Today central banks have a limited toolkit and the powers to deal with the savings glut (see image below), lack of investment, climate change and income inequality. There is a lot of money in the system but the velocity of circulation is slow – MV=PT – and this is one reason why we have little inflation.
Velocity of circulation of money is part of the the Monetarist explanation of inflation operates through the Fisher equation:
M x V = P x T
M = Stock of money V = Income Velocity of Circulation P = Average Price level T = Volume of Transactions or Output
Add to this COVID-19 and the impact it has had on especially developing economies and we have economic stagnation.
Some economists have suggested the need for more expansionary fiscal policy as well as structural reform to achieve economic growth. The latter being a long-term policy can take the form of price controls, management of public finances, financial sector reforms. labour market reforms etc. Although the US Federal Reserve is adopting a flexible average inflation target to avoid a disinflationary environment it will not be enough to deal with secular stagnation.
Secular stagnation Since the GFC in 2008 it is evident that low interest rates are the new normal and according to Larry Summers (former Treasury Secretary) we are in an era of secular stagnation. This refers to the fact that on average the ‘natural interest rate’ – the rate consistent with full employment – is very low. There can be periods of full employment but even with 0% interest rates private demand is insufficient to eliminate the output gap. The US was in a liquidity trap for eight of the past 12 years; Europe and Japan are still there, and the market now appears to believe that something like this is another the new normal.
Paul Krugman suggests that there are real doubts about unconventional monetary policy and that the stimulus for an economy should take the form of permanent public investment spending on both physical and human capital – infrastructure and health of the population. This spending would take the form of deficit-financed public investment. There has been the suggestion that deficit-financed public investment might lead to ‘crowding out’ private investment and also how is the debt repaid? Krugman came up with three offsetting factors
When the economy is in a liquidity trap, which now seems likely to be a large fraction of the time, the extra public investment will have a multiplier effect, raising GDP relative to what it would otherwise be. Based on the experience of the past decade, the multiplier would probably be around 1.5, meaning 3% higher GDP in bad times — and considerable additional revenue from that higher level of GDP. Permanent fiscal stimulus wouldn’t pay for itself, but it would pay for part of itself.
If the investment is productive, it will expand the economy’s productive capacity in the long run.This is obviously true for physical infrastructure and R&D, but there is also strong evidence that safety-net programmes for children make them healthier, more productive adults, which also helps offset their direct fiscal cost (Hoynes and Whitmore Schanzenbach 2018).
There’s fairly strong evidence of hysteresis — temporary downturns permanently or semi-permanently depress future output (Fatás and Summers 2015).
Source: “The Case for a permanent stimulus”. Paul Krugman cited in “Mitigating the COVID Economic Crisis: Act Fast and Do Whatever It Takes” Edited by Richard Baldwin and Beatrice Weder di Mauro
According to the Westpac publication “Economic Overview” it is debateable as to what is the saving issue New Zealand is trying to address:
* a lack of saving that limits growth
* a lack of saving that impacts on external debt
* a lack of saving that impacts on those reaching retirement age
* a lack of saving that affects domestic capital markets
* a lack of saving that affects the government budget especially with an ageing population
Although our saving rate is low compared to other OECD countries – 22nd out of 28 countries – saving is not a reliable indicator of economic growth. For instance look at the following examples:
– Japan has had a high rate of saving and low economic growth
– USA is a rich developed nation but has a poor savings record
– Developing countries tend to have good savings rates.
Even our low saving rates hasn’t impacted greatly on investment as there has been open access to capital markets worldwide and NZ’s gross investment has averaged close to the OECD mean (22.5% of GDP). What has been the issue is the poor quality of investment – we have high residential and government investment, but relatively low business investment.
Poor quality invesment and significant foreign debt does leave NZ exposed to an external funding shock. But the best defence in this situation is a floating exchange rate (unlike the Euro zone countries). If NZ looks a dodgey investment the interest we pay will go up but the subsequent drop in the exchange rate will make our exports more competitive. According to Niall Fergusson (author of Ascent of Money and a Harvard Professor) a funding crisis is caused by:
1. Excessive debt
2. Excessive interest payments
3. Excessive reliance on foreign capital
4. Low GDP and investment
5. Political – government deficits
6. Irrational exuberance
How does a country get out of an extreme debt situation? As stated in the ‘Economic Overview’ there are a few options:
1. Cut spending to fit income
2. Lower interest rates
4. Print money and deflate debt
6. Generate a higher growth rate of GDP
For NZ the options are cut or go for growth. However policies that focus on higher savings are at high risk of failure. Better to have greater emphais on quality investment that can generate income and hopefully saving. However, our debt is mainly private rather than government which is the only redeeming quality.
Yesterday on Morning Report (Radio New Zealand) Reserve Bank Governor Alan Bollard urged for greater saving amongst the population. Three reasons for this:
1. it would reduce interest rates and boost economic growth
2. lessen New Zealand’s vulnerabilty to global finaincial shocks such as a financial crisis
3. take the pressure off the NZ$ and promote export growth
Furthermore our high level of external debt was the main reason behind the Standrad & Poors warning of a downgrade in NZ’s credit rating. The Government expects to return to surplus by 2016, but speeding that up would be one of the most important measures to improve the level of savings. He suggested the Government should also think about moving towards a Nordic-type tax system where income on capital is taxed at a lower rate than labour income.
In the year to March 2010, New Zealand’s gross savings rate increased to 16.9% of GDP from 14.8%. However in OECD terms this is quite low but one needs to be cautious about coming to conclusions that high savings rates are paramont for economic growth. In recent years Australia has maintained a savings rate of 22% compared to New Zealand’s 16.9% but if you look at Ireland over the last ten years its savings rate exceeded that of Australia (see chart below) – we all know what happened to Ireland in the last few days.
Likewise, the United States’ gross savings rate has for the most part has been below that of New Zealand and Japan’s has been well beyond both countries. It’s difficult to argue these two major economies are chalk and cheese in their present economic predicament or outlook. We also note that while the German economy has been a shining light through the global recession its gross savings rate has fallen noticeably over the last couple of years.
We all have heard of the Paradox of Thrift which states that if everyone tries to save more money during times of recession, then aggregate demand will fall and will in turn lower total savings in the population because of the decrease in consumption and economic growth. However there is reason to believe that another paradox of thrift might become prevalent over the next few years.
Since the finacial crisis interest rates of 1% or below have been evident in most industrialised countries and this has had severe ramifications for savers for the following reasons:
1. Low rates increase the liabilities of pension schemes as you need a much larger capital pot to buy a given level of income.
2. Deflation cuts the nominal incomes of those that have to fund future pensions, creating another potential gap between assests and liabilities. The consequences are clear for pension plans – more money will have to be put aside ie savings will have to go up.
3. Low interest rates makes it harder to accumulate a given capital sum as investment returns are lower. This means that more work needs to be done by the saver.
The Economist talks of a new cultural shift. We used to talk of borrow now, pay later but a more appropriate expression might be save now, rather than starve later. Another point to note is the numbers of people who do not have a pension plan in the UK:
47% of women of working age group
22% of adults aged between 55 and 64.
Low interest rates, which have the main aim of encouraging spending, could have the perverse effect of encouraging saving. Check out last week’s Economist article.
Another great RSA animation. Are we really as altruistic as we might like to think? Steven Levitt and Stephen Dubner of Freakanomics and SuperFreakanomics look at the case for reevaluating the evidence.