Some key global macro issues in a European perspective:

secular stagnation, financial repression and safe assets

Richard PortesLondon Business School and CEPR

II Europe - Latin America Economic ForumParis, 20 May 2014

The problem Long-term low real interest rates So it’s hard for investors to get yields they had

previously achieved – 8% targets won’t come back

Hence ‘search for yield’ and ‘safe assets’, some asset price bubbles, fed also by monetary policy trying to get rates down to stimulate the economy

But maybe even the rates we observe aren’t low enough, that is…

…maybe the ‘equilibrium’ real interest rate has fallen substantially – and then monetary policy, at least, is inadequate to get more investment and growth

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Road map Competing stories about low real interest rates Financial repression: what? why? how? Are government debt problems really leading

the authorities to financial repression? – unlikely, we think

Undesirable effects of sustained low interest rates

Are low rates a consequence of a safe asset shortage?

The evidence says no So maybe we really have entered an era of

‘secular stagnation’ – or maybe it’s something else

It matters! – are loose monetary policies and low rates likely to persist?

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Competing stories of long-term low real interest rates

‘Secular stagnation’ (Summers 8 November 2013)- the equilibrium real interest rate has fallen to -3%, say, and monetary policy can’t get us there with inflation at 1-2% (the ‘target’ of Fed, BoE, ECB, BoJ)- so ‘savings glut’ (Bernanke) – rather, underinvestment and low growth, but also asset price bubbles, as central banks ease, trying to reach ‘equilibrium’ real rate- when they decide to reverse, asset prices will fall sharply, because markets realise slow growth will continue

Financial repression (Reinhart and Sbrancia)

Low policy rates because financial crisis lingers

Shortage of safe assets (Caballero et al.)

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Financial repression: what and why?

Governments and central banks – ‘non-market forces’ – keep interest rates ‘artificially low’

This taxes savers to pay for government debt reduction

And if real interest rates are less than growth rates, the government can ‘grow out of debt’

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How can government debt/GDP fall?

Default – highly unlikely, except for eurozone peripherals

Surprise inflation – hard to engineer Growth rates rise – we can hope so! Primary fiscal surpluses – moving that way But if growth remains low, it’s hard to get

primary fiscal surpluses Are governments then tempted to impose

financial repression?

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Financial repression: how?

Direct ceilings on nominal interest rates, especially for depositors

Central bank buys government bonds, pushing nominal rates down

Inducing inflation lower real interest rates Financial regulation pushes savers to hold

more government bonds Capital controls may keep savers from exiting

and thereby keep domestic yields down

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But what is ‘artificially low’?

In a slump, the nominal interest rate hits the zero lower bound, and it’s still not an ‘equilibrium’ rate – it is still too high to be consistent with full employment

That has been the problem in the US, UK, Euro area, and Japan

The secular stagnation story says this may be the ‘new normal’

So nothing ‘artificial’ about low interest rates, not a sign of financial repression

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No significant financial repression in DM economies – in particular, Europe

No ceilings on interest rates Low inflation, and inflation expectations are below

CB targets for ECB and Japan, at target for US and UK

No capital controls Real interest rates not ‘historically low’ for US and

UK Yes, new regulatory measures – the liquidity

coverage ratio and Basel III – push banks to hold more government bonds

But the authorities now realise that this is mistaken- can’t keep on pretending government bonds are risk-free- mustn’t increase deadly nexus between banks and sovereigns

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The historical record

Reinhart and collaborators claim that much of the reduction in government debt/GDP since 1950 in a large sample of countries was due to financial repression – i.e. ‘artificially low’ interest rates

But Scott and collaborators claim precisely the opposite for G7 countries 1960-2005

And Goldman Sachs seems to side with Scott et al.

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Primary balance is important throughout, (r – g) in early period, the latter mainly because of high g

So don’t blame financial repression for low interest rates

It wasn’t the main factor in the postwar debt reduction

Nor is it likely to be the way advanced countries deal with their debt problems going forward

Still, we do have low nominal and real rates – and if prolonged, they may have undesirable effects

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Consequences of low interest rates

Transfer from creditors to debtors – to the extent that monetary policy affects real rates, it redistributes

Households with variable-rate mortgages benefit, those holding endowment policies and purchasers of annuities suffer

And low nominal rates pose problems for institutions with fixed nominal obligations – indeed, their solvency may be threatened by accounting rules that assume the low nominal rates will go on forever

