that “we have huge populations wanting to defer consumption”. However, given the deterioration in human coordination over time and space it is a reasonable conclusion that society’s capital wealth (i.e. our commonweal) is today in a poor state. It is likely that the difficulty in undertaking a reliable exchange of income to wealth over time and space has led to a significant misallocation of capital. Symptoms of this poor quality exchange include a lack of long-term manufacturing capital formation, excessive housing stock and capital depletion through too high a level of short-term consumption.Instead of huge populations deferring consumption, we have huge populations who hold insufficient wealth and plan to live off the pension provided by the State.
With regard to your suggestion of “pension default”, there is no doubt that this will occur. Improved longevity has greatly increased the savings demands of the populous. A working life is typically at most 35-40 years (say age 23 to age 63) to be followed by 25-35 years (say age 63 to ages 87-97) in retirement. It is implausible that most people that have saved sufficient quality wealth to provide income for themselves throughout a long retirement. This is where some form of tontine will become essential, in addition to working to a later age.
This is where your “second out” of immigration is just an ‘extend and pretend’ and it doesn’t solve the real problem which relates to the lack of accumulated wealth. If income is taken from young ‘immigrants’ to pay the Age Pension of older (but sometimes still capable) ‘locals’ this is morally bankrupt and hardly likely to provide an environment which will encourage new people into the commonality.
It is not natural for the interest rate on gold bonds to be zero or negative. Stable low interest rates are natural under free exchange and this stable low interest rate encourages capital formation.
In our current monetary system, productive activity is penalised and speculative activity is rewarded. As local nominal government bonds (‘fiat bonds’) are unnatural, the interest rate is unstable and driven by speculation (aka central bank front-running).
You mention housing as one of the few services that you consume that was produced a long time ago. Shelter, food, water and clothing are the primary needs of human. There is no surprise that residential housing is the choice form of saving for most people. They don’t understand why, but they have the history of fiat ‘money’ on their side!
You suggest “equities are destined to disappoint”. Clearly this will depend upon the quality of the form of wealth over time and space. Those companies producing productive income should remain in high demand. Similar to housing it is the fiat denominator that is most at risk.

Pereg25 said...

Hi Dmitry Kozlov: You say:
'If I have an assembly line today which pumps out X, say, cars, and bring me Y in profits, I can consume hookers today (perfect example of produced-on-spot service), or I can buy a second assembly line.'

Isn't the purchase of the second assembly line in itself 'consumption'. It may not be hedonistic/purile or gratifying consumption, but it is consumption nevertheless; after all the workers employed to produce said assembly line or raw material owners from whom you purchased the components for the assembly line may well decide to consume conspicuously, on cocaine and hookers!!

Martin H said...

Hi John,
You mention that individuals “can inter-temporarily move consumption around …. But collectively we can’t”. This is better thought of people accumulating wealth with their surplus income (save) during their productive years, so that they can convert that wealth into income (dis-save) when they are aged.
It is because income is perishable that you are right to say much of what you consume “was made this year”. Income is the hairdresser cutting the hair of a client. Income is the milk produced by the diary.
With regard to your comment regarding ageing populations, in countries such as Japan what should be most evident is that the capital base (long-term wealth) is at peak levels. Sadly this is not obvious. Instead, much of the Japanese older population holds fiat monetary claims – essentially only forced claims through taxation over the income of the fewer younger people.
We can collectively defer consumption by redirecting our efforts towards capital goods and away from near term income production – the ‘productivity’ argument you cite – but there is limited evidence that this is taking place, particularly in a manner that will produce more income in future periods. Instead, much current activity seems to be poorly directed.
You argue that “we have huge populations wanting to defer consumption”. However, given the deterioration in human coordination over time and space it is a reasonable conclusion that society’s capital wealth (i.e. our commonweal) is today in a poor state. It is likely that the difficulty in undertaking a reliable exchange of income to wealth over time and space has led to a significant misallocation of capital. Symptoms of this poor quality exchange include a lack of long-term manufacturing capital formation, excessive housing stock and capital depletion through too high a level of short-term consumption. Instead of huge populations deferring consumption, we have huge populations who hold insufficient wealth and plan to live off the pension provided by the State.
With regard to your suggestion of “pension default”, there is no doubt that this will occur. Improved longevity has greatly increased the savings demands of the populous. A working life is typically at most 35-40 years (say age 23 to age 63) to be followed by 25-35 years (say age 63 to ages 87-97) in retirement. It is implausible that most people that have saved sufficient quality wealth to provide income for themselves throughout a long retirement. This is where some form of tontine will become essential, in addition to working to a later age.
Your “second out” of immigration is just an ‘extend and pretend’ and it doesn’t solve the real problem which relates to the lack of accumulated wealth. If income is taken from young ‘immigrants’ to pay the Age Pension of older (but sometimes still capable) ‘locals’ this is morally bankrupt and hardly likely to provide an environment which will encourage new people into the commonality.
It is not natural for the interest rate on gold bonds to be zero or negative. Stable low interest rates are natural under free exchange and this stable low interest rate encourages capital formation.
In our current monetary system, productive activity is penalised and speculative activity is rewarded. As local nominal government bonds (‘fiat bonds’) are unnatural, the interest rate is unstable and driven by speculation (aka central bank front-running).
You mention housing as one of the few services that you consume that was produced a long time ago. Shelter, food, water and clothing are the primary needs of human. There is no surprise that residential housing is the choice form of saving for most people. They don’t understand why, but they have the history of fiat ‘money’ on their side!
You suggest “equities are destined to disappoint”. Clearly this will depend upon the quality of the form of wealth over time and space. Those companies producing productive income should remain in high demand. Similar to housing it is the fiat denominator that is most at risk.

