Very Low Interest Rates - Response to John Hempton, Bronte Capital
/The following letter is a response to a blog post by John Hempton, Bronte Capital, 'Some thoughts on very low interest rates'. http://brontecapital.blogspot.com.au/ posted on 17 June 2016.
Dear John,
Thank you for making public your thoughts on very low (even negative) interest rates, inviting criticism and then opening the issue to debate.
You mention that individuals “can inter-temporarily move consumption around …. But collectively we can’t”. The “moving consumption around” is better thought of people accumulating wealth with their surplus income (save) during their productive years, so that they can convert that wealth into income (dis-save) when they are aged and can no longer work. This allows a person to live in comfort and safety.
Instead of focusing on consumption it is better to focus on income where income is conceived as a steady flow of goods and services.
"By its very nature, income is perishable. If not used presently, its value may evaporate. Therefore the economizing individual divides his gross income into two components: income-to-be-consumed and income-to-be-saved. He converts the latter into wealth which he plans to convert again into income later, as the need arises. There are problems with these conversions. The value of income and wealth must be secure. The risk of letting the quality and quantity of goods and services that make up the income erode must be reduced to its irreducible minimum". Professor Antal Fekete
It is because income is perishable that you are right to say much of what you consume “was made this year”. Income is the hairdresser cutting the hair of a client. Income is the milk produced by the dairy. Income is the goods and services that people use.
Many people think income is the money paid into their bank account or that paid to them in cash. However, the money paid to a person in this manner is not income. Instead, the money is the good that has been exchanged for the income.
When you are employed at a company, essentially you are paid in the surplus (after costs) goods and services of that company. Those surplus goods and services are typically sold by the company in exchange for money and then that money is used to pay wages. Wages could be paid in the form of company scrip with that scrip then used to purchase goods & services, often historically at the company store. Alternatively, you could be paid in the form of the goods and services. That is, however, subject to the problem of declining marginal utility for most goods and services. You only need so many haircuts and can only consume a certain amount of milk before getting sick. You could of course, exchange those surplus haircuts or milk for other goods and services. However, as haircuts and milk are not the most marketable goods / services, it is more efficient for you (or the company on your behalf) to exchange the surplus production for the most marketable good (money).
Because income is perishable, surplus income must be exchanged, normally into money (the media used for indirect exchange). If the hairdresser doesn’t have a client who wishes to have his/her hair cut, then there is no income. If the milk is not drunk or used in production of another product, then it goes off and there is no income.
Income is therefore the goods and services we help produce. When a person is young and healthy, in their prime active years, they will consume some of this income (mostly through indirect exchange) and convert the remaining income into wealth. If the quality of the wealth is high, then in the future when the person is aged and can no longer produce an income, they are then able to offer that wealth to someone else in exchange for income. Wealth is therefore a form of store of future income.
The formation of productive capital is the foundation of the success of capitalism. The Entrepreneur with the loan of funds from the bondholder, together with the use of funds provided by the equity investor, employs people and capital to produce products and services in demand from the consumer. Wealth is a claim to a share of future income (products & services) net of costs arising through the deployment of capital and people.
Wealth therefore relies heavily on the quality of claims on income from the deployment of capital and people. In this regard, the problems arising from our current monetary system do not bode well.
Professor Antal Fekete concluded that the causes of the Great Depression are found in the combination of three factors: (1) the fatally relaxed accounting standards, (2) the creation of the Federal Reserve Banks in 1913, making the monetization of debt possible, and (3) the destruction of the gold standard in 1933. He states "These three factors interacted to cause wholesale capital destruction in the productive sector. It was not the collapse in demand that caused the collapse in production, as asserted by the currently fashionable Keynesian and Friedmanite orthodoxy. It was the exact opposite: the collapse in production causing the collapse of demand. The collapse in production occurred in response to the invisible destruction of capital due to the falling interest-rate structure which, in turn, was engineered by the bond speculators, chief among them the banking fraternity".
With regard to your comment regarding ageing populations, in countries such as Japan what should be most evident is that the capital base is at peak levels. Sadly this is not obvious. Instead, much of the Japanese older population holds fiat monetary claims – essentially only forced claims through taxation over the income of the fewer younger people.
We can collectively defer consumption by redirecting our efforts towards capital goods and away from near term income production – the ‘productivity’ argument you cite – but there is limited evidence that this is taking place, particularly in a manner that will produce more income in future periods. Instead, much current activity seems to be poorly directed.
You argue that “we have huge populations wanting to defer consumption”. However, given the deterioration in human coordination over time and space it is a reasonable conclusion that society’s capital wealth (i.e. our commonweal) is today in a poor state. It is likely that the difficulty in undertaking a reliable exchange of income to wealth over time and space has led to a significant misallocation of capital. Symptoms of this poor quality exchange include a lack of long-term manufacturing capital formation, excessive housing stock and capital depletion through too high a level of short-term consumption.
