How Low Interest Rates Have Hurt Economic Recovery

satyajit das
In the aftermath of the financial crisis that broke out in September 2008, after the investment bank Lehman Brothers went bust, central banks all across the Western world drove interest rates close to 0%.

This was referred to as the zero interest rate policy or ZIRP. The hope was that with ZIRP the interest rates on loans offered by banks would remain very low and in that environment people would borrow and spend more.

They would buy more cars…More homes…More TVs..

And this would ensure an economic recovery. QED.

But things did not turn out to be as simple as that. As Satyajit Das writes in his new book The Age of Stagnation—Why Perpetual Growth is Unattainable and the Global Economy is in Peril: “Low rates also discourage savings. But sometimes, in a complex cycle of cause and effect, they may perversely reduce consumption as lower returns force people to save more for future needs.”

And in fact low interest rates may also lead to lower consumption. How is that possible? As Das writes: “Citigroup equity strategist Robert Buckland has argued that low rates and QE reduce employment and economic activity, rather than increasing them. These policies encourage a shift from bonds into equities.”

Interestingly, those who have retired from work have had to shift their money into stocks because of low interest rates. As Das writes: “In October 2014 an American retiree with US$1 million invested in secure, two-year US government bonds would have earned US$3900 in annual interest, 92 percent less than the US$48,000 they would have received in 2007. The retired and savers in advanced economies were forced to purchase riskier securities or invest in dividend-paying stocks to earn a return.”

And these investors were looking for income from the investments they had made in stocks. As Das writes: “As investors are looking for income rather than capital growth, they force companies to increase dividends and undertake share buybacks. To meet these pressures, companies must boost cash flow and earnings, by shedding workers and reducing investments to cut costs. The process increases share prices and returns for shareholders of the company, but is bad for the overall economy.”

What does this mean? With interest rates on bank deposits and other fixed income investments at very low levels, people have moved their money to equity. These investors force companies to increase dividends and at the same time buyback its own shares. When a company buys back its own shares a lesser number of shares remain in the open market, pushing up the earnings per share. With fewer shares going around, it also increases the chances of a higher dividend per share.

Interestingly, with interest rates at such low levels, companies have been borrowing money to buy back their own shares. As Albert Edwards of Societe Generale wrote in a research note in November: “The primary driver for the rapid rise in bank lending…has been borrowing by US corporates and we all know they have been using the Fed’s free money not to invest in capacity expanding expenditures, but rather to buy back mountains of their own shares…Corporate debt borrowing at an $674bn annual rate [is] closing in rapidly on the all-time borrowing splurge of 2007!

Also, in the pressure to boost earnings companies have had to fire people and at the same time reduce investments to cut costs. This has led to hire share prices but it has also led to a situation where employees have been fired from their existing jobs and new jobs haven’t been created. Any person who has been fired or is likely to be fired is unlikely to go out shopping, as the basic idea behind lower interest rates is.

This has an impact on consumption and economic growth. Hence, in a very perverse sort of way, low interest rates may have had a negative impact on consumption. And this has meant economic growth has not recovered as fast as it was expected to.

Also, the ZIRP has pushed up stock markets all over the developed world and in the process helped the rich become richer. As L Randall Wray writes in Why Minsky Matters—An introduction to the Work of a Maverick Economist: “According to a study by Pavlina Tcherneva, 95 percent of the benefits of the recovery from the global financial crisis have gone to the top 1 percent of the income distribution. Another study finds that the top one-thousandth (top 0.1 percent) of the U.S. population now owns fifth of all the wealth.”

The trouble is that the rich do not increase their consumption if they get richer. As Das writes: “Higher income households have a lower marginal propensity to consume, spending a lower portion of each incremental dollar of income than those with lower incomes. US households earning US $35,000 consume an amount from each additional dollar of income that is around three times that of a household with an income of US$200,000. Given that consumption constitutes around 60-70 percent of economic activity, concentration of income at the higher end limits growth in demand.”

