Friday, July 6, 2012

Central bankers opposed to functioning markets

As I outlined in the kleptocracy post Chinese households save an absurdly large proportion of their income in bank deposits with regulated interest rates earning about 1 percent nominal.

This is an observable fact. The reasons for it (I blamed the One Child Policy and deliberate financial oppression) are less observable - but the fact of these enormous savings is not in doubt.

Inflation is also highly observable in China. Whether you believe the official statistics or not does not matter. Inflation causes observable political disturbance and many companies are complaining about cost pressure.

There is no doubt that inflation rates in China have been above the regulated bank interest rate and that situation has been persistent.

Simple observable fact: one of the biggest savings pools in the world and possibly the largest incremental savings pool in the world (Chinese middle and lower classes) have saved (and are clearly prepared to save) at observable and high negative real interest rates.

My speculation: if there were full capital mobility the market clearing real interest rate for riskless assets globally would be negative because of that large pool of savers prepared to save at negative real rates.  

If this is true then we should not be at all surprised by gilts in the UK at 1.5 percent and inflation at 3 percent. There is no reason at all to think the market clearing real interest rate has to be positive - indeed given the nature of the incremental savings pool in the world there is a reason to think the reverse. Indeed it is just an extension of what Bernanke observed when he talked about an excess of global savings...

Unfortunately you cannot produce negative real returns on riskless assets unless you allow some inflation.

Central bankers however do not see it that way. Mario Draghi (European Central Bank) still thinks inflation is an ill to be avoided - rather than necessary for market clearance. Mario Draghi is anti-market - and anti-market clearing. He is not the only offender.

I have a follow up post to begin to explore investment and social implications.

For comment.



Kyle said...

I would humbly suggest keeping in mind that at least one central bank -- the federal reserve -- was started with the underlying mission of creating inflation. Maybe the europeans are different but i doubt it.

No one officially admits the job of the fed is to create inflation but that is reality.

Natural result of market economy is deflation but over time that makes life harder for banks and other politically important people. A little bit of inflation gives business and individuals the illusion of growth, which everyone likes.

Trouble is that over time the economy adapts so that it takes more and more effort on the part of the fed to create inflation (Hayek's nobel prize speech).

Draghi wants inflation, he just can't say it.

Anonymous said...

The 1 year time deposit rate is 3.5%. Why do you insist on saying 1% despite multiple comments to the contrary? Thanks.

John Hempton said...

Most the time the rate was about 1 - and the inflation rate was about 8.

But you are right - the rates are currently higher at least at regulated term rates.

And they are STILL substantially below the inflation rate.

Moreover most the time there are DUAL interest rates as per this paper:

The low rate is applied to most deposits (you really need to be rich by Chinese standards to earn the high rate) and most the time according to the data in this paper the low rate is binding.

The low rate in many instances still is that low - and whatever - it is binding a LONG way below the inflation rate.

John said...


I didn't follow your leap of reasoning from the situation in China (which is China specific, circumstance-based) to a general theory at the global level. Care to elaborate?

Anonymous said...

"My speculation: if there were full capital mobility the market clearing real interest rate for riskless assets globally would be negative because of that large pool of savers prepared to save at negative real rates. "

Sorry John, but I'm a little slow.

1. Why would Chinese savers be likely to take on forex risk for a negative real rate? I can (sort of) see why they may accept the risk in their own currency, but not for a foreign one. (Switzerland's situation is unique and can not be generalized)

2. Why should the global demand for money be less than supply? At some price, people would be willing to borrow, I think.

I'm sure you've thought these issues through, so I am not contributing to your knowledge by asking--rather, I'm just hoping that you'll be able to contribute to mine.

Anonymous said...

Sorry--a quick follow up to my prior question re: global demand Vs supply of money: am I not correct in assuming that in an era of global negative real rates, at the very least any company paying a dividend would be better off borrowing money to buy up their own shares?

Also, that in an era of negative rates, everyone will essentially lever up as much as they can and as far out on the yield curve as possible (issuing zero coupons, ideally), and that this should always be able to soak up the excess supply of cash?

I have a few other questions along these lines, but I guess I could probably figure them out on my own after a little thought if you could explain why my above assumptions are incorrect.