Instead of huge populations deferring consumption, we have huge populations who hold insufficient wealth and plan to live off the pension provided by the State.
With regard to your suggestion of “pension default”, there is no doubt that this will occur. Improved longevity has greatly increased the savings demands of the populous. A working life is typically at most 35-40 years (say age 23 to age 63) to be followed by 25-35 years (say age 63 to ages 87-97) in retirement. It is implausible that most people that have saved sufficient quality wealth to provide income for themselves throughout a long retirement. This is where some form of tontine will become essential, in addition to working to a later age.
It should also be acknowledged that the Age Pension in Australia and many overseas government pension schemes are unfunded. The government has not put aside accumulated wealth from prior year tax collections to pay for its Age Pension liabilities. Instead it relies on general revenues, including taxation revenues, and government borrowings to pay the Age Pension. The ageing demographic will expose this fraudulent approach. The populous believes it can rely upon the Age Pension in old age, but the Age Pension has no backing other than the ability of the State to tax (younger) others - and the taxation of (younger) others diminishes their own ability to save for retirement. It will not be possible for younger generations to pay for the Age Pension of others and then also save for their own retirement. It is also grossly unfair.
This is where your “second out” of immigration is just an ‘extend and pretend’ and it doesn’t solve the real problem which relates to the lack of accumulated wealth. If income is taken from young ‘immigrants’ to pay the Age Pension of older (but sometimes still capable) ‘locals’ this is morally bankrupt and hardly likely to provide an environment which will encourage new people into the commonality.
Given the problems facing the Age Pension arising from its unfunded status, the populous should be made aware that access to the Age Pension will become more restricted over time and that in all likelihood the real purchasing power of the Age Pension will decline. This is already starting to happen with the recent changes to eligibility including the pension age and assets test. Financial planners too regularly assume that the current rules of the Age Pension will apply in future periods. That is highly unlikely. The State should publish its Age Pension liability so that younger people can better understand how much, in addition to their own savings, they will be required to pay for the retirement of others.
With regard to your question “How is this disappointment to be settled on people?” a key important factor will be the quality of wealth over the time / space dichotomy. That is: wealth should be held in a form that retains its capability to convert into income over time; and wealth should be held in a form that retains its capability to convert into income over space.
One suggestion you mention is that “Inflation takes away our savings”. Firstly, inflation is an ill-defined term, the measure of which is therefore also ill-defined. The ‘basket of goods’ in the consumer price index may not correlate closely to your own purchasing habits. Also, it is not possible to quantify some components, such as changes in the quality of a product. Secondly, the payment media is compromised. The fiat payment media is effectively a cheque-kiting scheme between the Treasury and the Central Bank. The Central Bank holds the Treasury’s securities as assets and holds its own issued payment media as a liability, but the Treasury’s securities are payable in the Central Bank’s payment media. If the Central Bank were to buy back the Treasury securities held by the public (i.e. ‘Quantitative Easing’), then the Treasury securities are eliminated on consolidation, but the fiat payment media raised and then spent by the government is in circulation! Effectively the Treasury would be printing money to pay for its deficit spending. In Australia, the central bank hasn't undertaken a 'QE' program. The central bank has, however, supported the commercial banks to create bank liabilities as fiat payment media through the act of borrowing short and lending long. If the public were to wake up to this ruse, then the marketability of that fiat payment media may well collapse.
The bid / offer prices for goods & services change every day, and over different regions, depending on the utility of the marginal sellers and the marginal buyers. There is no asset which you can now purchase for income that can be guaranteed when sold over time / space to provide exactly the same or a higher income.
The asset that is the closest to providing the same or a higher income when sold over time / space is the most marketable good. The most marketable good has near constant marginal utility. A feature of the most marketable good is that it retains near constant marginal utility over time / space. Therefore the closest we can go to a ‘risk-free’ asset is the most marketable good, which is gold coin. Second to the gold coin in marketability is the silver coin. The real bill and then the gold bond (with sinking fund) would be other assets which approximate the ‘risk-free’ asset.
Interest is quite a different concept. It is the incentive we are paid to convert short-term wealth (money) to long-term wealth. At the first level you are right it is the bargaining between the Annuitants (those long wealth and short income) and the Annuitands (those long income and short wealth). The Ageing population should mean the ratio of Annuitants to Annuitands is always increasing and the thinning of marginal Annuitands will put downward pressure on the interest rate. That said, the Annuitant and the Annuitant are not the only participants in capital markets. The interaction of Entrepreneurs, Inventors (those persons involved in the formation of R&D capital), Capitalists and Market-makers all help to reduce the interest rate to a low level.
