In the next downturn (which may have started last week, yee-haw), the world’s central banks will face a bit of poetic justice: To keep their previous policy mistakes from blowing up the world in 2008, they cut interest rates to historically – some would say unnaturally — low levels, which doesn’t leave the usual amount of room for further cuts.
Now they’re faced with an even bigger threat but are armed with even fewer effective weapons. What will they do? The responsible choice would be to simply let the overgrown forest of bad paper burn, setting the stage for real (that is, sustainable) growth going forward. But that’s unthinkable for today’s monetary authorities because they’ll be blamed for the short-term pain while getting zero credit for the long-term gain.
So instead they’ll go negative, cutting interest rates from near-zero to less than zero — maybe a lot less. And their justifications will resemble the following, published by The Economist magazine last week.
DENMARK’S Maritime Museum in Elsinore includes one particularly unappetising exhibit: the world’s oldest ship’s biscuit, from a voyage in 1852. Known as hardtack, such biscuits were prized for their long shelf lives, making them a vital source of sustenance for sailors far from shore. They were also appreciated by a great economist, Irving Fisher, as a useful economic metaphor.
Imagine, Fisher wrote in “The Theory of Interest” in 1930, a group of sailors shipwrecked on a barren island with only their stores of hardtack to sustain them. On what terms would sailors borrow and lend biscuits among themselves? In this forlorn economy, what rate of interest would prevail?
One might think the answer depends on the character of the unfortunate sailors. Interest, in many people’s minds, is a reward for deferring gratification. That is one reason why low interest rates are widely perceived as unjust. If an abstemious sailor were prepared to lend a biscuit to his crewmate rather than eating it immediately himself, he would deserve more than one biscuit in repayment. The rate of interest should be positive—and the sharper the hunger of the sailors, the more positive it would be.
In fact, Fisher pointed out, the interest rate on his imagined island could only be zero. If it were positive, any sailor who borrowed an extra biscuit to eat would have to use more than one biscuit in the future to repay the loan. But no sailor would accept those terms because he could instead eat one more piece from his own supply, thereby reducing his future consumption by one, and only one, piece. (A sailor who had already depleted his supplies, leaving him with no additional hardtack of his own to eat today, would be in no position to repay borrowed biscuits either.)
That was bad news for thrifty seafarers. But worse scenarios were possible. If the sailors had washed ashore with perishable figs rather than imperishable hardtack, the rate of interest would have been steeply negative. “[T]here is no absolutely necessary reason inherent in the nature of man or things why the rate of interest in terms of any commodity standard should be positive rather than negative,” Fisher concluded.
Two years ago, when the Bank of Japan (BoJ) began charging financial institutions for adding to their reserves at the central bank, its negative-rate policy was harshly criticised for unsettling thrifty households, jeopardising bank profitability and killing growth with “monetary voodoo”. Behind this fear and criticism was perhaps a gut conviction that negative rates upended the natural order of things. Why should people pay to save money they had already earned? Earlier cuts below zero in Switzerland, Denmark, Sweden and the euro area were scarcely more popular.
But these monetary innovations would have struck some earlier economic thinkers as entirely natural. Indeed, “The Natural Economic Order” was the title that Silvio Gesell gave to his 1916 treatise in favour of negative interest rates on money. In it, he span his own shipwreck parable, in which a lone Robinson Crusoe tries to save three years’ worth of provisions to tide him over while he devotes his energies to digging a canal. In Gesell’s story, unlike Fisher’s, storing wealth requires considerable effort and ingenuity. Meat must be cured. Wheat must be covered and buried. The buckskin that will clothe him in the future must be protected from moths with the stink-glands of a skunk. Saving the fruits of Crusoe’s labour entails considerable labour in its own right.
Too many Crusoes
Even after this care and attention, Crusoe is doomed to earn a negative return on his saving. Mildew contaminates his wheat. Mice gnaw at his buckskin. “Rust, decay, breakage…dry-rot, ants, keep up a never-ending attack” on his other assets.
Salvation for Crusoe arrives in the form of a similarly shipwrecked “stranger”. The newcomer asks to borrow Crusoe’s food, leather and equipment while he cultivates a farm of his own. Once he is up and running, the stranger promises to repay Crusoe with freshly harvested grain and newly stitched clothing.