And this explains why low interest rates through large parts of the Western world haven’t had the kind of impact that they were expected to. What this tells us is that there are no universal solutions to problems even though economists and politicians often sound very confident while offering them.

And this is something dear readers that you need to keep in mind the next time you hear a politician or an economist, talk about the economy, with great confidence. Economics is not an exact science.

Disclosure: Satyajit Das wrote the foreword to my book Easy Money: Evolution of Money from Robinson Crusoe to the First World War

The column appeared on the Vivek Kaul Diary on January 18, 2016

Western central banks maybe holding less gold than they claim

The price of gold as on January 1, 1979 was $226 per ounce (one troy ounce equals 31.1 grams).
On August 6,1979, Paul Volcker took over as the Chairman of the Federal Reserve of United States. The price of gold on that day was at $282.7 per ounce having risen by 25% since the beginning of the year.
When Volcker took office things were looking bad for the United States on the inflation front. The rate of inflation was at 12%. The price of gold against the dollar had also been rising at a very past pace. The price of gold on August 31, 1979, at the end of the month in which Volcker had taken charge was at $315.1 per ounce, up by 11.5% from the day he took charge.
The world had clearly lost its faith in the dollar. By the end of September 1979, gold was quoting at $397.25 per ounce having gone up by 26% in almost one month. And so the dollar would continue losing value against gold. On January 21, 1980, five and a half months after Volcker had taken over as the Chairman of the Federal Reserve of United States, the price of gold touched an all time high of $850 per ounce. In a period of five and a half months the price of gold had risen by an astonishing 200%. What was looked at as a mania for buying gold was essentially a mass decision to get out of the dollar and buy gold.
The mania ended quickly and the very next day(i.e. on Jan 22, 1980) the price of gold was down by around 13.2% to $737.5 per ounce. The price of gold kept falling over the next two decades and reached a low of $252.8 on July 20, 1999.
The central banks of Western Countries (i.e. United States, Canada, Japan and Europe) were the largest hoarders of gold. With gold prices having fallen to levels of $250 per ounce, the value of their gold holdings had taken a tremendous beating over the years. Also sitting in their vaults gold wasn’t earning any interest either. Hence they started lending out this gold to banks known as bullion banks.
As Eric Sprott & David Baker write in a recent report titled Do Western Central Banks Have Any Gold Left? “It made perfect sense for Western governments to lend out (or in the case of Canada – outright sell) their gold reserves in order to generate some interest income from their holdings. And that’s exactly what many central banks did from the late 1980’s through to the late 2000’s.”
This allowed the Western central banks to put gold which is essentially a useless asset to some use. As James Turk and John Rubino write in The Collapse of the Dollar and How to Profit from It – Make a Fortune By Investing in Gold and Other Hard Assets “Lending, for instance, involves, the central bank transferring gold to a major private bank, known as bullion bank, which pays the central bank a small-but-positive interest rate, then sells the gold on the open market,” write the authors. This allowed central banks to convert their gold into cash and also earn some interest on it.
Sprott and Baker suggest that “Collectively, the governments/central banks of the United States, United Kingdom, Japan, Switzerland, Eurozone and the International Monetary Fund (IMF) are believed to hold an impressive 23,349 tonnes of gold in their respective reserves, representing more than $1.3 trillion at today’s gold price.”
While it did not matter what central banks did with their gold in the eighties, nineties and even in the 2000s, things have changed now. These countries now are highly indebted and are printing money left, right and centre to repay their accumulated debt as well as get their economies up and running again.
Given all the money printing that is happening it would be good for them if they do have some gold left in their vaults and haven’t lent out all of it. “The times have changed however, and today it absolutely does matter what they’re doing with their reserves, and where the reserves are actually held. Why? Because the countries in question are now all grossly over-indebted and printing their respective currencies with reckless abandon. It would be reassuring to know that they still have some of the ‘barbarous relic’(as John Maynard Keynes referred to gold) kicking around, collecting dust, just in case their experiment with collusive monetary accommodation doesn’t work out as planned,” write Sprott and Baker.
