The Federal Reserve has declared that it may push U.S. interest rates into sub-zero territory. This will have a load of unforeseen consequences. After my last article analyzing this new economic territory from an Austrian-economics perspective, I take a look at the same problem through the lens of Keynesian theory.
In Friday's article I discussed the new sub-zero yield economy from an Austrian perspective:
In Friday's article I discussed the new sub-zero yield economy from an Austrian perspective:
Under negative interest rates, the upfront question for the investor is already how much money he is willing to lose. When there is no yield to compensate for greater-than-zero risk, all the investor has to look at is - yes - the risk for losses. Since treasury bonds such as those issued by the U.S. government remain zero-risk investments, they will become increasingly attractive to investors. This is significant from the perspective of Austrian theory. It means that government manipulates the debt market to a point where they can attract more investors to fund their spending today. In macroeconomic terms, this reverts the intertemporal allocation of economic resources compared to what Austrian theory tells us, but it a logical conclusion precisely based on that theory. There is an over-allocation of resources today - in the form of excessive government spending - and an under-appreciation of the need for investments for tomorrow (i.e., in the form of private-sector investments). Plainly: negative interest rates, driven by government debt, will aggravate the economic imbalance we already have between government and the private sector.
Let us now add the Keynesian perspective. Its main contribution is an understanding of how sub-zero yields will make the economy more unstable and, over time, reinforce macroeconomic stagnation. Here, the theories of Austrian and Keynesian economics merge in a powerful outlook. The full extent of that outlook will be saved for a separate piece; first, we need to inform ourselves by means of traditional Keynesian economics.
Of the many contributions that Keynes made, for our present purpose his work in monetary economics is perhaps the most consequential. He developed the foundations for the "horizontalist" understanding of money supply (see Basil Moore's eminent book Horizontalists and Verticalists) and he helped bring uncertainty into the economy through demand for money.
Monetary horizontalism has never made its way into the mainstream macroeconomic textbook, except as a matter-of-fact non-analytical feature. What textbooks have picked up on, however, is the distinction that Keynes made between two forms of money demand:
- Transactions, i.e., our demand for money for the purposes of regular spending; and
- Speculation, i.e., our demand for money for investment purposes.
The distinction between the two types of money demand is significant for our understanding of what sub-zero interest rates do for our economy. Specifically, our focus is on the speculative demand for money - or investment demand as it should more appropriately be called. The investment demand for money is the key variable. Its main property, described in Figure 1, is that it responds negatively to the interest rate. When the rate drops, people hold higher money balances because they wait for opportunities to buy assets for speculative purposes:
This curve represents a trade-off between holding cash and buying bonds. When the interest rate is high, prices on debt instruments such as government and corporate bonds are low. Therefore, it pays to buy them. Conversely, high bond prices are associated with low interest rates; since people expect bond prices to fall they abstain from investing in them.
There are two apparent limitations to this analysis. First, it does not take the stock market into account. Undoubtedly, a notable omission. However, if we assume that decisions on holding cash vs. bonds is more short-term in nature than investments in the stock market, it makes sense to continue this analysis as it is. Furthermore, there are implications for the stock market that we will get back to in a moment.
Secondly, the term "money" is confusing. In its origin, Keynes's monetary theory literally spoke of money as cash, a valid assumption at the time. However, today it would be more appropriate to think of "money" as liquidity, ranging from cash to easily accessible bank deposits and other equity of similarly easy-access kinds.
Despite these limitations, our analysis gives us a basic understanding of what an ultra-expansive monetary policy does to the economy. Therefore, let us look at Figure 2 which explains the effects of an increase in money supply, i.e., a cut in the interest rate:
The increase in the supply of money (1) lowers the interest rate from a level at the line Ms (for money supply) to the line Ms'. This takes the rate from positive to negative. As a result of the cut in interest rates, bond prices go up and people hold more cash (2).
So far so good. This exercise looks like nothing more than the exploration of the mechanisms that determine supply and demand for part of the market for money. However, the textbook version of this exercise assumes that interest rates are positive at all times; there is no taking into account the nature of a market with a negative interest rate. Back when Keynes formulated his monetary theory and it was incorporated into the Hicks-Hansen and eventually IS-LM models, it was inconceivable that interest rates could actually go negative.
Simply put, we need to formulate a new theoretical approach to the monetary sector of the economy that can account for how people behave when rates are negative. It is a good start to use the definition of speculative - or investment - demand for money, as it is already detached from the transactions demand and therefore inherently suitable for basic portfolio-decision analysis.
