Of academic and ancient wars
The ECB and the Larry Summers vs Paul Krugman contest
Almost exactly at the time the European Central Bank (ECB) is preparing another decline in the deposit rate, doubts in academic circles on the efficacy of negative rates are mounting. This is not helping Draghi at a time when he is now facing “ex ante” public dissent from the hawks on the Governing Council. Their reservations are more focused on a resumption of bond buying than on a depo cut, and we think Draghi still commands enough of a majority to deliver a “package” on 12 September. Still, we are concerned by the divorce between the enthusiasm of the market for deeply negative yielding assets and the macroeconomic benefit which we could get from it. Draghi often says that for rates to be higher tomorrow they first need to be lower today. However, a key ingredient in this happy sequence is a fiscal stimulus. If this is not forthcoming, the whole strategy could prove counter-productive.
There was quite a bit of introspection at Jackson Hole and Jay Powell in his introductory remarks set the tone: how can central banks deliver on their mandate when the neutral interest rate is low. The dominant neo-keynesian answer to this – advocated by Paul Krugman in particular – is relatively simple: dispose of the zero lower bound (ZLB) on interest rates. Indeed, if the neutral interest rate – which is consistent with trend nominal growth – is already low, then in case of even a run of the mill cyclical accident, nominal rates may need to fall in negative territory quickly to re-start the economy. This can be achieved by conventional means – “simply” taking the policy rate below zero – or by unconventional ones – such as QE. Larry Summers in a series of tweets and a short Project Syndicate column published when Jackson Hole was starting cast a doubt on Krugman’s fix.
Summers explicitly relied on Thomas Palley’s longer paper which provides a long list of reasons why negative rates could fail to re-start the economy:
- Higher savings ratio. In principle, lower interest rates have an ambiguous impact on consumption. The substitution effect (households bringing forward their consumption) is positive while the income effect (households, who are net creditors, receive less interest payments) is negative. Usually the net balance is positive. However, when interest rates are negative, households may “over-react” and raise their saving because they are psychologically adverse to see their nominal interest income fall and not just slow down (Kahneman’s endowment effect). Summers adds a twist with “target saving behaviour”: assuming households save to achieve a certain level of future income, expectations of negative interest rates would make them lift their saving effort.
- Bank lending contraction. Palley exhumed a few sentences by Keynes on “intermediation costs” suggesting that while the “pure” interest rates may well be negative, banks may be (and usually are) unable to pass it to actual borrowers. More generally, Summers argues that deteriorating bank profitability in a context of negative rates may ultimately lead to a decline in aggregate lending.
- Capital mis-allocation. A key point in Palley’s approach is that as long as firms can find non-reproducible assets with a non-negative return (e.g. land, or precious metals, or know-how, patents and copyrights owned by rival firms), they should rationally decide to take loans to buy such assets rather than increase their productive capital. Remember that in principle rates can be negative only in a situation in which current and expected demand is particularly weak. Expected return on productive investment is thus depressed. In the end, individually it becomes rational to chase those non-reproducible assets, even if it is collectively a losing game. This would help explain why firms are at the same time taking loans and hoarding cash (for imminent M&As or to buy-back their own equity). In short, Palley argues that negative rates are conducive to bubbles. Summers again adds his own twist on the capital allocation issue with the “zombification” theme. Ultra-low to negative interest rates allow unproductive firms to survive. This impairs the usual “creative destruction” process which would ultimately raise the overall productivity level of the economy.
The risk for the economy is to be trapped in a vicious circle. We are particularly concerned with Summers’ and Palley’s points on capital mis-allocation. If productive investment and productivity are ultimately impaired by negative rates, then trend growth, and thus the equilibrium rate keeps on falling, which in turn raises the probability that actual interest rates need to go into negative territory in case of adverse cyclical shock.
A lot of these objections are not new. The ECB itself has for a long time admitted the existence of a “reversal point” beyond which a negative rate would become counterproductive. There are also some limits in our view to the new “negative rate bashing”. For instance, “bubbles” may have transitory positive effects, for instance they can spur more spending via positive wealth effects or improve lending conditions via a rise in the value of collateral. The issue of course is how to unwind them and the subsequent monetary normalisation becomes more complicated, but on balance they may still be a net positive over a whole cycle. Also, there are ways to mitigate the impact on banks - for instance via long term injection of liquidity at negative rates.
Still, it is difficult to advocate the continuation of negative rate policies if nothing is done on expected demand. This would call for a significant fiscal push. Fiscal policy has turned mildly expansionary since 2014, and quantitative easing (QE= has contributed to make this financially sustainable (Exhibit 1). But since the Euro area is now facing a new, negative external shock, the fiscal stance would need to become even more supportive. The mere continuation of the current policy would not be enough.
We pointed in our “monetary policy special” a few weeks ago to a tactical game from the ECB: hoping that taking rates further down would foster a change of policy stance in Berlin, under pressure in particular of the local financial industry. Summers’ approach is the opposite: central banks should keep their powder dry and offer little additional support to force the fiscal authorities to face up to their responsibility and engage in accommodation.
Beyond the tactical game with the fiscal authorities, we are concerned that, short of a fiscal stimulus, treating additional monetary easing as a net negative becomes a consensus view, with self-fulfilling effects on the economy via confidence. In any case, this is another reason to believe monetary policy is now generating only marginally positive returns at best. In such a configuration, a prudent approach by the ECB would be to announce only a modest package in two weeks, at the risk of disappointing the market. Our call is that the ECB will not break the 33% limit on bonds bearing collective action clauses.