Crusoe realises that such a loan would serve as an unusually perfect preservative. By lending his belongings, he can, in effect, transport them “without expense, labour, loss or vexation” into the future, thereby eluding “the thousand destructive forces of nature”. He is, ultimately, happy to pay the stranger for this valuable service, lending him ten sacks of grain now in return for eight at the end of the year. That is a negative interest rate of -20%.
If the island had been full of such strangers, perhaps Crusoe could have driven a harder bargain, demanding a positive interest rate on his loan. But in the parable, Crusoe is as dependent on the lone stranger, and his willingness to borrow and invest, as the stranger is on him.
In Japan, too, borrowers are scarce. Private non-financial companies, which ought to play the role, have instead been lending to the rest of the economy, acquiring more financial claims each quarter than they incur. At the end of September 2017 they held ¥259trn ($2.4trn) in currency and deposits.
Gesell worried that hoarding money in this way perverted the natural economic order. It let savers preserve their purchasing power without any of the care required to prevent resources eroding or any of the ingenuity and entrepreneurialism required to make them grow. “Our goods rot, decay, break, rust,” he wrote, and workers lose a portion of their principal asset—the hours of labour they could sell— “with every beat of the pendulum”. Only if money depreciated at a similar pace would people be as anxious to spend it as suppliers were to sell their perishable commodities. To keep the economy moving, he wanted a money that “rots like potatoes” and “rusts like iron”.
The BoJ shuns such language (and, in the past, has at times seemed determined to keep the yen as hard as a ship’s biscuit). But in imposing a negative interest rate in 2016 and setting an inflation target three years before, it is in effect pursuing Gesell’s dream of a currency that rots and rusts, albeit by only 2% a year.
The “rot and rust” referred to here is of course inflation. And the economists proposing aggressive inflation as a desirable kind of public policy cite a lack of demand for borrowing as their rationale. Which is wrong for a variety of reasons, including:
1) Most forms debt are soaring in most places, making the idea of a borrower shortage look kind of silly. Global debt has about doubled in the past two decades to $233 trillion, or a record 330% of GDP. And US per capita consumer credit – the proceeds from which are spent in large part on Japanese stuff — is rising at an apparently accelerating rate, which implies robust demand for credit.
2) The idea that a rapidly-depreciating currency is a force for stability is, well, crazy, because people aren’t stupid. When we see a currency losing value we naturally front-run the process by borrowing as much as possible and spending the money on stuff that we otherwise wouldn’t buy. This will indeed generate growth in the short term. But long-term it leads to an over-leveraged society that is vastly less stable than it was before the debt binge. Like today’s, in other words.
3) The assertion that “sound” money with an unchanging value leads to unacceptably low levels of economic activity can be disproved with a quick glance at the history of the Classical Gold Standard, a period of two centuries prior to World War I in which national currencies were simply names for different weights of gold. During this period of stable money, inflation was zero (actually slightly negative, meaning money got more rather than less valuable) and growth was robust. The next chart shows inflation since 1800. Note that the trouble began with the establishment of the Federal Reserve in 1913 and really got going with the 1971 breaking of the final link between gold and fiat currencies.
4) To the extent that anyone anywhere is reluctant to borrow it’s probably because past episodes of hyper-easy money have saddled them with so much debt that new debt is now somewhere between scary and inconceivable. The solution to this group’s problem can’t possibly be more borrowing.
5) To state point 2 in a slightly different way, encouraging people, corporations and governments to borrow rather than save leads to a society with no savings (duh!) and therefore no cushion against life’s vagaries. Here again, the result is a system lacking resilience and therefore more likely to collapse.
An alternative to pro-inflation Keynesian theory that’s consistent with 3,000 years of history (rather than Japan’s past couple of decades) is that money is the one thing that should never “rot, decay, break, rust” because it’s not a commodity that’s consumed.
Instead, it’s the store of value and communication medium that society uses to preserve wealth and express ideas of value. Changing it is like making “minutes” or “kilometers” different over time. The resulting dysfunction outweighs whatever benefits might accrue to the political class in the moment.
But of course in the panic of the next downturn these arguments will be ignored and interest rates will plunge to levels that seem shocking even by today’s loose standards. Whether that ignites an unstable boom or an immediate crash remains to be seen. Either way, a return to “normal” as that term used to apply is out of the question.