Alan said...

As a fund manager, you should know that negative rates really mess around with capital allocation decisions. We should write off the PIIGS debt as there is no other choice including some of the Chinese stimulus debt, let the debt holders take the bath, recapitalise the ponzi financial system provided we bring back Glass Steagall and focus on the real problems such as the ageing of most of the Western world and China.

Shawn said...

" Indeed it is just an extension of what Bernanke observed when he talked about an excess of global savings..."

Wow .... you still think the fairy tale of EXCESS savings existed?

Have you thought about the other side -- DEBT?

Greenscam and BurnMonkey conveniently blame the savings glut for derailing their interest rate policy, but Mish bury them for good.

I am sure Mish would happy to exchange a few notes with you about the mystery of saving gluts.

RichL said...

My apologies in advance if this all sounds a bit disjointed, but…
I don’t subscribe to the premise that savers are willing to accept negative interest rates. Low demand for funds, along with government policy, forces rates lower.
A major driver of unemployment and low inflation has been the virtualization of what were tangible products. TV, encyclopedias, newspapers, and scores of other products have been displaced by phone and computer apps. The costs of producing these products were adding to employment, and costing more money. Is it possible that this lower cost product substitution is creating a reduced need for capital as well as labor?
This trend is worldwide and persistent, and older (German) policymakers may be only partially aware of the economic effect. If you’ve spent a lifetime being fearful of the economic chaos caused by hyperinflation, you are not likely to believe that capital should have a negative interest rate. Richard Koo has given the example of low-cost money being akin to apples that just stack up on the shelf; putting 100 or 10,000 apples on the shelf at the same low price doesn’t change demand. The Japanese experience of low rates led to price deflation. It isn’t clear to me whether low rates drove this deflation or the opposite. Low rates impact the income of retirees, which can cause them to spend less.
On the other side of the coin, if the poor weather in the US Midwest causes reduced crop yields, we could have an inflation that will have the greatest effect on the poor. Because there are so many countervailing trends that can affect demand for products, a reasonable price for money can be fairly diverse among countries.
What I’m trying to suggest is that rate setting is cultural, and setting rates that are not understood by a citizenry is not acceptable. Negative rates, plus fear, could lead to withdrawal from the market that could be profoundly deflationary- the opposite of what the policy is trying to accomplish.

Mike T said...

I don't know if this is true -- that we need inflation to have neg real rates.

Look at what Denmark did today.

The central bank cut its NOMINAL deposit rates below zero!

F.S. said...

It is reasonable whatever that is perceived safe and liquid could carry a negative real rate. It is really a service to provide a safe and liquid asset so there is good reason to charge for it. Cash (as in paper currency) had always carried negative real rate. Now that bank deposits are getting just as convenient, thanks to ATM and debit cards, and even safer (from theft/misplacement), it is reasonable that they also carry negative real rates.

Anonymous said...


Here you're touching a subject I've been thinking much about recently.

In a little more generic form, I'd formulate it as a global perception that one's assets have a God-given right to be invested with positive real returns .

and I would venture to add
or are entitled to be retained at all (e.g. at zero real rate, or like -1% or -5% real rate, but not -50 or -100)

Traces of this thinking are evident in your previous topic: what makes you think the "old man" was entitled to retain his $10mil if he was neither able to make investment decisions himself nor choose a right man to do it for him?


Anonymous said...

"Natural result of market economy is deflation but over time that makes life harder for banks and other politically important people."

Huh? Population growth and decline in natural resources is deflationary? Huh???

Cash212 said...

I would suggest that nobody would accept you giving them $97 back tomorrow for lending them $100 today. They would likely be willing to pay a small fee for convenience of holding and processing their $ but not much.

Even in a world where money supply is fixed and prices generally decline, creditors would still demand a positive rate of interest on their capital.

You see negative yields in some markets (e.g. Switzerland) but what you don't see are the expectations of yield enhancement from currency appreciation.

Anonymous said...

"Central bankers opposed to functioning markets"

Given that you're long BAC (among others) - a bank that only continues to exist because the US government refused to allow creative destruction to run its natural course - I'd suggest you get down off the cross John. They need the wood.

