Capping Banks' Rates

I've recently been in a discussion win which some academic proposed an interest rate cap for bank loans. When I asked whether he meant during the crisis or in general, his answer was "of course in general". His argument was that given the Modern Portfolio Theory which states that specific risk can be diversified away, when banks have a large amount of people as loan-takers then their individual risk will be diversified away and all you will be left with will be systematic risk which you can do nothing about. Thus, if the risk you have is just the latter, why should the banks charge different interest rates to lenders?

Although at first the idea might sound appealing to some, (it also abides with the "banks are bad people are good" motto), the problem with these kind of statements is that it shows a basic misunderstanding about how both the banking system and the risk-reward relationship actually work. To begin with, even in academia, higher risk is associated with higher reward. The basic reason is that you require a higher expected return to invest in something which will have a higher probability of costing you money. Simply put, if the risk of losing money is 10% one will surely ask for more potential money than if the risk is 5%. Thus, if the bank chooses to lend money to someone who has a 10% probability of defaulting then it makes sense to charge a higher rate than the one to be charged to someone whose probability of defaulting is just 5%.

"Sure" the academic would go on "but that risk can be diversified away". Well it depends what you really mean by that. Suppose that you have a stock market with stocks, between which you have to distribute your funds, having the following risk-return relationship:

Now suppose that someone told you that regardless of the risk, all stocks would have returns of exactly 6%. Where would you put your money into? Any reasonable investor would not be foolish enough to put his money in any stock which has a return of more than 6% in the above scenario because he knows that he will not be compensated for the risk he will assume. Thus, stocks 1,4,7,8,9 and 10 would have no-one to purchase them since their return would not be sufficient for the risk the investor assumes. In addition, stocks 2,5,6,11 and 12 would receive too much attention from investors since the risk they are posing is very little compared to what the capped return has become.

Let's put this is into banking perspective: instead of stocks, we have loans. Loans with higher expected return are those with higher interest rates, as for example business lending. If we cap the return banks can have at e.g. 6% then there will be loans which will not be issued, although in normal times the bank would most likely assume that risk and provide the funds (at a higher rate of course). What would this mean: essentially, those who have safe assets they can put as collateral, such as real estate or cash, would get funding while those who do not (for example 90% of the population) will not. This policy is not that terrible to the banks as they can adjust for these shortcomings; it is much more hazardous to the ordinary person who does not have collateral and cannot borrow at the low rates the bank will offer.

Why can't we force the bank to lend to the little guy you might inquire. Simply because the little guy bears more risk than the "big" guy. The bank has the discretion to reject any loan application it does not fit its risk-return profile. Forcing the bank to take up any loan while at the same time capping the rate is not a good idea; unless of course we really want another sub-prime lending crisis. 

In addition, high risk loans require higher capital requirements: business and consumer loans without any guarantees require much more than the 60% it is required for guaranteed ones. But the banks still give them. Not too many of course but they do. The thing is that if you take out all of the high risk loans you will be left out with no new Facebook, Google or Twitter. To get big you have to start small. And small without any lending is just tiny.

The reader would notice that my question was on the timing of the policy: if this is just a policy to be implemented as a short-term one I would have no problem against it. Why? Simply because just after a crisis banks are less willing to lend, and if they do then they lend to those who has a very low risk profile (i.e. the "big" guy). You don't have to take my word for what I described in the previous sentence; Hyman Minsky and Joseph Stiglitz said it much better, more than 30 years ago. Thus, as banks are less willing to give out funds, it would be much better to cap the rates during a crisis than after or before it for the simple reason that it would be much better for the existing loan-takers. It would take the burden off their shoulders, create an additional boost in consumption (or increase savings), thus moving us out of the recession. 

The short-term nature of this cannot be over-stated. If such policies are to be followed in the long-run then we would be in a situation where those who have will get more and those who haven't would get nothing. This is not only unfair it is also economically inefficient as, growth would also be threatened under such a scenario as no new high-risk projects would be assumed. Summing up: capping bank rates is good for the short-run, but only during a severe banking crisis; otherwise it does more destruction than benefit.

Population Growth and Interest Rates

One of the most basic tenets of economic modelling (Samuelson and Solow for example) has been that in a stationary economy the interest rate is defined by the rate of growth of the population. If population is decreasing the we get negative interest rates and if population is increasing we get positive ones. I have to admit that I had not given much thought about that until recently since I just considered it to be just another of the great simplifications economists make when they want their models to work. Yet, after reading Samuelson's original model, it somehow got into my head. If one also remembers Krugman's points on Japan and the relationship population has with inflation then the relationship between population, the economy and the interest rate is not as vague as it appears.

It is more often true than not that interest rates reflect inflation. If inflation is high (low), interest rates are also high (low). Yet inflation is not only governed by population; money supply, both commercial bank-created and central bank-created, matters much more in establishing the price level the short-run as do corporate profit margins, import prices and other (for more details see this). If this holds, which it does, it would mean that the shorter the duration of an instrument the larger the effect of the current price level on it. With respect to interest rates, it would mean that the short-run interest rate (e.g. on Treasuries) is more prone to changes in the price level than the long-run rate (e.g. on 20-year Bonds).* This can also be seen in inverted yield curves in times of high inflation.