The central banks do not have to declare about the gold that they are lending out. So it continues to show as a part of their book even though they have lent it to bullion banks, which in turn have gone ahead and sold that gold. As the authors point out “Under current reporting guidelines, therefore, central banks are permitted to continue carrying the entry of physical gold on their balance sheet even if they’ve swapped it or lent it out entirely. You can see this in the way Western central banks refer to their gold reserves. The UK Government, for example, refers to its gold allocation as, “Gold (incl. gold swapped or on loan)”. That’s the verbatim phrase they use in their official statement. Same goes for the US Treasury and the European Central Bank.”
So the actual physical gold with the central banks might be much lesser than they claim. Also, Sprott and David feel that central banks are continuing to “lend” out their remaining gold reserves. This they conclude through a mismatch in the supply and demand for gold. The demand from the five main sources i.e. gold being bought by central banks all over the world, US and Canadian mint sales of gold coins, gold bought by exchange traded funds, Chinese consumption of gold and the Indian consumption of gold has increased by 2,268 tonnes over the last 12 years. Over and above this there is demand from private buyers of gold which go unreported.
“Then there are all the private buyers whose purchases go unreported and unacknowledged, like that of Greenlight Capital, the hedge fund managed by David Einhorn, that is reported to have purchased $500 million worth of physical gold starting in 2009. Or the $1 billion of physical gold purchased by the University of Texas Investment Management Co. in April 2011… or the myriad of other private investors (like Saudi Sheiks, Russian billionaires, this writer, probably many of our readers, etc.) who have purchased physical gold for their accounts over the past decade. None of these private purchases are ever considered in the research agencies’ summaries for investment demand, and yet these are real purchases of physical gold,” write Sprott and David.
Hence, the gold demand figures that are actually reported are actually underreported as many of the investments in gold aren’t taken into account. And thus demand is made to match supply of gold which is believed to be at 3700 tonnes. If more accurate demand numbers were to be used a huge discrepancy between demand for gold and the supply of gold, would be revealed. And the demand side would exceed the annual supply of gold. “In fact, we know it would exceed it based purely on China’s Hong Kong gold imports, which are now up to 458 tonnes year-to-date as of July, representing a 367% increase over its purchases during the same period last year. If the imports continue at their current rate, China will reach 785 tonnes of gold imports by year-end. That’s 785 tonnes in a market that’s only expected to produce roughly 2,700 tonnes of mine supply, and that’s just one buyer,” write the authors.
So the question is where is all this gold coming from? It might very well be that Western Central Banks are continuing to lend gold to bullion banks which in turn are continuing to sell this gold. As Sprott and David point out “They (i.e. Western Central Banks) are the only holders of physical gold who are capable of supplying gold in a quantity and manner that cannot be readily tracked… it can only lead to the conclusion that a large portion of the Western central banks’ stated 23,000 tonnes of gold reserves are merely a paper entry on their balance sheets_– completely un-backed by anything tangible other than an IOU from whatever counterparty leased it from them in years past.”
What are the implications of this on the price of gold? As the Turk and Rubino write “Because the bullion banks have promised to eventually return the borrowed gold to the central banks, they are, in effect, “short” gold. That is, at some point in the future they are obligated to buy gold in order to repay the central banks.” And when this happens “the result will be a classic “short squeeze,” in which everyone tries to buy at once, sending gold’s exchange rate through the roof.”
Of course, the assumption here is that central banks demand their gold back. Whether that happens, remains to be seen. As Sprott and David conclude “At this stage of the game, we don’t believe these central banks will be able to get their gold back without extreme difficulty, especially if it turns out the gold has left their countries entirely.We might also suggest that if a proper audit of Western central bank gold reserves was ever launched…the proverbial cat would be let out of the bag – with explosive implications for the gold price.”
The article originally appeared on on October 26, 2012.
(Vivek Kaul is a writer. He can be reached at [email protected])