Negative rates, deficits and defaults

Japan’s, the US’s and Europe’s central banks and governments continue to fly by the seat of their pants, since none of their policies restored prosperity since the 2008 crisis.  Incomes stagnate, labor force participation is at historical lows, and though measured unemployment dropped, the fact that there are no pressures whatsoever on compensations suggests that the decline in unemployment rates no longer signals better times.  In Canada, the drastic drop in prices of natural resources and the value of debt backing that industry has brought particular shock-waves to finance, insurance, and other sectors, indirectly backed by these debts leveraged few times over.

One puzzle is that after decades of discarding the Keynesian approach and its jargon, perceptions of solutions are again now framed in its terms, in spite of the fact that the approach does not apply at all to post-2008 world of high debt and reduced collaterals.  Framing today’s problems in such terms misleads, government borrowing does not solve the problem and negative interest are a particular solution – but not for making things better, but for preventing governments from defaulting in today’s particular global circumstances.  Let us see how and why.

In 2008, equity in homes evaporated in the US, as did much collateral held by financial institutions and stock markets crashed. While quickly injecting liquidity into the banking system so as to unfreeze the flow of currency makes sense (“currency” comes from “current”: it has to move to give it value) and needed no new theorizing, such central bank intervention had nothing to do with a Keynesian framework.

It was in the next steps that this framework was used.  Instead of asking how to deal with the large outstanding private and public debt, evaporated collateral and lower income growth with  “assets” expected to be “solid” having melted into thin air (housing in the US, oil here), governments framed the solution in terms of Keynes’ “aggregate demand.”

But take a household who has been saving 5 percent of his $1,000 monthly income before the crisis. He spent $950 and deposited $50 in a bank, who lent it, leading to $1,000 spending.  Assume that after the crisis this household still has $1,000 income, but now there are no borrowers for $50 even at zero interest, as the pre-crisis borrowers not only do not want to spend and expand unless futures incomes would be rising, but cannot: their collateral is gone. Whether the $50 sits then in a mattress, at a bank or as reserve at the Fed, is marginal.  Spending drops to $950.  If the households getting the $950 also save 5%, but borrowers do not demand their $47.5 additional savings either, total spending drops further by $97.5.

Keynesians attribute such chain reaction to “animal spirits” – a random fluctuation in people’s minds, with no events precipitating it.  They recommend a comical solution: Let governments promptly borrow $97.5 and spend it, be it “digging holes in the ground,” or even wars, as Keynes himself put it, though to be fair, Keynes noted that cathedrals might do too (spending on mosques were not on his mind then).  Income is restored and that’s about it.  Sounds like a joke, but is all in his and followers’ presumed scientific treatises and these days’ political and central bankers’ discourse.  The practice fits Irving Langmuir’s, 1953 Nobel Prize in chemistry, notion of “pathological science,” meaning scientists’ practice of following the scientific method of falsification but straying into wishful thinking.

Briefly, in 2008 around the world, and in Canada now, significant amounts of what people expected to be “wealth,” including value of “real” estate, were gone, but debts and mortgages were not. Since debtors lost collateral and equity and creditors wrote down the value of loans, the past weighed on present options.  Perhaps if in English we used the French term for “real estate,” “immobilier”, crisis would have been mitigated.  The word captures the essence of this asset class as the term “real,” implying value is sustained, does not (and captures the fact that too that immobile assets are easier to tax, governments having the incentive to immobilize their populations).  While it is true that repaying the debt or interest on the debt represents someone’s income, but with collateral gone and policies leading to expectations of no future income growth, private borrowing drops.

How can Keynesian remedies of instant governments borrowing and spending expected to improve the situation?

When government spends the $50 of unwanted savings, total spending is – theoretically – restored to $1,000.  The policy sustains incomes, but whether the $50 creates assets, we do not know: $50 more now flows through the government. Does such change in borrowing and spending mitigate the debt hangover and restores expectations of higher sustainable incomes?  The answer is:  If the borrowed $50 creates future assets, the policy may work.  However, if the $50 is spent on “digging holes,” then the $50 spending creates immediate incomes, true, but on people and devices used for digging a deeper hole.  Miners and Caterpillar benefit, but the deeper hole does not create future assets, never mind Caterpillar’s capex or any unemployment or aggregate figures.   Society is just digging itself deeper into deficit and debt holes, becoming less wealthy, but with rosy aggregate statistics.

Whereas in the past debt hangovers due to compounding mistaken policies were solved by either defaults; higher taxes in some cases (paying for the debt) and lower in others (the latter bringing speedier rebuilding of equity); inflation and devaluations in others, both diminishing the value of debts (and sheer luck too – when devaluating countries could export more to the rest of a booming world), these days the last two options – inflation and devaluation – do not work.

Devaluation does not work because every country has been slowing down, and one country’s devaluation may only trigger others and eventually currency wars.  And if governments pursued inflation it would lead either to defaults or drastic cuts in government spending in the US, Western countries and Canada, since some of these governments have already been financing their deficits with massive short term debts, and Canada would no longer be able to issue 50-year maturity bonds at the low rates it recently did, but would have to borrow short term too, paying higher interest.

The present circumstances of all countries slowing down is what allows central banks to engineer low, even negative, interest rates and prevent governments from defaulting or cutting spending drastically.  The low interest rates mean that while government debts increased significantly since 2008 (some 50% in the US and Canada), total interest payments hardly changed, meaning that compounding – what Einstein called the strongest force in the universe (and not the just documented gravitational waves) – slowed down.  Negative rates achieve what inflationary tax achieved in the past: prevent governments from defaulting and allow them to sustain spending.

The policy is not unprecedented. The Fed carried out this same policy during the 1940-50 decade (combined with inflation, though price controls during WWII and after meant that the full inflationary impact did not show up in official price indices).  Marriner Eccles, the Fed Chairman at the time openly acknowledged that the role of the Fed during wartime was to prevent government bonds from defaulting, and that the Fed was an agency of the Treasury.  Perhaps this is what would be needed these days: to fully acknowledge that what is happening now has nothing to do with “Keynesian” nonsense, but central banks are playing the same roles as they did in that decade.  Only now this is due not necessarily to wars, but a sequence of mistaken policies ending in high entitlement spending and much debt, alas with Keynesian type of deficit finance nit having created assets.  Continuing to frame today’s problems and solution in Keynesian terms are just making matters worse and prevents perceiving the only solution, namely:  policies inducing rebuilding equity – fast.

Reuven Brenner Brenner holds the Repap Chair at McGill University’s Desautels Faculty of Management. The article draws on his Force of Finance, Labyrinths of Prosperity and “Treasury’s Little Buddy,”(with M. Fridson).