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Guest Post: Human Action Under Ultra-Low Interest Rates

Tyler Durden's picture
Submitted by Tyler Durden on 09/02/2012 22:37 -0400



 

Submitted by Martin Sibileau of A View From The Trenches,

Today, we want to examine the origins of the idea that ultra-low rates of interest can exist, how this idea came about, why it was flawed and how it leads to an informal economic system.

 

Over the past months (and particularly in the last weeks), we have increasingly read negative comments on the ongoing zero-interest rate policy (ZIRP) and in some instances, negative-interest rate policy (NIRP). We find these comments were anecdotal. Not superfluous but anecdotal. They touch on the influence of ZIRP on savings, on the profitability of banks, on fiscal policies, on debt, etc. Perhaps, the anecdotal format is explained by an inclination towards induction rather than deduction and perhaps our discomfort with this is driven by our familiarity with the Austrian method.

Today, we want to examine the origins of the idea that ultra-low rates of interest can exist, how this idea came about, why it was flawed and how it leads to an informal economic system. It was a fallacy based on misunderstanding of the rate of interest and human action.

Origins of the idea that ultra-low rates of interest can exist

From our very limited knowledge in the history of economic thought, we are inclined to believe that the topic of zero interest rates was first introduced by John M. Keynes, when he contemplated the possibility of the existence of a liquidity trap (chapter 13), in his so-called “General Theory of Employment, Interest and Money”. Keynes did not see this as the result of explicit policy but as an aberration of market participants, driven by their animal spirits, which define their liquidity preferences.

Keynes’ concepts were popularized in visual format by Sir John Hicks , when he came up with the famous IS-LM model. In the graph below, following this model, we can see that the equilibrium rate of interest is negative. The “S” line is an indifference curve for the aggregate supply of loanable funds. In the axes, we see a benchmark rate of interest (r, vertical ax) and income (horizontal). The “I” line is the indifference curve for investment demand. As the rate of interest falls or income rises, the demand for investment goods increases. If the rate of interest falls too, the aggregate supply of loanable funds decreases.

The chart also shows that there is an income level that would get us to a desired level of employment (Yp). Logically, it would seem that either a higher level of investment or a lower level of savings is required, to “bridge the income gap”.

In our view, the whole approach of thinking in terms of indifference curves is ridiculous. Nobody is ever indifferent. Everybody is always making a decision. Having said that, let’s remember that Keynes challenged the notion that both investments and savings were sensitive to the rate of interest. For Keynes, investment demand was mainly a function of income and secondarily

of the rate of interest. In the same fashion, savings were also driven by income. To Keynesians, savings are by-product of consumption, that part of the income we did not consume at the end of a period:

Investment = f (Y)

Savings = Income – Consumption, but as consumption is a function of income: Savings = Y – C (Y)

 

Why the idea was flawed

It should now be clear that there is an inconsistency in simultaneously believing that investment demand and savings are mainly driven by income but that it is necessary to lower the interest rate to boost investment, as the Fed does…and the Fed is Keynesian! Keynes also thought that fiscal policy was necessary to boost investment demand, so that the intersection between the I curve and the S curve takes place at a positive rate of interest. By the same token, Keynes must have not considered increasing savings to bridge the gap (i.e. an increase in the supply of loanable funds), because that would have meant a reduction in income! In his own words (from Chapter 13):

"and whilst an increase in the volume of investment may be expected, ceteris paribus, to increase employment, this may not happen if the propensity to consume is falling off…(= savings increase)"

According to Professor Jesús Huerta de Soto, Keynes lacked a theory of capital, which cornered him into an horrible circularity:

On one hand, Keynes thought that the rate of interest was determined by the liquidity preference of the public (as in the chart above, because the liquidity preference determines the supply of loanable funds). In his own words:

"…whilst an increase in the quantity of money may be expected, ceteris paribus, to reduce the rate of interest, this will not happen if the liquidity-preferences of the public are increasing more than the quantity of money…"

On the other hand, Prof. Huerta de Soto rightly notes, if you asked Keynes what determines the liquidity preference of the public…he will answer: The rate of interest does! We  think (we are not PhDs in Economics or historians of economic thought)  the evidence of what Prof. Huerta de Soto points is found on Chapter 15:

“…In normal circumstances the amount of money required to satisfy the transactions-motive and the precautionary-motive is mainly a resultant of the general activity of the economic system and of the level of money-income(…); whereas experience indicates that the aggregate demand for money to satisfy the speculative-motive usually shows a continuous response to gradual changes in the rate of interest, i.e. there is a continuous curve relating changes in the demand for money to satisfy the speculative motive and changes in the rate of interest (…).. Indeed, if this were not so, “open market operations” would be impracticable…”

In summary, Keynes thought that the liquidity preference of the public determined the rate of interest, and that the rate of interest was determined by the liquidity preference of the public (i.e. the aggregate demand for money to satisfy the speculative-motive). Keynes oversaw that the rate of interest is nothing else but an inter-temporal rate of exchange, between present and future consumption.

 

Misunderstanding of the rate of interest and human action

This inter-temporal exchange rate is very relevant and we dare to say, instinctive. The fact that we understand it at its most basic level, which is the awareness of our mortality, is precisely what made us evolve into human beings. When time has a price, when the inter-temporal rate of exchange is relevant, when the rate of interest is positive and important, men tend to be more desperate than otherwise and they create, they take risks, they look for more efficient ways to produce what they need, they become more productive…they grow!

This basic instinct is so strong that even if a central bank determines that the rate of interest should be zero, humans, aware of their life cycle, will refrain from consuming today in exchange for consuming more tomorrow. Before you disagree with us on this, think about the following: The curve “S” above is for loanable funds, not for savings! If the interest earned from these funds is not “enough”, that will not prevent people from saving. People will just not invest their savings in loanable funds, in securitizable assets (which is in line with Hernando De Soto’s works on informal economies) . They will save in non-financial assets and if the public markets, manipulated by central banks don’t acknowledge that inter-temporal exchange rate, the public assets will be privatized.

Thus, we should not be surprised if, under zero-interest-rate policies in the developed world, we witness a growing trend in corporate leverage, with vertical integration, share buybacks and private equity funds taking public companies private. It would be only natural. We warned of this back on May 7th.

Another way of examining this is the following: The zero interest rate indicates that time is free. And as anything that is free is wasted, time will also be wasted. Therefore, the equity of a firm, which is the equivalent of a call option on the assets of a firm, will become very cheap in terms of the debt of the company, as the debt does not grow with time because no interest is due on it (this only holds true, if the company is profitable, as a friend pointed to us). Arbitraging for this distortion in relative value, lifts the price of stocks, and to make this process sustainable in time, central banks need to keep throwing liquidity to the system, until they no longer can….

Now, if savings leave the matrix “system”, we will see in the long run an important de-leveraging, as the credit multiplier becomes less and less powerful. With more assets outside the system, the pricing mechanism becomes less efficient, since there are fewer signals to market participants. Capital markets disappear, specialization decreases, economies of scale are threatened. With more assets outside the system, productivity plunges and with it, unemployment skyrockets in rigid (unionized) labour markets (characteristic of developed economies). As developed economies, with high stock of capital, rely on economies of scale, this fundamental transformation has enormous damaging potential.

The flight from the system brings more financial repression as a logic reaction. In those nations with established coercive savings plans pension plans , politicians set their eyes on these virgin pools of capital, to force a bid to their liabilities (i.e. sovereign debt). This process eventually spirals, since the financial repression aimed to prevent market participants from protecting their inter-temporal exchange decisions, grows exponentially and brings about precisely the opposite outcome: A complete defence of savings, now fully thrown into an informal economy.

At this point, something has to be said about wealth transfer, because not every market participant is able to re-allocate his/her  investments and re-direct his/her savings from the system to the informal world. Those who cannot save enough, those employed in firms and trapped in pension plans, will see their assets evaporate. If the harm is too significant, it may even be a cause for them to leave their condition as employees and become self-employed. This is the landmark of underdeveloped economies: A huge mass of self-employed, undercapitalized citizens in an informal system. The informality prevents them from accessing credit, which enhances their undercapitalization.