Anonymous said...

Agree with you completely that interest rates are largely driven based on time preference for consumption. The demographic issues are partly driving low interest rates but there are other factors.

1 - Corporations are hoarding large amounts of cash that is stranded due to corporate structures optimized to avoid taxes.
2 - A relatively small number of ultra-wealthy individuals who are holding cash and bonds well in excess of any reasonable assumptions about their remaining lifetime consumption
3 - Asian and Germanic mercantilism
4 - Large amounts of margin debt used in global asset arbitrage
5 - Large amounts of 'fictitious capital' that represents unrecognized losses

The Federal Reserve's decision to resolve the financial crisis by suspending accounting rules rather than recognize losses was a direct driver of #5. The Federal Reserves asymmetric policies which have suppressed volatility across a large range of assets classes has definitely encouraged #4 and contributed to wealth concentration #2.

The same can be said of central banks in Europe and Asia as well. I wish I could tease out the demographics from other contributors but my guess is that demographics isn't the major driver.

Lyall Taylor said...

John - agreed; the most likely outcome is people stop retiring at 65 and start retiring at 75-80. So you have more people producing goods and services for longer. That might seem to be an 'out', but it really also counts as a disappointment - if you retire older, you presumably are doing so because you have less savings & entitlements than you previously expected.

On the market clearing rate of interest - couldn't agree more. There is no fixed 'cost of capital'. Rather the cost of capital depends, like everything else, on its demand and supply. Consequently, if there is more 'demand' to save (i.e. supply of savings) vs. the demand for use of those savings (consumptive borrowing and real investment), then the market clearing price indeed will be negative. Most of conventional economic theory is based on the assumption that things are scarce, including capital. That is rapidly ceasing to be the case in many instances.

It is also perfectly possible for there to be a scarcity of 'risk' capital but an excess of 'don't want to take any risk' capital. Then you get reasonably priced/cheap equity markets but negative bond and money market real rates. It's also possible you have an excess supply of risk capital as well, in which case equity market will appear 'overvalued' most of the time (this is a problem with GMO's S&P valuation analysis - they assume a fixed cost of risk capital over time, but there is no guarantee that will prove to be the case; if it does it's pure chance). Under this scenario, the market is not overvalued; instead, the cost of risk capital has fallen.

LT

Anonymous said...

I agree that the market clearing IR can be negative. I also agree that without QE we may also have had negative IRs. Now, the distortions that I see are in determining the prevailing IR of assets that should not receive the risk free rate. These are the distortions of QE, evidenced by operation twist, and now the ECB purchasing corporate bonds among other programs. I also question if we would have interest rates negative for a long period of time vs only during a shorter duration 'event' if we allowed the free market to clear excesses. An historical comparison may be the forgotten depression as written about by Jim Grant.

Without central bank intervention we would likely see certain sovereign bonds and other not risk free bonds see credit spread increases vs tracking with the risk free rate. Through this mechanism we would likely not need to live through the long duration of market dissapointment.

Richard Wetherell said...

Great piece. If only our politicians could challenge themselves with this kind of thinking.

Yield compression is going to become an increasing issue here at home unless pension funds (and in Australia im talking about our Superfunds) get more creative with their investment strategies. There is going to be too much capital chasing easy low risk returns (if there isn't already..); no to mention a lack of geographic capital diversification.