Investment decisions are by definition intertemporal, and as such they are - also by definition - subject to uncertainty. The economy is full of features that help us make uncertainty manageable, from the institution of enforceable contracts to habits and implicit agreements that maintain the continuity in markets. The stronger these explicit and implicit features are, the less uncertain we are and the more confident we grow.
Investment demand for money is one of the key variables by means of which we continuously manage uncertainty. The downward sloping curve in Figure 2 represents a given state of uncertainty; if we grow more (less) uncertain about the future, we want to have more (less) cash on hand at any given interest rate - hence the curve shifts out (in).
Since economic theory has made no progress on the meaning of sub-zero yield for economic activity, we can only hypothesize at this point as to what happens to demand for money when interest rates fall below that level. Based on the notion that the demand curve shifts out with increased uncertainty, it is reasonable to assume a significant rise in demand for money below the zero mark. However, since this is not change in uncertainty in general but the effect of a change to the pricing of bonds, we will assume that the interaction between uncertainty and sub-zero yield causes a kink in the speculative demand curve for money:
As before, money supply increases, causing the interest rate to drop (1). This increases the speculative demand for money (2) because of the expectation that bond prices will decline, not rise. However, we now have a demand curve that changes slope below the zero-interest mark (3). As a result, unlike in the previous example where the increase in money demand stopped at Md', demand now increases significantly beyond that point (4).
Let us generalize this point. Negative yield means that the investor is deprived of any kind of return except that which comes from a price increase in the bond. That price increase, in turn, is by necessity of speculative nature: at the point of purchase, the price a bond buyer pays has taken into account all the available information in order to determine whether or not the price is right. Since the price is not set in isolation but a market price, it can only be changed from the day of purchase to the day of the bonds maturity, because of information unknown at the point of purchase.
Unknown information about the future is subject to speculation. Therefore, the only way for a buyer of a negative-yield bond to earn money is to have a speculative price increase add value he had not factored in at the time of purchase. In other words, if we buy a negative-yield bond with the expectation of making money on it, we make a speculative portfolio decision.
If we assume that the uncertainty affecting purchases of treasury bonds is related to the state of the government budget, then unanticipated changes in the deficit will also change the price of the bond. The reduction (increase) of a budget deficit will drive the price up (down), causing a speculative gain (loss) for those who already hold bonds.
The same analysis applies to corporate bonds, though here speculative changes in the bond price depend on changes in corporate profits.
If, again, we think of money not as cash but as highly liquid assets of various kinds, the sequence in Figure 3 suggests that in a sub-zero yield economy there will be a movement away from long-term, low-liquid equity and a concentration of portfolios around highly liquid, short-term holdings. However, there is a limit to how much highly liquid assets banks can accept that their customers hold; the ability of banks to make money on credit suffers when liquidity is in abundant supply. Therefore, it is rational to expect a systemic rise in costs on liquid deposits.
At this point, the only place for investors to make money is in lower-liquid markets. The stock market is fluid in terms of how easy it is for people to cash their investments, but under the assumption that
a) investors habitually view stocks as a longer-term investment than bonds, and
b) there are no regulatory or other institutional hindrances toward a move in general stock-market investor sentiment from long term to short term,
the combination of negative yields on bonds and de facto negative yields on bank deposits (such as fees for keeping money in the bank) will gradually shift the stock market the direction of shorter-term investments.
With a general inflow of more money into the stock market, stock prices will rise at given dividends. More of the money made by investors will come from rising stock prices - thus pushing the stock market in general in the "zero yield" direction. Since the same information-price dynamic applies here as with bonds, by definition this means increased reliance on speculative gains for those out to make money.
Following the brilliant price-theory work by Arthur Okun we should expect further development of derivative instruments to combine the hunt for speculative gains with high levels of liquidity in investments. On the margin, this will contribute to the tectonic shift we can expect in a sub-zero yield economy: further away from productive investments, into the speculative realm. Over time, as negative yield on corporate bonds grows side by side with negative yield on treasury bonds, the consequences for the economy as a whole are quite possibly going to be:
- More bubbles on financial markets;
- More flight from treasury bonds, causing central banks to print yet more money to fund budget deficits;
- More stagnation in household income, as equity-based income has become more important in the past 20 years; and
- As a result of all these factors, a more solid trend of economic stagnation.
With no pun intended, this analysis is a bit speculative by nature, but this is in general what a Keynesian approach to the sub-zero yield economy would tell us.
In the last installment in this series we will fuse Austrian and Keynesian analysis to see what these two heterodox theories together can tell us about our brave new world of big welfare states, big deficits and big negative bond yields.