Our Financial Future

Interest rates should be the rental cost of money. The greater the opportunities to make profits, the more people will be willing to pay for the available money to invest in further profitable ventures and the interest rates go up. That is reinforced in that if more people are trying to borrow the same limited supply of money the rental price of it must increase, to shake out the less determined borrowers. However, it does not quite work like that. If an economic boom comes along, who wants to kill good times when you can print more money? However, eventually interest rates begin to rise, and then spike to restrict credit and suppress speculation. Recessions tend to follow this spike, and interest rates fall. Ideally, the interest rate reflects what the investor expects future value to be relative to present value. All of this assumes no external economic forces.

An obvious current problem is that we have too many objectives as central banks start to enter the domain of policy. Quantitative easing involved greatly increasing the supply of money so that there was plenty for profitable investment. Unfortunately, what has mainly happened, at least where I live, is that most of it has gone into pre-existing assets, especially housing. Had it gone into building new ones, that would be fine, but it hasn’t; it has simply led to an exasperating increase in prices.

In the last half of the twentieth century, interest rates positively correlated strongly with inflation. Investors add in their expectation of inflation into their demand for bonds, for example. Interest rates and equity values tend to increase during a boom and fall during a recession. Now we find the value of equities and the interest rates on US Treasuries are both increasing, but arguably there is no boom going on. One explanation is that inflation is increasing. However, the Head of the US Federal Reserve has apparently stated that the US economy is a long way from employment and inflation goals, and there will be no increase in interest rates in the immediate future. Perhaps this assumes inflation will not take off until unemployment falls, but the evidence of stagflation, particularly in Japan, says you can have bad unemployment and high inflation, and consequently a poorly performing economy. One of the problems with inflation is that expectations of it tend to be self-fulfilling. 

As a consequence of low inflation, and of central banks printing money, governments tend to be spending vigorously. They could invest in new technology or infrastructure to stimulate the economy, and well-chosen investment will generate a lot of employment, with the consequent benefits in economic growth and that growth and profitability will eventually pay for the cost of the money. However, that does not seem to be happening. There are two other destinations: banks, which lend at low interest, and “helicopter money” to relieve those under strain because of the virus. The former, here at least, has ended up mainly in fixed and existing assets, which inflates their price. The latter has saved many small companies, at least for a while, but there is a price.

The US has spent $5.3 trillion dollars. The National Review looked at what would be needed to pay this back. If you assume the current pattern of taxation depending on income holds, Americans with incomes (in thousand dollars) between $30 – 40 k would pay ~$5,000; between $40 – 50 k would pay ~$9,000; between $50 – 75 k would pay ~$16,000; between $75 – 100 k would pay ~$27,000; between $100 – 200 k would pay ~$51,000. For those on higher incomes the numbers get out of hand. If you roll it over and pay interest, the average American family will get $350 less in government services, which is multiplied by however much interest rates rise. If we assume that the cost of a dollar raised in tax is $1.50 to allow for the depressed effects on the economy, the average American owes $40,000 thanks to the stimulus. Other countries will have their own numbers.I know I seem to be on this issue perhaps too frequently, but those numbers scare me. The question I ask is, do those responsible for printing all this money have any idea what the downstream consequences will be? If they do, they seem to be very reluctant to tell us.

The Recent Economy up to Covid-19

In the previous post I noted that Keynesian economics tended to fail because governments overlooked the second half of the prescription: when the going got strong, it was necessary to “pay back” the debt, or at least reduce the money supply. That results in politicians being party poopers, restraining the good times and what politician wants that with an election coming? The net result was with too much money floating around, we had the rather unexpected result of inflation coupled with stagnation/recession. More money would not solve that. Friedman had the answer, perhaps: stop government priming the economy and correct structural deficiencies. That was not followed either – Friedman had no more success than Keynes in getting politicians to behave. What resulted was the likes of Reagan reducing government expenditure, lowering taxes, and maintaining and expanding the government deficit. Then the US Federal Reserve set the tone by reducing the money supply, even though it knew that would send unemployment soaring. They simply did not care. Anything went in the name of “economic efficiency”. 

What was undefined was “efficiency.” To answer that we have to ask what is the purpose of the economy? To the bankers it seems to be to make nice profits for banks, but surely it is more than the keeping of tidy books. For some, it is to maximize wealth, especially for themselves. For some it is to generate the means of enabling people to live in a pleasant place and live alongside nature. For others it is to enable all people to get the best out of life. Under the new economics of Reagan and others, the emphasis was on the “basics”: get the government out of the economy because they don’t know what they are doing, focus on low and stable inflation, let the rich get richer, following which the wealth would trickle down. Except the evidence is, it didn’t.  Then when it became clear that squeezing the money supply, while it might have helped make the books tidier, was generating unemployment that was too great, so central banks switched to using interest rates as their primary tool. Which gets us to where the bankers are now. Interest rates have got to the point where depositing in banks is only good for security, as long as the bank does not go belly up.

What actually happened was that when the corporations noted that the government did not care about employment it fired its workers, thereby saving money on benefits, etc. and moved manufacturing to low wage countries. Basic manufacturing, like clothes, were exported to places like Indonesia or Bangla Desh, and more difficult manufacturing to China. That undoubtedly increased the wealth of the rich, but it sent the workers into low-paying jobs in the service industries. Meanwhile, there was a somewhat unrecognized crisis in the academic community, and in particular the physics community. Funding had dropped and we had a large number of highly educated unemployed. The physicists, in particular, were good at computer modeling, and they got jobs in banks to create new “financial products”. The banks made huge profits until about 2008. The problem with these “products”. which were sliced and diced debt, were based on the assumption that nothing significant could go wrong, but in the US, for political reasons, a huge number of houses were sold to people who had no hope of repaying the mortgages. Oops. 