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Potential dangers

Asset price bubbles? No clear evidence. ‘Search for yield’? – yes! Is that a problem? Only if you want ‘risk-free’

assets that pay substantial real yields But such assets haven’t really been available

for most of the post-1960 period – although some investors, misled by ratings, thought some assets were ‘safe’ that turned out to be highly risky

That leads to the second part of the story:Is there or will there be soon a shortage of reasonably safe assets? 14

Maybe – and if so, we should be scared! (say the FT and others)

FT Alphaville headline 5 December 2011: ‘The decline of “safe” assets’, presenting ‘the most important chart in the world’, titled ‘Shrinking universe of “safe” assets in the primary reserve currencies’

It gets worse:Financial Times headline 27 March 2013: ‘Global pool of triple A status shrinks 60%’

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‘The world has a shortage of financial assets’ (Caballero 2006) – and it will get worse

‘In the future, there will be rising demand for safe assets, but fewer of them will be available…’ (IMF Global Financial Stability Report April 2012)

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Preliminary question Where to draw the line? No asset is truly safe : not in default risk (CDS spread on US Treasuries 5-yr at

1.1.09 was 67 bps, long before August 2011 debt-limit scare)

nor liquidity risk (3-month US Treasuries stopped trading for 30 minutes at peak of post-LTCM turmoil, on 5.10.98)

nor inflation risk (US inflation went well over 10% in 1979-80)

nor exchange-rate risk (the dollar depreciated 50% against the DM from Feb 1985 to Oct 1987)

There is a continuum that requires judgment or reference to the markets - hence difficulties with the data

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Safe asset shortage, search for yield, and financial instability

The claim: it is the shortage of safe assets that pushed real interest rates down to ‘historically low’ levels pre-crisis, hence investors needing yield went into excessively risky assets – and it’s happening again!

Further consequences: global imbalances and asset price bubbles

Shortage of safe assets led private sector to create ‘private label’ safe assets that weren’t really safe but were certified by the ratings agencies and easily marketed

Bernanke (2013), Kocherlakota (2013), and the IMF in GFSR 2012 share the concern that safe asset shortages will lead to financial instability (volatility jumps, herding, cliff effects…)

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Evidence: Effects on interest rates?

Real interest rates did fall from 1980s and early 1990s to levels that seemed historically low in 00s – but they weren’t, because real interest rates were much the same in 1960s and lower in 1970s.

Hard to claim a shortage of safe assets both pre- and post-1971!

So was it ‘financial repression’? Doubtful: that would block cross-border transmission, but there was high co-movement of advanced economy and emerging market spreads 1960-1980.

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Evidence

Asset price bubbles – really? is there agreement on identifying asset price bubbles before they burst? Where are the bubbles now?

Interest rates and spreads – in fact, long-term US and UK government bond interest rates aren’t ‘historically low’, nor are spreads of corporate bonds

Volumes of ‘safe’ assets – how to identify supply and demand? What is ‘safe’?

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Gourinchas and Jeanne (2012)

Rates are ‘historically low’ from the early 2000s

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But the picture changes in a longer historical perspective

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Are spreads especially compressed? Not AAA

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So where is the search for (high) yield – as in 1998?

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‘The most important chart in the world…’

Credit Suisse 2012 Global Outlook 26

…unless it’s this one – with a very different message

H. Blommestein, Bloomberg Brief, 3 January 2013 27

Nor does Goldman Sachs buy ‘shrinkage’…

Global Economics

Weekly 27 June 2012

…and they have a nice idea: define ‘safe assets’ by positive yield correlation with risk appetite. Then US Treasuries, non-Euro area G10, German, Dutch, Finnish, US agencies and AAA-rated covered bonds are still treated as ‘safe’.

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So it’s hard to find the ‘safe asset shortage’

Hard indeed to define ‘safe’ Role of ratings is dubious at best GFSR bravely says ‘asset safety should not be

viewed as being directly linked to credit rating’ but does it all the same, like everyone else – yet downgrading of US, UK, France had no effect on 10-year yields

True, sovereign nominal yields are low That’s not because of QE: numbers aren’t big

enough, and no QE for Bunds – yet Bund yields are well below those on 10-year US Treasuries and UK gilts

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So again, why are long rates so low?

Either excess demand for safe assets or weak demand for funds from private

sector plus extended expectations of Zero Interest Rate Policy

The latter accords with both theory and the data

The question remains whether the low policy rates are cyclical (still not out of financial crisis) or a response to ‘secular stagnation’

The big issue: What will the central banks think, and how will that affect their policies?

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