Continuing with our rationale, it appears that long-term rates are affected by much more things than short-term ones. For example, a fall in the rate of population growth will probably not be visible for the next 5 or so years; new regulations or expected long-term projects and future inflation rates can also be included in this category. However, this should not be confused with long-term equilibria of any kind: this is not something which will work in the long-term if nothing changes (e.g. that GDP will rise in the long-run even if it has been falling in the short-run). This is the idea that results of some action are not visible now either because the change is very little every year or because it takes time for the whole plan to be completed. Think of it this way: we will find out if there is oil in area X but until all the studies and drillings are made 5 or so years will have to pass.

Thus, we can admit that there variables which take much longer to manifest are not having any effect in short-term interest rates but have an effect in long term ones. In the graph which follows, the correlation between bond yields and population growth can be observed. The further right you move along a line the longer the bond duration. 

The correlation, although not being an exact science, points out something very interesting. It appears that irrespective of whether the correlation is positive or negative, the longer the horizon of a bond, the higher the correlation (in absolute numbers). Although correlation does not mean causation, seeing that long-term demographic trends tend to have great effects on interest rates in quite important. The reverse may also hold but in a much broader sense: it does not just take low interest rates to affect population growth, yet an economy in a bad state may have some effect on that. This is not a generalized result however; if it was the all underdeveloped countries would face diminishing populations and all prospering ones would have huge population growth rates. Real life begs to differ with theory here.

Yet the main result is that population matters when it comes to interest rates. For example, have a look in Japan's data since the early 1960's (population growth is reflected on the right-hand axis):

Although changes in the population growth rate are rather small and interest rates are high, it can be clearly seen that the trend is quite similar. As population growth declines the yields in 7- and 10-year bonds follow the same trend. For example, the spike in the population growth rate in the early 1970's was followed by a spike in interest rates in the mid- to late-1970's. Obviously, the spike could also be attributed to other variables changing thus I will not insist too much on it. Still, the long-term trend is more revealing than anything else.

The spikes in yields over the time-frame seen above are not contradictory to what is being described in this post. They are actually more supportive than anything, since there is a magnitude of variables which affect long-term interest rates. As these variables have different effects on the rates it makes more sense for yields to fluctuate over time, depending on which effect is stronger. Nonetheless, interest rates and the economy in general have a strong tendency to prefer growing populations over falling ones for the obvious reason of increased demand. Thus, as correlations and trends indicate, population growth does make a difference in the long-term yields, even if its effects are almost zero in the short-term.

*Those of the readers who are thinking about the annuity formula which shows that if we increase the market interest rate longer annuity have greater fluctuations than shorter term ones I would like to remind that the formula assumes that the same market rate will prevail in all future cases. Yet, if for example, we consider the interest to rise for two years and the return to some lower level, the change in the 20-year bond will be far less than the change in the 1-year or 2-year bond since it will affect just 10% of the former's payments and none at all the present value of the maturity price while it will affect all payments in the latter's case including the maturity value.

Is the Interest Rate Inflationary?

This is a post I probably shouldn't write given the previous two ones on banking (here and here). It is, nevertheless a question, or more often, a "conclusion" I usually get when when a discussion on inflation arises. As most people have developed a somewhat irrational, deeply rooted fear of inflation perhaps instilled by the extreme rates of the 1980's, anything that appears it might assist in an increase in inflation scares them deeply. It is a reaction which runs deep in human psyche: if the extreme hurts us, then we do not even accept an infinitesimal quantity out of fear of escalation. Even so, truth is that the interest rate paid on loans is anything but inflationary. Allow me to demonstrate:

Suppose we have an economy where a bank has 60 units of currency in cash (not deposits, this is a very simplistic model). At a given time 0, a worker borrows the 50 units and builds a lemonade stand to sell his homemade lemonade from lemons he gathers at home (making his cost, other than personal labour, 0 units of currency). Lemonade is the only good for human consumption sold in this simple economy. The worker uses the proceeds from the stand to repay the loan; given that the bank wants to make a profit from the loan, it charges the worker an additional 10 units. If the loan duration is 10 years, then the total amount to be paid would be 60 units, or 6 units per year. Thus, the bank is making a profit of 1 units per year, while the worker is forced to pay half a unit per year as the cost of borrowing. 

At first, this might appear as unsustainable: how is the worker ever going to earn 6 units per year in such an economy? This most straightforward of questions, represents one of the parts of economics most people fail to see; the inability to comprehend the full circle of money, results in incomplete models and flawed understanding. The better question here is what the worker does with the money he borrows. If he could just build the stand and equipment on his own what would the point of borrowing be? He could just chop wood on his own, manufacture the screws, the nails and the hammers needed, create the juicer and cups he would need and make some boxes to keep his lemons in and have no need for extra money, just extra time. Yet, our worker cannot do all that; more so, he does not have to do all that because he purchase them and that is why he is borrowing the money.

The worker, goes to the manufacturer's shop, where, using the 50 units he just borrowed, he buys everything he needs and goes down the road to set up his shop. Although the manufacturer can create all these goods and sell them, does produce any lemonade; either because she does not have the time, the expertise, the raw material or even because she is just bored to do so since she can simply purchase it with the 50 units of currency she just got from selling her merchandise. She thus breaks the total amount to 10 annual purchases of 5 units' worth of lemonade.

Let's now consider the bank: the bank currently has 10 available units, expects to get an additional 6 every year. Yet how does the bank consume? The answer is rather simple if one considers all that exists in a bank branch. It has to pay for its employees, rent, electricity, office supplies and other equipment. For simplicity, we assume here that the bank only has to pay an employee, with a salary of 1 unit per year, with the employee spending the money in the only available good for consumption in the economy, i.e. lemonade.