The only out I see is if govt. can drastically change their attitude towards infrastructure and industry investment, increase the role of private funding vehicles and push superfunds to consolidate and engage in the provision of this capital (in structuring and providing both equity and debt). An added benefit of pushing a bigger financing burden onto the private sector would be a lower reliance on taxation revenue (which could be passed back through more optimal tax structures to help combat lower real yields).

Of course tax benefits dont have the greatest history of producing optimal capital allocation but in a low growth world I dont see much alternatives to competing for capital growth on a global scale.

RW

Anonymous said...

Dont worry. Case-Deaton suggests there is another equilibration device and its already starting to work.

Rich said...

A few things to maybe clarify your thinking:

- Yes you can defer capital goods expenditures. Look at US auto sales during the recession years. You can also defer expenditures on housing -look at housing starts during the recession. Local Governments can behave pro-cyclically, as they did in the US through the last recession. They fired building inspectors when new construction went away, and now there's a shortage of them, and building completions get delayed.

- Who will clean up and remove your bedpan when you are old and infirm? The older old use tremendous amounts of resources in their final years, and there will be more old folks around in some countries than there will be people to care for them. This increase in demand for labor will cause wage increases for service employees.

-Again, taking a cue from demographics, older people have more investable funds built from decades of savings from work. There are more of them,and having completed their working lives, they would prefer to earn more on their savings. Unfortunately, markets don't work that way- the boomers will be treated to a combination of lowered investment income until there is a relative shortage of investable funds and higher expenses in their final years as mentioned before.

But is that bad? From the perspective of a minimum wage earning worker-no.

Besides, I see no other way to achieve equilibrium than reducing unearned income for excess savings and increasing returns to semi-skilled labor as it becomes relatively scarce. This will play out later, when the proportion of boomers that starts hitting 85+ years old increases.

Anonymous said...

I think you are essentially correct about a number of assumptions but crucially missing a few insights that will broaden understanding.

Firstly, debt is future consumption AND debt is money creation. A loan creates an asset.

Baby boomers are no longer creating money as they retire, so they are no longer adding money to the global system.

They are also hogging jobs as per data, keeping youth out of the jobs market, reducing the ability of youth to earn a decent wage, and most importantly, "create money" via debt.

Furthermore, many youth start their working lives with "negative wealth" from student debt, so they have even less ability to borrow than previous generations.

Then at the global financial level, major banks are steadily withdrawing from wholesale eurodollar financing, partly from capital requirements, partly limited ability to make money from low demand because of global corporate austerity to support dividends.

This in turn exacerbates youth unemployment because one company's cost saving is another's lost revenue or people's wages.

I highly recommend you reading the PDF here:
http://www.alhambrapartners.com/2016/06/21/why-qe-will-never-work/

and read his other pieces that explain the slump in bank interest rate derivative exposure is a proxy for a collapse in the eurodollar market that the $11 trillion of Fed and other central bank QEs have been hopelessly inadequate to fill.

All that has driven global demand for yield and safe assets, but we are now on the verge of Irving Fisher's debt/deflation blackhole.

These financial "assets" are underpinned by $200 trillion plus in global debt that needs more and more new money to be created to stop it from imploding.

Default is money destruction, so is negative interest rate.

The rate of change of money creation is slowing rapidly, and this year was "saved" by China's $1 trillion debt splurge in the first quarter, but they know it cannot continue. The Premier has said as much numerous times.

So deflation remains in force and you are right, their will be global default on these assets in one form or another.

jim said...

People have pointed out that savings can be changed in aggregate by increasing investment and decreasing consumption. But John can simple restate the argument in terms of output, which cannot be deferred in aggregate.

But a low real interest rate should lead to more investment, which leads to capital deepening, which increases output per worker (even without productivity growth).

Anonymous said...

No doubt, too many par claims out there. Lots of disappointment to go around and who knows exactly how it falls. I do know this however - hedge fund managers have no better idea than me and it's impossible to predict who gets it right. Paying 2+20 is a heads they win/tails I lose proposition. Glowing articles will be written about the winners, but it will be totally random.

WellRed said...

I have been in the 'very low for way longer than you think' for about 6 years now. Seems like the 'wealth being eaten by inflation' is playing out more or less globally (UK has had the worst of it).

My view however has been bullish on equities: compared to rates I don't think they're cheap. If rates stay this low -- your basic argument -- isn't there a lot of room for equities to run as the market continues to adjust in super slow motion? Even in an environment of flat to negative earnings, it feels like there is a lot of scope for continued multiple expansion.

But then again I am not nearly as close to markets as I used to be.

