Finally, after long being urged to worry about deflation and not inflation,
the European Central Bank has again lowered interest rates. In the wake
of the multiple reductions by Alan Greenspan this was only a matter
of time. After all, it is now received wisdom that lower interest rates
hold the key to a revival of demand in the Organisation for Economic
Co-operation and Development world.
But is it not time we looked more closely at this simple assumption?
We should look not only at its failure in Japan, but generally at the
impact of lower rates on household incomes. That is apparent in Hong
Kong as well as Japan and much of Europe.
Cuts are often a zero-sum game. For every over-leveraged corporation,
homeowner or borrower from credit card or auto finance company who will
benefit, there are those who lose income.
In Japan, low returns on savings have discouraged those with strong
personal balance sheets from spending more. Low rates have prompted
increased savings, not higher consumption. They end up delaying dealing
with structural economic problems. More likely they exacerbate them.
Faced with very low interest income, the response in Japan has been
for the thrifty to save even more in compensation for reduced expectations
of future, and particularly post-retirement, income.
Meanwhile the very low rates in Japan have enabled those deeply in
debt - mostly corporations - to put off the cuts, restructurings and
closures that are necessary for a return to economic health. They have
also encouraged the belief that the outsized government debt incurred
in a vain attempt to stimulate the economy is manageable because the
interest cost is, for now, so low.
The government has attempted both Keynesian fiscal stimulation and
monetarist expansion of money supply to get out of the hole. But the
fiscal stimulus has mostly gone to uneconomic public works projects
or to direct lending to unviable businesses. The monetary expansion
has failed because the economy is still burdened, not just with bad
loans in the banking system but with excess supply in many areas of
In Japan, and Hong Kong, near-zero interest rates might be justified
by the long period of deflation they have endured. Rates have remained
positive in real terms while negligible nominal rates have not had the
stimulative impact once expected of them.
The US, meanwhile, does not face deflation - at least not yet. Inflation
is around 2 per cent while the federal funds rate after the last cut
is just 1.25 per cent and money supply is still growing at a smart pace
- M2 growth at 7 per cent over 12 months and 8.5 per cent annualised
for the past three months.
It is hard to imagine that yet another reduction will do anything for
capital spending, given the existing level of over capacity and the
high risk premium now placed on much corporate debt. More likely it
will just delay the capacity reductions and corporate failures needed
to restore pricing power.
The latest US cut may enable the home refinancings and real estate
prices surge to continue.
But encouraging baby boom homeowners for whom retirement is not so
far off to reduce the equity on their homes will make matters worse
in the future. Meanwhile, small savers who have accumulated large net
credit positions in bank and savings and loan deposits will see their
incomes further squeezed.
Low rates may make it easier to finance a war. They may also help end
the dollar's over-valuation. The US currency slipped in the wake of
rate cut expectations and a 10 per cent decline from here would certainly
help US corporate profits. But on balance, low rates will make those
who have been thrifty in the past even more so while delaying the slowdown
in household and corporate debt creation needed for longer term economic
Internationally, low rates are constraining spending with healthy household
savings and strong current account surpluses. At the same time, they
are fuelling spending in the US and other economies where consumption
is excessive, savings minimal and current account deficits huge. In
a vain attempt to avert a necessary recession, they are storing up much
bigger problems for the future.
As for Hong Kong, low rates have helped the minority who over-indulged
in the pre-1997 speculative bubble. Very low interest rates also suggest
that low returns on capital are to be built into our expectations -
which, as in Japan, can only create an even bigger gap between reality
and what corporate pension funds have assumed and what some life insurance
companies have rashly promised.
Pension underfunding in the US and Europe was bad enough, and if very
low interest rates mean that more corporate profits have to be diverted
to fill the gaps, capital spending will be further curtailed.
Whatever their short term impact, the latest round of rate cuts sends
the wrong message. Worse, they will not work.
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