The transactions for each of the 4 involved in the economy in year 1 looks like this (total money means total money available for spending):

In year 2, the same chain of  even would again unfold:

Finally, at year 10, the balances would become:

Note that here, the amount of money in the economy, as stated at the beginning, is not customers' deposits. If they were, the reader will remember from here, that when a new loan is issued, money in the economy is increased and from here, that when that loan is repaid the amount of money is reduced back to its original levels, until the amount is again re-lent. In this model, where the bank just lends out cash, money is not reduced with debt repayment, yet although the interest rate appears to create money out of thin air, all it does is in essence re-distribute money in the economy.

When a loan is repaid, the bank's income is the spread (i.e. the difference) between the deposits and loans interest rates. This money is nevertheless not withheld from the economy: they are either paid as salaries and wages to employees, or spent for equipment, rents, etc. These are all included in the bank's costs one might suggest. True, but even if we use just net profit as a measure, money is almost never left sitting idly in a safe-box. The part employed as retained earnings is used to facilitate expansions, upgrades and other stuff which will make the bank more competitive in the future. This is nothing else but consumption, albeit under a different name. Even if retained earnings are not used for consumption and are just put in marketable securities, it really makes no difference, since even marketable securities are a form of consumption (they are, in essence, a short-term loan). How about the rest of the money? Well, we shouldn't forget about dividends right? Banks pay dividends to their shareholders who are able to employ that money as they please, meaning either spending or investing it. When interest is charged, nothing leaves the economy as many would like to believe; it is just distributed differently, just like when you and I decide to spend or save.

An increase in the money supply and thus in inflation, occurs only when new loans are issued and not when the repayment means that the borrower will have give back more money (in nominal terms always) than he borrowed. The conclusion is that money does not really stay in a bank's box when the latter charges interest and receives its profit: it is mere re-distribution. Obviously, whether this re-distribution is the optimal from the society's point of view is something completely different and certainly beyond the scope of this article.

Note: The same situation would also hold if the bank was lending customer deposits, yet the amount repaid would have to be re-lent at the same time to keep money supply stable. This does not mean that the interest rate would have any different function: it would again be just a re-distribution of funds.

What Natural Interest Rate?

Most of the times, the articles that inspire me to write leave a positive impression on me. Other times, I just feel that a subject needs to be clarified or that an issue has not been addressed properly. There times though, like this one, where articles I read do not seem to understand that the issues they address are so theoretical and so convoluted that they have very little use (if any) to either consumers or firms. Although I like theory and believe that especially in macroeconomics many more (useful) conclusions may be reached from theory than empirical work (although not dismissing the latter), I share a strong resentment towards theory which cannot really focus on reality and presents the world on how it could potentially be or how its author believes it should be. Without further ado will let you know that the article which sparked this response is Miles Kimball's Natural Interest Rates: Clearing Away the Confusion

Perhaps, in some way, Kimball has cleared away the confusion on what he feels is the natural rate of interest. Although he mentions that low output levels lower the short-run interest rate (which is true) and the deeper the recession the lower interest rates should be to counter it (which is partially true), it appears that Monetarism got the best of him. Nobody would argue that interest rates play an important role in recessions, yet they are not a panacea: they can be employed to assist but they cannot do all the work on their own. For example, he states that monetary policy supposedly determines the equilibrium interest rates in the market. Yet, this not only does not really hold as Central Banks are most of the times retroactive in their responses; it is not until commercial bank rates rise that Central Banks raise theirs, meaning that unless we are to employ the previous period's policy rates in our calculations, we wouldn't factor the effect of monetary policy in estimating the short-run interest rate.

In addition, what is my greatest disagreement with not only Kimball but many economists is what is presented as the "natural" interest rate. This, is nothing but a number which might (or might not since we cannot see it) be true if we had no wage stickiness, price-stickiness or, in general, if them people (and yes I do mean all of us) did not distort the idea world economists are trying to build. (Ironically, economists do not act like the ideal people of the ideal world...)

The essence of the disagreement is that he believes (as many other economists do to be fair) that we could have both a medium-run and a short-run interest rate. What most economists fail to see is that we cannot distinguish one from the other even if they exist. In fact, they are so convoluted that we can only see the result of this interaction, without being able to see the original inputs. According to his definitions, we have an ultra short run, a short run and a medium run which would appear like this:

(Click to Enlarge)

As anyone may observe, in the medium run we would be experiencing the results of 4 distinct short run periods and 16 (!) ultra short run periods. This means that when we are about to measure the medium-run interest rate of an economy we have to take into account the short run as well, as it defines it. Suppose that we were at #1 and now we are almost at #16. According to the calculations made at #1, we would be witnessing the results of the medium-run interest rate which, according those calculations would be, say 2%. Now suppose that a recession or a boom occurs at #15, meaning that the interest rate would either be at 1% or at 3%. These effects are not due to neither fiscal policy nor technology shocks which Kimball understands as affecting the rate. They are, in fact, outcomes of the whole business cycle, models which lie behind the sticky-price, sticky-wage models.

The claim is that this medium-run "natural" interest rate is not a constant. If it was, then debunking their thinking would be too easy. Nevertheless, even saying that the medium run interest rate is not a constant actually indicates that we have some knowledge about what it would look like and we can re-calculate it with every new piece of information we get.