Brexit: the Spartans won in the end
Boris Johnson is well versed in the classics, which he read at Oxford. He usually mentions Pericles as his favourite historical character. It is thus only right we draw attention to the parallels between the current episode of the Brexit drama and Greek history, both ancient and modern.
Let us start with modern history. This week the British Prime Minister chose to “suspend parliament” to reduce (but not altogether eliminate) the capacity of those who will oppose a “no deal” to force him to request from the European Union (EU) another extension (“no deal Brexit” is the default outcome if nothing changes by 31 October). This has some domestic implications – more on this in a moment – but we suspect this is primarily a ploy to convince the EU negotiators that he “means business” and that they should not count on the British parliament to alter the Prime Minister’s stance. In the British administration’s view, this would normally make the EU more amenable to concessions.
This reminds us a lot of the referendum Alexis Tsipras won in July 2015 rejecting the “bailout” conditions offered by the EU. The idea was that the Europeans would understand Athens “meant business”. Actually, two weeks after the referendum and coming close to a euro exit, the Greek government had to accept the terms of the bailout.
Now, the UK is not Greece. The ramifications of a “no deal” Brexit for the EU economy would be more profound than those of a Grexit which, by 2015, had become much more manageable. Besides, Europe is facing so many headwinds at the moment – with real prospects of a recession in Germany – that some “peace and quiet” on the Brexit front would be more than welcome. Still, it is unlikely that the EU would be ready to move very far away from the key tenets of the withdrawal agreement negotiated with the previous Prime Minister. These are matters of principle for the EU, and in any case the fundamental imbalance has not changed: no deal Brexit would be an annoyance for the EU. It would be a catastrophe for the UK.
Maybe some progress could be made on the “backstop” – the principle according to which the UK would de facto remain in regulatory and tariff alignment with the EU on goods, to ensure no border controls in Ireland. There has been a flurry of ideas to find alternative solutions – such as the “mutual enforcement” proposal by constitutional experts in the Verfassungsblog. Most of these last minutes ideas look quite sketchy, but there might be enough sense of emergency now for all the parts to the negotiation to agree on a “fudge” right now, the technical details postponed to some soft deadline during the transition period which comes after a deal.
An issue though is that such a “fudge” – which is by no means guaranteed – may not even be enough for the hardliners in the tory party to accept a “reformed deal”. This is where the parallel with Greek ancient history comes in. Boris Johnson reportedly knick-named those “ultra-Brexiters” who actively favour a no deal the “Spartans”. The press was reporting earlier this week that he would “see them down” and would not demand more from the EU were the council to accept a change to the “backstop”. But then he may not have the numbers in parliament to get the deal through. Boris Johnson certainly remembers that in the end, the Spartans won and Athens was defeated.
The only “narrow way” for Johnson would thus either to “terrify” enough “remainers” to support a deal to offset the “Spartans”, or alternatively to precipitate early elections which could return a wider majority for Johnson, making him less dependent on the “Spartans” (and the Northern Irish unionists). This is how we understand the domestic objectives of the “suspension of parliament”.
The remainers have until September 9th to find a majority to force the executive to request an extension. If this fails, parliamentarians will reconvene only two days before the 17 October European Council, normally the last chance to negotiate a deal. They would then be pressed into accepting whatever agreement Johnson will have hypothetically been able to broker with Brussels.
What happens if the remainers manage to find a majority? Then, it is likely Johnson would call an early election, campaigning on a “people against parliament” platform, asking the country to give him a clear mandate for a tough stance towards the EU. There would be just enough time to do so before the deadline. And then either a “pro deal” or “remain” majority emerges from the elections, and this very divided camp needs to sort out exactly what they want (another referendum? A “Norway-like” tight relationship with the EU?), or a “hard deal” to “no deal” majority emerges, and we are back to square one: would the EU move its position enough for a deal to pass.
But we also need to contemplate two other options:
- One, that the parliamentarians fail to stop the PM in his tracks, but that no deal can muster a majority in the Commons on 17 October. i.e a “double no”: no majority to extend, no majority to pass a deal. Then, unfortunately, “no deal” is unavoidable on 31 October.
- Two, that faced with procedural difficulties to agree on a motion to extend, a majority of PMs support of “motion of no confidence” against Johnson. Then Johnson can refuse to resign – there is some legal uncertainty here – and precipitate elections potentially AFTER the deadline. In this case, exiting with “no deal” would also be outcome. This puts the “remainers” in a very delicate situation: even finding a majority to replace the PM is not guaranteed to avoid no deal.
In this note our key assumption is that Boris Johnson wants a deal, just a different one. That is in itself complex, but not yet impossible to achieve and get passed. If he is reconciled with the possibility of no deal, then the outlook is much grimmer. At this stage we want to believe that rhetorics should not be taken at face value. It is a close call. It has been our long-standing view that any resolution on Brexit is likely to entail elections – with the uncertainty it entails. We think the latest events have raised this probability.
 “Whither Central Banking”, Lawrence H. Summers and Anna Stansbury. 23 August 2019.
 “The Fallacy of natural rate of interest and zero lower bound economics: why negative interest rates may not remedy Keynesian unemployment”. Review of Keynesian Economics. Summer 2019.
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