As pointed out by Professor Fekete those who believe falling interest rates are always beneficial to business and, as such, could not aggravate deflation “are confusing a falling with a low structure of interest rates. While the latter is beneficial, the former is lethal to producers. When interest rates are falling, the low rates of today will look like high rates tomorrow. A prolonged fall in interest rates creates a permanently high interest-rate environment. This paradox explains the reluctance of the mind to admit that a prolonged fall in the rate of interest spells deflation and, possibly, depression. Worse still, falling interest rates mean that business has been financed at rates far too high. This fact ought to be registered as a loss in the profit/loss statement, and be compensated for by the injection of new capital (much the same as would losses caused by damage to plant and equipment due to war, for example). Instead, businesses choose to ignore the loss, and they merrily go on paying out phantom profits in the form of dividends, further weakening capital structure. When they plunge into bankruptcy, they wonder what has hit them.”
Through the lens of time / space it becomes clear that a local nominal government bond is far from the ‘risk-free’ asset. It is, however, the asset that most people in financial circles commonly refer to as the ‘risk-free’ asset. The so called ‘risk-free’ nature of local nominal government bonds reflects a general perception that the government will always be able to meet its payment obligations due to both its ‘unlimited taxing authority’ on the populous and its control of the fiat payment media through its central bank. It should be noted, however, that the payment media is local and therefore may not be able to be used through space, and that it is nominal and therefore may not be able to be used through time. A local nominal government bond falls a long way short of satisfying the time / space dichotomy required of the ‘risk-free’ asset.
It is not natural for the interest rate on gold bonds to be zero or negative. Stable low interest rates are natural under free exchange (using the most marketable good for exchange) and this stable low interest rate encourages capital formation.
In our current monetary system, productive activity is penalised and speculative activity is rewarded. The volume of productive activity constantly shrinks, while the volume of financial activity constantly expands. In the end, the financial markets attract all of the available funds, gobbling up much of the producing sector. As local nominal government bonds (‘fiat bonds’) are unnatural, the interest rate is unstable and driven by speculation (aka front-running).
As highlighted by Professor Fekete “Let us focus on the fact that not only has speculation aided and abetted by the government brought down the rate of interest, but it is also responsible for making it to plunge to zero. Speculation also makes the volume of activity in the credit markets to grow at an exponential rate as derivatives such as bond futures and options proliferate at a prodigious rate. By now speculative activity represents a high multiple of the volume of productive activity. Previously, the former was a low percentage of the latter, as speculation was limited to addressing risks created by nature to the exclusion of risks created by man. In 1971 this limit was forcibly removed. Speculation addressing risks created by man, that is, by governments and central banks (e.g., interest and foreign exchange risks) started to overwhelm the economy and, by now, it is increasing at an exponential rate in good times as well as in bad. The artificial creation of risks has caused a chain-reaction of speculative activity with unforeseeable destructive consequences. As we shall see, volatility of the rate of interest is matched by that of the price level. Moreover, the two are linked. This linkage leads to resonance between the gyrating rate of interest and the gyrating price level. Resonance brings about runaway vibration as manifested by exponentially increasing amplitude (the exact opposite of the more common phenomenon of damped vibration). The runaway vibration of the rate of interest and the price level hits the economy with ever greater destructive force. Unless a valid policy of stabilization is put into effect, and soon, the ever widening swings in the rate of interest and the price level threaten the economy with collapse.”
You mention housing as one of the few services that you consume that was produced a long time ago. Shelter, food, water and clothing are the primary needs of humans, so owning a house provides shelter and the capability to produce your own food as a form of insurance protection. Apartment living doesn't generally offer that protection. While house ownership carries with it the rights to occupation, it also carries with it the responsibility for the costs of depreciation & maintenance and the burden of government agency costs which are surplus to the services provided. This may include land tax, stamp duty on purchase, capital gains tax and any excessive council rates.
In a free market, the decision to own a house or be a tenant of a house should depend very much on the subjective value assessment of individual. Those people who highly value the stability of long-term possession would likely prefer to own their house. Those people who highly value flexibility of location would likely prefer to rent a house. Those people who have accumulated short-term wealth and wished to exchange that into long-term wealth, would consider purchasing a house, but not necessarily the one in which they intend to live.
In a free market, the rental on a house would rise or fall depending on the marginal supply and marginal demand for like houses, but overall it would be quite stable. This would provide owners the ability to enter into long-term leases with tenants.
Our current housing market is anything but stable. So what went wrong? Many, especially those trained in neoclassical economics, will point to a lack of supply of housing. They call for even more 'land release' and apartment 'infill'. While there may be a small element of truth in their arguments, they are wrong. What went wrong was the denominator. Fiat ‘money’ has taken away the economic choice of humans to rent rather than own housing. There is no surprise that residential housing is the choice form of saving for most people. They don’t understand why, but they have the history of fiat ‘money’ on their side!
You suggest “equities are destined to disappoint”. Clearly this will depend upon the quality of the form of wealth over time and space. Those companies producing productive income should remain in high demand. The fiat denominator used for most equity ‘prices’ is the most at risk, just look at the Caracas Stock Exchange market index!!
References: The Pentagonal Model of Capital Markets, 2004, Professor A. Fekete http://www.professorfekete.com/articles%5CAEFMonEcon102Lecture5.pdf