The reader may inquire why I am bothered with this. Yes, the medium-run interest rate is never what we calculate it to be, not just because of stickiness but because such a medium run does not exist. Still, this is just the tip of the iceberg. Kimball's argument is that investment, as he understands it, occurs when the benefit relative to amount spent is more than the real interest rate plus the depreciation rate and the obsolescence rate. What Kimball is trying to say (I think) is that basically the return on the investment made should be higher than the cost. Yet, this does not really depend on just the real rate, or to be specific the firm does not really care about the real rate. It does care about its return though. As long as the estimated return from the project is higher than the estimated rate it has to pay then the project is valuable. The firm cannot really know about the interest rate, more so about inflation, even at the Ultra Short-Run. It can only estimate them. Now, these estimates may actually affect both the rate as well as inflation, yet they are neither constant nor precise. They are mere estimates, which, considering Kimball's arguments should affect the medium run. Yet, there can be no medium-run estimate and neither can there be a long-run one. The reason is that they both require the economy to remain stable and stability is something the economy has never done.

It's not just that the economy needs to be stable to have the medium-run interest rate come out like we estimate it. It's that we have to magically transport ourselves from 2013 to 2025, with the state of the economy being exactly as it were 12 years ago, the same short run interest rate and have the exact same conditions. But... oh wait, if we had that, then we wouldn't experience the medium-run interest rate but the short-run one. This, makes the medium run a state which we cannot ever experience, even in theory.

Another issue with regards to the interest rate ups and downs is why the interest rate is lower in recessions and higher in booms. The reason that rates are lower in recessions is not because the real rate is not high enough or that depreciation rates are higher than in other periods (in fact depreciation should be the same in recessions and in booms). The reason is that the expected return in a recession is lower than the one in a boom. These are based on scenarios given the state of the economy at the time. When a wide enough problem has occurred in the economy which keeps demand down, it makes sense to lower estimates about perspective demand (whether firms are correct in estimating that is another question which is beyond the scope of this article). This means that the expected return of the project will be lower. Thus, the firms will say no to high interest rates and will continue to say no until these rates are lowered. The same logic can also be applied to consumers. If rates remain high because of Central Bank inaction, it could seriously harm investment expenditure in the country (or region).

Obviously corporate finance experts take the possible duration of a recession into consideration when they make their scenarios, but as usual when times are bad, people tend to err to the side of caution. In Kimball's words, the firms choose whether to "rent" capital (i.e. rent buildings, etc) and treats buying capital distinctly (separating it into two companies). Yet, renting capital would be the same as buying it if one considers that buying the capital means that they have to pay a depreciation expense which those who rent it do not incur. This is not really mentioned in the article, and at a point I just get the feeling that we employ perplexity for the sake of perplexity.

In addition, he mentions that people who work in corporate finance are more eager to buy when business is good than when business is bad. In all fairness, this all depends on how good or how bad things are. If sales are down 5% because of a recession, then we would be more willing to buy capital at a cheaper price than when sales are up 5% because of a boom and capital costs more. More so, he mentions that since capital does not change fast increases in wages and total worker hours push the rental rate up. This is true but it's not the whole story: the rate does go up but it is only because demand has already gone up and the firm is better off producing more than it did. Why? Well because the firm, seeing its products have more demand wishes to produce more in order to have more profits. Yet, this means that their estimates concerning new projects has been re-evaluated upwards, making them more eager to get money at just a bit higher rates than the current ones.

Thus, the workers who actually see this from the inside and understand that since their firm is expanding, money is more plentiful now and the outlook is going to be better in the future (in addition to seeing their employers earn much more than before) they demand higher nominal wages. This, in addition to the already higher demand, makes the interest rate rise. Now, from what we have already learned, this means that demand will be further encouraged with rates increasing even further.

Yet, in this analysis we have left out the role of the banks: when banks have more liquidity that they want, they are more willing to give out that money as loans. Thus, even though the demand for funds is increased during booms which makes the interest rate rise, the bank's willingness to supply funds is also increased (this means lowering the interest rates). The first is much more powerful than the latter though, for the simple reason that those who want to get money are usually more than the amount of money the bank is willing to lend, thus, the interest rate does not skyrocket unless in extreme situations (too much inflation for example). Another reason the rate does not skyrocket is that investment projects do not really skyrocket themselves. Although firms would have enjoyed it, they cannot earn a 35% annual return on a project (unless in very extreme and unsustainable cases) putting an upper limit to the rates; no firm would borrow at 15% when the most it can make is 12%.

Concluding, the main topic to be extracted from the article is that the defining powers of interest rates are firms, consumers and banks. The lower limit in a recession is imposed by the Central Bank (in the sense that it will not allow for the rate to fall below some point, i.e. not become negative) and in booms by the expected return on investments. There is no such thing as a "natural" rate of interest since it would necessarily mean that there are "unnatural" ones. There is only the prevailing interest rate of the economy. In addition, there is no "medium-run" interest rate, nor is there any way of actually experiencing such a rate; even if we lived in an ideal world filled with "homo economicuses".

Interest Rates on Sovereign Bonds: The Price of Debt

The aspect probably most sought after by the financial industry of both government and corporate bonds is yield. Yield indicates the yearly return a bond will give its owner based on the interest payments he will receive and the price the investor will acquire it for. Although at the time of issue a bond's yield equals its interest rate, the situation is soon altered as trading makes the two deviate. Yet, from the sovereign's point of view, the most important aspect of bond issuance should be the interest rate, for the simple reason that it reflects the price it has to pay for the credit received.