Finally, we ask that you note one last thing: As productivity, employment and production decrease, even a steady and low rate of inflation has the potential to morph into hyperinflation. It’s only a matter of time, and it occurs once the capital markets (including the futures markets) vanish, when the only reason to demand currency is for transactional purposes, when the demand of currency to settle debts is only marginal.

 
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Mon, 09/03/2012 - 08:44 | 2757380 Unbezahlbar
Unbezahlbar's picture

Excellent article...thanks. Also helps expalin why the Housing Bubble is fake prosperity when borrwing costs are zero (or near zero). 

House prices can tumble and tumble hard. I see many houses in my old neighborhood that used to sell for $150 psf now on the market for $45 psf, sitting there for months....

A huge amount of wealth you thought you had can disappear very quickly. All it takes is for house buyers to refuse to go into vast amounts of debt especially when rates begin to correct to their norm.

People seem to forget what "normal" is. Market forces can teach a tough lesson as interest rates (and house prices) regress to the mean.

Mon, 09/03/2012 - 08:50 | 2757392 deez nutz
deez nutz's picture

Keynes theories never considered an economic downturn during an environment of over 40 years of keynsianism.   In summation he never placed his theory over a template of his theory. 

We did!!  and we are going to get a really surprising answer very soon!!

Mon, 09/03/2012 - 09:05 | 2757420 AynRandFan
AynRandFan's picture

So, if you can't earn interest on your money you spend it?  Who does that?  Nobody.  Low interest rates promote more risk-taking among investors looking for income.  So instead of using one's cash for spending, the average investor uses it to buy junk bonds and over-valued stocks like Facebook and Apple.  Keep in mind also that extremely low interest rates are a sign of a bad economy and high unemployment.  In that atmosphere, nobody wants to go out and spend the cash they saved.  Instead, they want to hoard it.

Mon, 09/03/2012 - 10:14 | 2757592 GMadScientist
GMadScientist's picture

More incompetent tilting at corpses from the crowd who can't tell speculating investors from "the public".

Mon, 09/03/2012 - 11:45 | 2757746 resurger
resurger's picture

nice read

Wed, 09/05/2012 - 23:41 | 2766933 neutrinoman
neutrinoman's picture

Nice article. Keynes' idea of liquidity preference is just the inverse of the money velocity. The faster is V, the lower is LP; the slower is V, the higher is LP. In the money equation, MV = PQ = Y, a given money supply M supports a higher Y (total spending) if V is higher and LP lower; it supports a lower Y if V is lower and LP higher.

The monetarists believed that V is constant, or doesn't vary much. But it does. In particular, during inflation, V speeds up; during deflation, V slows down. This is self-reinforcing or "pro-cyclical," behavior. During "normal" times, V doesn't vary a lot, it's true.

Keynes' major book (he wrote a lot beforehand, closer in spirit to classical economics) was not a "general theory," but a confused attempt to come to grips with the aftermath of the first modern financial bubble. The world began its steps away from the gold standard in the 1920s, and arbitrary credit creation became possible. However, the newly created money was supposed to be backed by gold at a fixed rate, but no one was creating more gold. So there had to be a deflationary day of reckoning, which there was (1929-33).

What Keynes actually discovered (without realizing it) is that a "pure money" economy has no natural equilibrium. Rather it has an infinity of possible equilibria. The real economy (microeconomics) does have a natural equilibrium (making some broad assumptions about diminishing returns and scarcity -- which don't always hold -- but hold most of the time, and enough to make it all work). If there's a simple, fixed relationship between the "real" and "money" economies (like a gold standard, a money rule, or a Taylor rule), all is well. The indeterminacy of the money economy is irrelevant. But alter that relationship -- either suddenly, repeatedly, or continuously over time -- and a large indeterminacy about money, interest rates, and the value of time represented by interest rates results.

In practice, central banks today implement a mishmash of half-baked monetarism and Keynesianism. The supposed "liquidity trap" that needs to be cured by more wacky policies is really the result of those wacky policies; the supposed cure IS the disease. ZH just had an article about how corporate bond issuance has been dropping as interest rates have dropped: there's your answer. Put interest rates back on the road to normal, and lending will pick up again. ZIRP is leading to radical credit rationing, added to all the other, idiotic pro-cyclical policies that reinforce the collapse.

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