We have sort of recovered from that, but the legacy is that thanks to COVID 19 the debt levels of so many countries is extraordinarily high, interest rates are ridiculously low they cannot go lower, so there is no incentive to save. Money goes into assets, which merely inflates the price of the assets. Stock at $100 is worth that if you can sell it for that, but at the end of a period of time, you have to look at the overall returns on investment. In a bubble, everyone makes money until the music stops, then the losses are concentrated on the then holders. COVID has forced the nervous investors to cash out and the stock market fell, but it is coming back because of the quantitative easing. So what happens when the quantitative easing stops and the bonds are cashed out?What is clear is that we cannot look to the past for ways to get out of this. We have to try something new, but what? If you look at our leaders, do any of them have a solution to what happens after quantitative easing? Or do they have their heads in the sand and assume that will be for another electoral cycle?

Where to now, economy?

While I write futuristic novels, none of them involve trying to predict the future; rather I use the future as an excuse to formulate a situation that has little merit other than to be the background to a story that is really looking at something else. However, like most people, I am curious about what could be coming. That includes wondering where the economy is going.

Some time ago I saw an interview with Mervyn King, an ex-Governor of the Bank of England. According to him, in a market economy banking crises are endemic because a market economy cannot provide all the required price and investment signals. This is effectively a statement that there is an inherent failure in the market economy, and it arises because nobody can predict the future, and there are the problems of positive feedback (where the effects of the problem make it worse) and hunting (where the correction dramatically overshoots and causes the opposite problem). Thus suppose commodity A suddenly has a shortage. Prices rise, the masses start acquiring A and the price rises further, but there is no fundamental reason for the rise. When reality strikes, prices drop, and keep dropping.

I recall in my youth the price of potatoes tanked, and farmers found themselves dumping them. My father immediately began renting land, and with a trailer, went around the potato dumps and picked up free seed. Next season, because everyone had got out of potatoes, and also partly because of adverse weather in places, prices leaped five times above average. At that point, my father made a lot of money, but immediately got out of potatoes, on the grounds that next year everyone would be back into them. Now, King’s point is, bankers lend to farmers, but they cannot know what next season’s prices will be, and hence cannot know whether the farmer will prosper or go bust. In New Zealand there are a number of dairy farmers who got into it with expensive farm conversions when prices were very high a couple of years ago. When the world became swimming in milk, the debts still had to be serviced.

The question then is, can anything be done about this? My guess is, so far there are no signs that anything better would work. A long time ago I was in the old USSR, a command economy, and basically it was not working at all well. Prices were stable, by command. I went into a restaurant and picked up a menu that was printed twenty years before and the prices held! The problem was, I also went into a major store to see an array of empty shelves. The prices might have been stable, but if the goods were not available, their price was irrelevant. In one of my trilogies, I proposed an economy that was stable, BUT there is no evidence it would actually work. The proposal was simply background to make the rest of the story easier to follow, and in any case, there were price rises due to resource shortages. However, there was no possibility of major recessions, or major booms. Perhaps I was dreaming?

Another one of King’s points was that while central banks avoided a catastrophe in 2007 – 2008, since then, the basic fundamentals have not been corrected. In particular, there is a serious disequilibrium between saving and debt, largely due to very low interest rates. The problem is, the longer this goes on, the harder it will be to return to some desirable “normal”.

King was also somewhat skeptical about the European Union, and noted that a single interest rate imposed on countries with varying rates of wage and cost inflation leads inexorably to divergence in competitiveness. Well, yes, it would. German banks would seem to have to take some major losses, but they seem reluctant to do so. (Note that Germany itself has defaulted on debt before.)

King’s way out is to boost productivity and growth, and he was enthusiastic about the TPP trade agreement. My guess is that Trump will kill that option.

The problem I see with that analysis is that King thinks society in the future will be more or less the same as now. I am less convinced. In many western countries, the biggest problem is that local manufacturing has been exported, and this has led to the hollowing out of middle classes. While the very top corporations are raking in huge profits (and paying increasingly less tax) the wage earners tend to find their wages actually reduced. Governments are compensating by increasing their borrowing, thus taking advantage of lower interest rates. The problem here is, with the exception of the US and others undertaking quantitative easing, while central banks might offer low interest rates, they do not lend because to do so without borrowing is simply to enlarge the money supply. The US has got away with quantitative easing largely because trillions of dollars have been secreted away in foreign banks as a consequence of tax avoidance. However, the debts remain.

For the general economies of countries like New Zealand, while the Reserve Bank recently lowered interest rates, the commercial banks actually slightly raised them. The reason: they need deposits, and as interest rates have dropped, people have gone searching for yield elsewhere. Here, a lot has gone into housing, largely because there is a shortage of houses, but this has not created a lot of new houses. Instead, as King would have noted, this must lead to a bubble happily fermenting, although because of the underlying shortage (which is politician induced) it may not burst. Here, politicians are the problem through sending perverse signals and regulations to the market. Money has also fled towards stocks, but again that tends to raise the price when more money goes there than into new ventures. Now, what happens if this bubble bursts? Governments are in so much debt they have little room to maneuver. By itself, politicians might consider that as merely unfortunate, but the problem then is the consequences, one of which I included in my novel ‘Bot War. I hope that consequence does not come to pass, but I am far from confident.