The rationale behind this idea is simple: when a nation has to pay more to get credit, its possibilities for growth are diminished as it is obliged to allocate more of the yearly budget to service existing debt, depriving resources from the economy both through decreased government spending as well as increased taxation or unnecessary money printing. In addition, funds employed to service the debt could have been used more effectively in promoting more growth, which in its turn would decrease the debt burden and the borrowing costs promoting a benevolent cycle. In the Eurozone, the situation is exacerbated by the fact that no nation has the liberty to use a sovereign currency, thus increased borrowing costs are a burden the taxpayer unavoidably has to assume.

On examining the current data on bond interest rates (one has to do some data mining to find what the average interest rate paid is) one of the most interesting aspects is that bond interest rates were increasing even before the crisis for some countries. The following is a graph of the interest rates on bonds of 9 Eurozone countries from 2001 to 2011 (data obtained from World Bank and Eurostat. Cyprus did not have any data at the World Bank database prior to 2007)

Not surprising, the lowest interest rate throughout the years has been the one of Germany, yet the Cyprus one is rather amazing. Historically, the island now notorious for setting a precedent on depositor bail-ins, had at a time been paying interest rates with a spread of approximately 7.5% from the German one. Yet, as it appears, the market caught up with what had been going on and in 2011 Italy, Ireland and Greece had taken her place as the leading interest payers in the region. Unfortunately, the World Bank database was not yet updated for 2012 data.

Nevertheless, although the numbers are not up-to-date, they indicate that the market has much predicting power, even in the case of sovereigns. Italy's interest rates have been on the rise since 2010 as have been Greece's and Portugal's although Italy has not yet requested any assistance, Portugal required assistance a year later and Greece did not file for help until mid-2010 and the aid received was for restructuring the debt. In addition, France has also seen interest rates rise in the last two years (2010-2011) as a result of increasing uncertainty about the state of her economy. One can safely assume that data for 2012 would indicate that interest rates in the troubled countries have further increased while in safer countries like Germany they have decreased.

This, is supposedly a problem the OMT should have addressed. When at the issuance of government bonds, the yield (which equals to the interest rate) in higher than a threshold (and importantly the country is still in the markets, i.e. not considered junk), the ECB has pledged to intervene and purchase the bonds itself. Yet, even at relatively lower interest rates than the threshold, a country's ability to service it's debt is severely affected if the interest due is high. For example, with debt at 108% of GDP in 2011, Portugal had to pay more than 5bn euros just for interest payments or approximately 10% of her revenues. The percentage for Greece was 17% of revenues while for Germany and France was just over 5%, making troubles for the Greeks even harder as they have to generate a large amount of money just to cover their interest expenses, without addressing any other problems.

Thus, if the problem of extracting large amounts of money from the population to cover increasing interest rates is not addressed, then recovery will almost certainly be delayed for even longer. As governments cannot print any new money, increased interest rates as a result of uncertainty and fear about the sovereigns' futures can only signify that more funds would be taken from the real economy and given to non-productive uses, creating a vicious cycle. This, will only add to the abundance of problems faced by the South while not promoting any solutions whatsoever.

Counter-economics for the Japanese Economy: Interest Rates and Growth

Japan provides one of the most interesting cases of economic booms and bursts the world has ever experienced and provides a staggering example of how the real world is affected by the state of the economy. Since the Japanese real estate bubble of the late 1980's, the economy has gone through what has been dubbed as the Japanese lost decade(s). Strangely, although many indicators show that the economy has been growing and things should be doing much better, it does not really feel like this to most economists and certainly not to most residents. (Click to enlarge graphs; all data from tradingeconomics.com)

The above indicate that both government and consumer spending have been on the rise for the past 15 years, and although confidence has seen its ups and downs it nevertheless is approximately at the same levels as during the late 1980's boom, as it was during the mid-2000's. Thus why no growth? Population (which has been slowly declining) would matter in these data only if aggregate consumer spending was less than before. Yet, this does not appear to be the issue. In addition, increased government spending also adds to aggregate demand, thus making its rise even greater. Interest rates, both interbank and central bank, are at all-time lows, which means that people should have incentives to invest or spend. This should, theoretically boost the economy and take it out of the recessionary cycle. Right? Wrong.

Despite what prevalent economic theories proclaim, interest rates are not dictated by policy but by the market. Using, the basic supply and demand knowledge from Economics 101, it is easy to see that when supply of funds is greater the interest rate paid to keep those funds in the bank is lowered. Conversely, when the economy is booming and people tend to spend more than they save, demand for money is higher by the banks (since they need it to lend more and thus have more income), making rates higher. The graph below should further clarify the subject.

The line indicates the long-term trends in savings and as you may see it has been clearly rising over the past 15-18 years and has only recently shown signs of slowing. This should also make us understand why bank credit has also been falling since the mid-1990's, with a mild recovery in the mid-2000's. Since savings have been on the  rise for the last 15 years, then people had no incentives to invest, thus no incentive to borrow money.

Thus, not surprisingly, the increase in the M2 money measure (whose increase has also been slowed down since the early 1990's) was driven by the increase in the monetary base. When the M0 trend was slowing in the mid-2000's, the rise in private sector loans made up for that loss, thus keeping the M2 trend stable.