Negative real interest rates are as natural as the Nobel prize for economics. They are the result of the refusal to allow any bondholder to realize the consequences of their malinvestment.

Anonymous said...

I would suggest that Mr. Cash re-read the post that he is commenting on. It is happening on a huge scale.

Ian Whitchurch said...

Anonymous July 6, 4.24pm,

The reason you save at negative interest rates is so that you've still got most of your capital in a crisis.

If that capital is somewhere the same people who put the rest of your capital at risk cant get it, even better.

Martin, Sydney said...

Central banks inflate with credit not base money like Zimbabwe. Japan tried all the tricks and still ended up deflating for 22 years (and it's still not over). The central bank can set a rate but cannot force banks to lend and borrowers to take on more debt. If you are a borrower it doesn't matter whether the bank turns you away at 10%, 5% or 1% because you have a weak credit score. Similarly if you are a creditor and worried about defaults you may not to lend your money out at any rate.

WellRed said...

I think this is right on. However, I am not sure that full capital mobility is a necessary precursor. As you outline later in the post, we already have negative real (and in some cases nominal) rates on a broad swathe of risk-free assets. I havent fully sorted it all out, but I think that the more important factor is the aggregate creditor/debtor status in various countries/sectors.

I am going to speak in broad strokes here, so focus on the message, rather than nitpicking details. China is a net creditor. As are a large number of other developing countries, which 30 years ago, were net debtors, with (for the most part) productive capital investments being made in said nations by developed-world savers. As developing countries moved from aggregate debtors to aggregate savers, the capital flows reversed. However, most of the aggregate borrowing was coming from the developed-world household and government sectors, whereas corporate sectors were hovering around flat (see for numbers from the US). That means that the worlds excess savings was being put to work funding government programs and investment in houses and frivolous personal consumption. I think we can all agree these are not the sort of "investments" that typically carry positive return.

This was a major contributing factor in the financial crisis As the worlds savings are funneled into such enterprises, financial engineers were forced to resort to alchemy to pump out 6% AAA-rated assets that the world´s savers demanded, teetering on the back of what is fundamentally poor global capital allocation. See: financal crisis.

Hopefully my story made some sense. Bottom line, it strikes me that there simply aren´t enough productive capital investments available globally. As a result, capital flows to unproductive investments, ensuring that negative real yields are here to stay. The more negative the better in fact, as that will restore equilibrium more quickly.

Anonymous said...

You should be more than willing to save at highly negative rates. Saving is often not at option. If you are well off and 55 years old, you are much more concerned with keeping purchasing power at 75 or older than buying a few more gadgets today. You may be willing to sacrifice 2-3 cents per year to defer purchasing power risk free, at least with some portion of your wealth.

This is not hypothetical. I know many people that would not spend a single extra dollar if rates were negative. The only possible response is to buy some asset -- gold, land, etc and hope it appreciates, or depreciates less.

Kyle said...

Productivity gains drive increases in supply. Not a consistent number each quarter but over time its a strong trend unless someone interferes -- gov.

Had long term price stability in the 1800's in US -- lots of ups and downs but overall flattish prices with big GDP growth. Lots of volatility in economy and especially with employment and wages -- cant have both.

This isnt a particularly original thought.

Ian Whitchurch said...

". That means that the worlds excess savings was being put to work funding government programs and investment in houses and frivolous personal consumption. I think we can all agree these are not the sort of "investments" that typically carry positive return. "

Yeah, because bridges that dont fall down, roads that dont have potholes and sewer systems that work are all negative economic returns.

Oh, and there might possibly be something in this theory that having a functioning education system helps a modern economy.

We need less stupid right wingers.

WellRed said...


I agree with your premise, but a lot of government spending is not funding the programs that you mention. The US COULD do well with more investment in education, but that is not where the borrowing is being channeled. The Iraq war comes to mind... I am struggling to see the productivity gains from multimillion dollar payloads. You would think as a right winger it would be a nobrainer for me, but I'm struggling..

As for bridges, roads, etc, diminishing returns on capital. Hence why I think a global system where savings flow from areas with large capital stocks to those with lower capital stocks makes more sense than vice versa.

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