NEW YORK – During the past several weeks, global financial markets have reacted with great volatility. The two key drivers are increasingly bad economic news coming out of China as well as the anticipated increase in U.S. interest rates, the first such rise since 2006.
To cut right to the chase: The Federal Open Market Committee of the Federal Reserve Bank of the United States should not raise interest rates!
Central bankers who favor an increase in U.S. interest rates overlook that they no longer live in their parents’ world economy. As a matter of fact, too many policymakers and central bankers across the globe still live in the 20th century.
They have not yet realized that we live in a radically altered world economy that will shape the 21st century for some time to come. That tardy realization is not just unfortunate. It is a bad omen.
The acumen of central bankers has to be put into serious question. They celebrated themselves for accomplishing the “great moderation” in inflationary expectations over the past decades or so, even though that outcome had next to nothing to do with central banks’ management of monetary policy.
Still, there are many observers who argue that an increase is long overdue. After all, rates have been near zero since the financial crisis of 2008 and surely the U.S. economy is doing better, even if there is still a lot of room for improvement. Isn’t interest rate policy supposed to be anticipatory in nature?
That statement is both right and wrong at the same time. Yes, interest rate policy is to be anticipatory — and not reactive. But that alone would ignore the fundamental structural changes in the world economy.
Inflation may be the function of one of two factors (or both): A cost push and/or a demand pull. But the world in which we live today is defined by the opposite. Let me call it a cost crash and a demand lull. In a world obsessed with discussions about various needs for “structural” reform, this structural shift is the one that we all need to pay laser-like attention to.
Costs are crashing all around us: Energy, transportation, technology and labor (the latter through factors such as globalization as well as the destruction of collective bargaining in the advanced world).
There is also increased automation, widespread deployment of robots and the prospect of absolute cost pulverization through 3-D printing.
In addition, the products we do make dramatically increase in their inherent value. If you bought a computer two years ago and bought one for the same price now, its computing power would probably have doubled (Moore’s Law).
Therefore, developed nations calculate inflation differently today by applying what is referred to as hedonic models. These models take into account changes in value. The outcome is lower inflation rates.
Then you have a demand lull. Most advanced countries have rapidly aging populations. Older people consume less. Moreover, wages are not rising.
This is partly so because of the end of collective bargaining and partly because many advanced countries have aggressively moved from high-paying manufacturing jobs to low-paying services jobs.
The end result is that those who are younger and employed earn proportionately less than previous generations and, therefore, they consume less (which results in less demand).
The development of emerging markets, impressive thought it has been so far, has not effectively counter-balanced these demand changes in advanced nations.
It has often been argued that China must move from an investment-driven growth model to a model based on consumption. That sounds good.
But the problem is that the world’s largest country by population and the second-largest by GDP is really quite poor in per capita terms.
What’s worse, China has the fastest-aging population in the history of the planet. In 2000, there were six workers in China for everyone over 60 years of age. By 2030, there will be barely two.
China will be old before it will be rich, unlike today’s advanced countries.
This means that China will not become the “consumer of last resort.” Other emerging countries, such as Brazil, India, Indonesia and Turkey have very large and young populations. But it would require dramatic policy reforms in those countries to boost global demand.
In other words, a global chronic cost crash and a global chronic demand lull will keep inflation permanently very low. Can there be spikes? Yes, just as much as there have been troughs in periods of higher inflations.
This is a major shift in paradigm. It also requires a rethinking of monetary policy. Central banks are very familiar with fighting inflation. They tighten monetary policy through raising interest rates. To look at it the other way around, if there is no inflation and none is expected, there is no need to raise interest rates. Higher interest rates are not a policy goal.
As the merchants held in their defense of interest payments in the 12th century: “Time is money” — or, to put it differently, “interest rates” are a measure of the future value of money.
Not so coincidentally, the whole usury debate during the medieval period was about just that. The Roman Catholic Church insisted that “time” belonged to God.
The English theologian Thomas of Chobham hence claimed in the early 13th century that “the usurer sells nothing to the borrower that belongs to him. He sells only time which belongs to God. He can therefore not make profit from selling somebody else’s property.”
One need not adhere to the philosophy of usury as defined by the Catholic Church in the 13th century to grasp the true purpose of interest rates.
To be sure, every “world” we live in comes at a cost. Inflation is a tax on the poor. Equally, our new world of low or no inflation undermines pivotal structures of our economy.
We have built our entire life insurance and pension systems all over the world on certain (and much higher) interest rate assumptions.
This was no accident and it worked very well as it was based on strong historical evidence. However, for at least 15 years at this stage, these expectations have not been met.
Many life insurance companies in Germany are on the verge of collapse. The same will be true for not fully funded pension systems in any country.
That, in turn, will lead to one of two consequences: Either excessive risk-taking by pension funds, where statutory or regulatory frameworks allow that, or the demand that pensions will be dramatically cut.
In either scenario, this will lead to some very negative economic consequences for the world’s economies.
They require painful adjustments and lower pension benefits in advanced countries with rapidly aging populations. And making that adjustment will only aggravate the existing demand lull.
But in the end, interest rate policy has to be a function of economic fundamentals. Inflation is not caused by raising interest rates, rather are such rates to pre-empt inflation.
Therefore, without inflationary threat there is no purpose to raising interest rates.
If policymakers fail to change their thinking on monetary policy to meet the requirements of our world today, they will ultimately lead us into a long period of deflation, deep recessions and impoverishment.
Uwe Bott provides consulting and research services to large financial institutions.