Where I am getting with this? Bear with me for a second. Up to now, economic thinking has taught us that the central bank dictates policy, lowering rates in times of recession so that people can borrow with greater ease thus boosting investment and consumption; raising rates in times of growth, to hold things from exploding. Nevertheless, this successful policy is not an issue Japan can be proud of. Deflation has set its game in the country over the past few years and is not about to leave any time soon. Whether you call the situation a liquidity trap or anything else it matters very little to the people. Then big question is how this can be changed.

You cannot have too much of good thing and QE in Japan is living proof for this. We cannot know what result Shinzo Abe's policies will have on the economy, but we can nevertheless be optimistic that they will continue to put an upwards pressure on prices. This should induce investment and growth in both the medium- and the long-run. We are forgetting though that QE is nothing more than an asset swap, supposedly forcing banks to lend more money since they have all that excess liquidity in their hands. What it does not say is how much banks will lend and how willing are customers to assume those loans.

As mentioned before, economists traditionally believed that monetary policy, as dictated by the Central Bank, was tantamount to countering crises and recessions. After years of education, finance practitioners have also grown accustomed to the "fact" that the interest rates are dictated by the almighty Central Banker. These are the gospels of monetary policy and, along with "unorthodox" measures like Quantitative Easing are supposedly the most important facets of the Central Bank's function.

This understanding of the world dates from the monetarist view of the 1950's. The previous understanding of how the world functions can be found in Keynes's "Tract on Monetary Reform", where it is stated that interest rates are mainly formed by the continuous interaction between banks and customers and not the Central Bank. When demand for money is higher (i.e. customers want to borrow) banks increase their interest rates both so that they can attract more funds (to loan out later) and as a response to the increase demand for their supply (if demand for a good is increased then, all else being equal, price would rise).

While it is true that increasing or decreasing the interest rate has some effect on the overall state of the economy, it is however also true that the trend is dictated by the economy and not by the central bank. Thus, in the case of Japan, although the interest rate has been kept at very low levels over the past decade we have seen no significant increase in bank lending (other than the slight increase in the mid-2000's) or investment. This can only lead to one conclusion: people are more prone to save than to spend or invest, thus keeping the interest rate down.

The question then becomes when do people tend to spend more. The answer is relatively obvious: when they have more money and feel wealthier, as Ben Bernanke states. Low interest rates should in theory boost lending but the fact is that lending is also high when interest rates are high. The rather counter-intuitive to economic thinking, conclusion we may reach is that if interest rates are increased then both consumption and investment can potentially rise. The reason is that higher interest rates also boost spending. The maths are really simple (formulas from Wikipedia)

The future value of an annuity depends on both the interest rate on money and the number of periods. If a person wishes to save €100,000 in the next 10 years at a 1% interest rate then he will have to save approximately €790 per month. Increasing the interest rate to 3% would mean that the amount he saves would be decreased to €720 per month. The difference between these amounts is the potential increase in private consumption. The intuition behind these calculations is that people wish to save for their future, keeping a specific number in mind.They save enough to reach that number, but when assisted by increased interest rates they can save less and also reach their goals. This has a three-fold advantage: it assists people reach their goals, makes uncertainty about the future fall, increases current spending making investment and inflation grow and subsequently rises asset and stock market prices fulfilling the "feeling wealthier" notion. 

Although the idea appears to be strange, eliminating uncertainty about the future which is what makes savings fall and consumption rise. Quoting Bernanke,

"To the extent that home prices begin to rise, consumers will feel wealthier, they’ll feel more disposed to spend. If house prices are rising people may be more willing to buy homes because they think that they will make a better return on that purchase. (...) The issue here is whether or not improving asset prices generally will make people more willing to spend. (...) If people feel that their financial situation is better because their 401(k) looks better for whatever reason, or their house is worth more, they are more willing to go out and provide the demand." 

In addition, while realizing that higher wages and lower unemployment would make 65% of people spend more as a recent poll suggests, we tend to forget that the only thing which could make wages increase is an increase in consumption and spending. Then why shouldn't we use this doctrine in the US or other countries a reader might inquire. For the simple reason that Japan is facing stagnation not for the past couple of years but for the last 2 decades. Risk aversion is now deeply rooted in the Japanese culture and only a strong shock would be able to bring them back to a more sustainable path.

Critics might argue that raising interest rates would mean more trouble in repaying existing loans or creating new ones. What is forgotten here is that with an increase in the price level means that the real value of the loans will be decreased, thus allowing them to repay them with more ease. In addition, the increase in the level of prices should increase investment and consumption, leading to higher nominal wages, again assisting with loan repayments.

What should not be forgotten here is that the aforementioned policy cannot go on indefinitely (although the program should not have a specific end date) because of crowding out effects. When the economy reaches (or is close to) full capacity, government spending should be significantly decreased to counter for the expansion in consumption and investment. This should (in theory at least) bring the country to a more stable growth path than the current one.

What (German) Taxpayer Money at Risk?

It is not that anyone expected small countries to receive the same treatment as larger ones. Nor that everyone would be treated equally in the EU. Other than proclaiming "solidarity, friendship, co-operation" the people of Europe have seen very little of that from their politicians (not to mention other nations' politicians). What makes matters even worse is that decisions taken at the highest level are not even consistent.