Value Investor said...

Bank of England may likely to go zero interest rate if not holding to the current rate. Consumer confidence in UK dropped to the lowest in 21 years. Impacts of BREXIT really are just surfacing out...at least for until 2017. We will see a bad hit to the UK property market in the short term at least.

Value Investor said...


With BREXIT, I view there are good value investing opportunities especially in forex play and gold investments. UK property market will be badly hit too due to rising unemployment rate.

The way I looked at it, interest rate for uk will be zero if not maintain at current holding. This is needed to boost business and consumer confidence.

Andrew Martin said...

A terrific piece. I work as a pension actuary for retirement plans that in the macro sense are practically "individuals" and they save/defer consumption based on rules imposed and their own preferences, but I have long told people that in the macro, the only way for the Baby Boomers (or anyone else for that matter) to retire at the standard of living they are expecting, someone somewhere has to produce the goods and services they will consume. And, yes, one way to help fix that is more immigration. Another is free (or freer) trade. The UKIPs, Trumps, et al of the world are against both. One reason they don't tell people that it is the same as making pension defaults a policy is that they don't even understand it (or they do and they lie to themselves and/or us about it.)

Excellent blog BTW.

Ben Schroeder said...

Thought provoking. I certainly hope you are wrong. What gives me hope is the idea that per capita consumption is rising, as enabled by technology (which is deflationary, making real returns possible at negative nominal rates), and technology is owned by equity holders. So we might hope that our expanding knowledge will fuel consumption growth that profits equity holders, so much so that despite countercurrents you describe we prosper nonetheless. If you think about how much progress humanity has made in recent years it doesn't seem too far fetched to believe.

harry said...

Chinese savings is a strong argument in this direction and provides some empirical evidence as well.

The one child policy means for every 4 grandparents there is one grandchild. No reasonable Grandparent would assume they would be supported by grandkids. Neither would they rationally assume the chinese state could support them. So they should save very aggressively for their old. An attempt to transfer current consumption into the future. However the Chinese savings market hasnt given you a lot of choice for savings vehicles. instead people have been forced to invest their cash in any old crap. One estimate I saw suggested that real returns were - 5% on real estate investment. However, what alternative do the local population have?

I think there is a quote from William Gibson - "The future is already here, its just unevenly distributed".

Ken Lee said...
This comment has been removed by the author.
Ken Lee said...

Put it this way, perhaps the current economic situations, ie low inflation, low interest rate, negative real interest rate and low growth, are something to do with the demographics.


The baby boomers, the largest age group in developed countries, have been retiring since 2005. After retirement, they're either spending the reserve they saved before or living on the monthly payment from their pension funds, ie saving rate is negative for them. Meanwhile, those who're going to (but have not yet) retire would increase their saving in the run up to retirement. The interactions of these two forces jointly determine the trend of the supply of saving and labour.

On the other hand, the governments in developed countries are generally suffering increasing structural fiscal deficit with payment to retirees outstripping contribution/tax receiving from the working groups in tandem with population aging. They're filling up the deficit with tax hike and debt issued to the central banks and public investors. The governments' demand for credit is rising, and meanwhile entrepreneurs are being discouraged to invest in new projects that create jobs and improve productivity. As such, credit is increasingly channeled to the payment for claims to retirees and asset markets, eg properties and stocks. The piling up public debt will only be paid with new debt issued to central banks or public investors, as the money has been spent on unproductive projects (payment to retirees, asset bubbles), which makes productivity improvement impossible. This set in motion a vicious cycle.

The existing dynamics, ie low inflation and low interest rate despite increasing deficit, can sustain itself only because there are so many younger baby boomers who are still working hard and saving more for their retirement. But after this age group retire, inflation will spike and so will interest rate, as the supply of labour and saving will not be enough to keep the system running. Even that, the real interest rate would still be negative, but nominal interest rate and inflation higher.

Ken Lee said...

The ordinary Chinese don't have much saving, as almost all savings in China are concentrated on the hand of a few (mainly communists and their cronies). The parvenu you guys saw in London and New York are the minority 1% (>10 million, still a huge number).

Kenneth Andersen said...

A wise man once said:

"Nobody can predict interest rates, the future direction of the economy, or the stock market. Dismiss all such forecasts and concentrate on what's actually happening to the companies in which you've invested."

:)

Dermot said...

@ John , Worthwhile to consider the fiscal theory of price levels....

https://www.skagenfunds.lu/globalassets/pdfs/miscellaneous/com/prices-and-policies-29.08.2016.pdf

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