Lately, an article in Spiegel reminded us of two incidents which happened during 2011:

1. The bail-out and nationalization of Hypo Real Estate

2. The bail-out of Commerzbank

In the first case, the German state assisted the mortgage-lender with more than €20bn, while simultaneously guaranteeing about €145bn of assets in it. The latter is just a case of the state funding the bank with more than €18bn and the bank winning a European approval to postpone the sale of its real-estate unit by 2014, effectively changing the bail-out terms.

What should be noted is that these funds came from actual German taxpayer money, with no obligation of actually returning those money back. In contrast, all other bail-outs in Europe cannot be considered a waste of taxpayer money. Let's elaborate on that. About a year ago, the bail-out agreement with Greece resulted that the latter would have to pay an interest rate of about 3.65%. Four months ago, at a Eurogroup meeting, Finance ministers agreed to reduce that rate by 1%, in order for the debt burden to remain sustainable. Thus, the effective interest rate earned is approximately 2.65%.

For comparison, the highest deposit rate for fixed or time deposits in Germany is currently at 1.4% according to Europe Bank Account Rates. Thus, the German state is in fact investing German taxpayer money, earning a substantial 1.2% more than having it sit around in a bank. There are those who might say that this reflects the fact that Greece represents a risky investment that makes interest rates so high. Yet, according to formally used risk-weights investing in government bonds is a zero-risk investment. In addition, none of the money invested in the country has so far been lost; in contrast 71% of the private sector money involved in the deal vanished into thin air. The EU appears to be the best investor in the world right now: it has money to invest, needy countries who are begging for money, thus agreeing to pay a higher interest rate (although lower than the market one) and it has the opportunity to shape laws the way it wants so that its funds are protected.

Until now, the EU has agreed on providing €144.7bn to Greece, out of a total €164.5bn package. This means, that if percentages are used as in the European budget, 21.11%, or €30.54bn of that money will come from Germany. This is an amount less than 1% of the German GDP, yet it allows for more than €800m for interest proceeds per year, for the next 30 years. What is more, this is more than €380m per year more than what they would have gotten if they had invested the money in a bank. 

It was more than known that Germany was earning huge amounts of money through lower debt interest rates; during last August, the yield for German bonds was actually negative! People were actually paying Germany to hold their money. Yet, Germany, as the rest of the well-off EU countries are pushing the deal even further by being both regulators and investors. The excuse of protecting "German Taxpayer Money" is not quite valid at the point: the German taxpayer is either earning a significant amount of money for that investment, or his money is not at all in danger if the ESM/EFSF or the ECB is paying. Regarding every euro coin as your own does not make it such.

Think of the latest deal with Cyprus. The amount to be given via the EFSF/ESM funds is €10bn, with the island paying an interest rate of about 2.5-2.7%. The most interesting part is that there are no taxpayer money at risk: by construction, all Eurozone countries have to guarantee the fund, yet no country will actually hand over any assets to it; bonds will be issued in order to cover the bail-outs it will make. Essentially, this makes the EFSF a large speculative fund with no chance of losing money: 2.5% yearly return on risk-free assets, through borrowed money and an ability to shift regulation at its will.

Then why is it that they worry about taxpayer money if that is not invested? I will leave the discussion on whether having a state act as a speculative vehicle good is beneficial. Yet, if the major concern for assisting an ailing state is moral hazard, then why not regulate banks more efficiently in the first place? For example, why did the ECB throw so much money at a bank which was evidently bankrupt since last summer? Better policies are in need if the intention is to keep the euro alive. 

P.S. As for the obsession with price stability, if the ECB is generating money, even via the "printing machine" so feared by German authorities, this does not mean that Germany will face a large inflation rate nor is that money German; they belong to Europe and the receiving nation. In addition, as Paul Krugman stated more than two years ago, money in one country does not affect inflation in all the others. For example, Cyprus could have a 20% inflation and the overall EU inflation would have been affected by much. This simple fact is also declared on the ECB's website (although I could not find the actual weights) and yet it is never mentioned.

A Good Result After All

Greek Finance Minister Yiannis Stournaras and Jean-Claude Juncker.
Source: http://tvnewsroom.consilium.europa.eu

I am more than happy to see that the EU leaders have reached a decision concerning the fate of the Greek debt. Many rumors had been surrounding this Eurogroup meeting and many feared the worst when German Finance Minister Wolfgang Schäuble and Luxemburg Prime Minister and President of the Eurogroup Jean-Claude Juncker announced that a deal was close. The new deal will allow Greece to reduce its debt burden to 124% of GDP by 2020 and to "substantially lower" than 110% by 2022 as reported in the Eurogroup statement on Greece.

For once, I have to say that they paid some attention to what I had been raging about all this time. In the What will happen to Greek debt article I had posted on Thursday, on of the two possible solutions mentioned had been pausing interest payments for a period of 5 years. What they did was not the exact same as what I had proposed but very similar:

1. decrease interest rates on the outstanding debt by 1%

2. lower the guarantee fee costs paid by Greece on the EFSF loans by 0.1%

3. extend the maturities of the bilateral and EFSF loans by 15 years

4. commit the Member States to pass on to Greece's segregated account, an amount equivalent to the income on the SMP portfolio (which basically is the Greek debt the ECB holds and basically belongs to each EU nation in a specific proportion for each) accruing to their national central bank as from budget year 2013. Member States under a full financial assistance programme are not required to participate in this scheme for the period in which they receive themselves financial assistance

In addition, as soon as the the EFSF disbursements are approved by the parliaments of all Member States, Greece will receive 43.7 billion euros, of which 34.2 will be given in December and the rest in three installments during the first quarter of 2013. Thus, as Greece will need to use 23.8 billion to recapitalize banks, almost 20 billion will be left to be allocated in the nation. 

What is the most important moral of this decision is that for once a decision was made to accommodate a nation and not to punish it for what had happened. The solution, unlike the one for the bond haircut, is more likely to yield positive results both in the short run as well in the long run without having any adverse effects on any country's economy. Hopefully, this would bring an end to series of decisions which were aimed at assigning blame rather than promoting what is good for the Union. And maybe, in a few months, they will realize that inane austerity is not the solution for the problem in the EU. Bad decisions, irresponsible bankers and corrupt politicians and policymakers are.

Interest Rates and Growth-Part 2

In the previous article I have shown data which indicate that the interest rates for loans in the South is much greater than the ones in the North. One way of explaining why is by looking at the bank rates for deposits with maturity of less than a year (Source: ECB). Have a look:

Cyprus

Greece

Spain

France

Well I think that the graphs are obvious: the cost of money for the Southern banks is substantially higher than for the Northern ones (for a graph of Germany's deposit rates take a look here). So, apparently the lending rates will be higher in the South than in the North. The big question here is why does it cost so much get new money in Cyprus, Greece and Spain?

In my opinion it boils down to two things: Uncertainty about the future of the economy and the banking system and the constant need for new money to fulfill regulatory requirements from a fixed pool of deposits. 

While the first is obvious, meaning that when a depositor or investor fears about losing his money he should be given a risk premium (i.e. additional motives, in this case a higher interest rate) in order to entice him not to leave. However, as many investors are risk averse (i.e. afraid of taking risks, in the finance lingo) they are fearful of moving their money to a country with economic difficulties and thus banks have difficulties in getting money from abroad, especially if they only operate within the country.

It is true that most Southern countries do not have banking institutions which operate in many EU countries. For example while Bankia, is the 4th largest bank in Spain and while it operates in Germany, Austria, China, France, Ireland, Italy, Poland, Portugal, the UK and the US it has limited access to funds outside Spanish borders. In the end of the spectrum, Banco Santnader, with significant presence all over the world has negligible needs. The same goes for Cyprus as Cypriot banks only have important presence in Greece, which has now evolved as the main cause of their problems. The only bank with a relatively large presence in the island which is not either Greek or Cypriot is Société Générale. In Greece HSBC and Citi are the only ones which are neither Greek nor Cypriot. In all three countries the market share of international banking institutions is minimal. The same holds for Italy, where only UniCredit has substantial presence in foreign markets.

Although I am not in favor of large banks (remember too big to fail scenarios in 2008-2009?) in this case, having a presence abroad would mean access to cheaper deposits, thus in its turn lowering both the deposit and lending rates in the country. Note that the banks which needed government intervention for continuing their operations during the EU sovereign crisis (and not the sub-prime lending one) were mostly the ones with limited access to foreign cash.

In addition to what I have said above look what the Governor of the Central Bank of France has stated: the interest rate facing individual private banks depends on the funding costs of the state where they are domiciled and not on the ECB overnight interest rate”

Yet, it seems like none of the EU policies has taken this phenomenon under consideration. If policies in the Euro level cannot have any effect in the national level then what is the Union's and ECB's purpose?

Interest Rates and Growth

In early July 2012, the ECB decided to cut the interest rate by 25 basis points (for those who are not familiar with the expression one basis point is 0.01%. So 25 basis points is essentially 0.25%. Don't ask me why the just cannot say 0.25% I have wondered about it many times before!). This was considered as an attempt to boost investment in the Eurozone, by making both lending and deposit banking rates fall. The following graphs represent the effect this policy had in Germany for deposits and loans with maturity up to 1 year (all the data for the following graphs were collected from the ECB website):

Deposit Rates

Lending Rates

As you may see deposit rates have been steadily falling over the last year, reaching a level below 0.5% in July. The lending rates had reached a top of 4% in late 2011 and have roughly stabilized at about 3.30-3.40% during the last months. Obviously the EU policy change had some effects in reducing the deposit rate whilst it had insignificant ones in the lending rate.

Now, compare this with the lending rates in Greece, Italy, Spain and Cyprus:

Cyprus

Greece

Italy

Spain

Notice anything different? Yes, indeed. For each one of these countries the interest rate has been higher than Germany's by about 1.2% in the case of Italy and an astonishing 4.1% in the case of Cyprus. Greece, with all the apparent problems in their economic system has a lending rate of approximately 7%! Although the EU policy of reducing interest rates from 1% to 0.75% has obviously had some effects in these countries. the fact is still that with lending rates this high there cannot be a significant increase in investment. Without an increase in investment the above countries cannot have the growth they need to raise from the depths of the banking and sovereign crisis they have entered about a year ago.

Rates this high did not even occur in 2008 in Germany where at its maximum, the rate was about 6%. While the common approach for central bankers and policymakers is to manipulate the interest rate when the circumstances require it, this is not always the optimal solution. In order for the banks to be able to lend, they themselves have to have an abundance of money and not worry whether they can achieve Core Tier 1 requirements which have increased in the midst of a banking crisis! (In the realm of bad decisions, this has to be one that deserves to be appointed king).

Thus, having no resources to lend, banking institutions in the South have to be extremely selective of whom they will lend. Having less than enough deposits, makes the deposit rates soar, making lending rates follow. More on deposit rates on the following article.