Answering some questions on Interest Rates & Spirals

 You have savers on one hand who have funds in excess of their spending and on the other side those who are short on it. The two can transact through a mechanism which will allow the saver to get a return on his savings at a later date through the right application of an interest rate that will take care of the inflation. A very basic course in economics will tell you that when demand for loanable funds increase, the interest rate increases and vice versa.

Thus we come to the real interest rate that is nominal interest rate minus inflation. I still remember the high days of inflation in India, well above 9%, when the nominal interest rates were in the region of 18%, which brought the real interest rates in the region of 9%. The real interest rate picture for India over a longer time scale is shown here. Well one would notice that the current times have seen the real interest rate taper off to the region of 5% to 6%, which is a very good denouement.

Let us look at some advanced economies like U.S. The picture shows that some forty years back U.S. was exactly where India is today, whereas now in U.S. the real interest rates have dropped below 2%.

What do these trends mean? The high savings over investments of these advanced nations like U.S. that have led to loanable funds to zoom to such high levels that the demand for such funds have tapered off to low levels leading to low interest rates and low inflation as well.

To put it differently, the output gap after the last crisis left such a deep hole that current investment potential falls short of the amount of excess savings that the world holds. But where are these excess savings parked?

Well you will find them mostly held by corporations as in S&P 500 or in Sovereign wealth funds as well as with individuals that are locked in assets of all kinds. These assets take shape of equities and fixed assets and all kinds of commercial paper; it could also mean housing assets, commodities of all kinds including precious metals.

But does this mean the world is not in debt? Well no, it is hugely in debt as debts make allowance for better investment opportunities when the interest rates are low. Imagine you are a corporation with millions of dollars of reserves or surplus, would you mind taking on debt that is available at a low rate for your investment needs than take a bite from your reserve? This is a purely economic consideration and if your surplus can be deployed better in investments that would earn you more than the interest rate that your loans would attract, you would be better off with debt.

So you currently see S&P 500 corporations that have so much of surplus and reserves, still taking on debt from the market at low rates as that gives them some additional earnings potential. The stock buy-back programs, for example are mostly funded with these debt instruments.

Let me get back to where I started from. If savings is in excess, interest rates will tend to be low.

Now let me introduce the topic of deflationary spiral. If economic activities stay the way they are with a persisting output gap, the conditions will be ripe for subdued investments and there will be mostly investments into assets that are not going to generate economic activities.

If you are investing into assets like stocks (through buy-backs) it will most likely not generate new economic activity. In other words when new investments into fixed asset investments dry out, the general tendency would be to move into assets that will not generate further economic activities but act as parking spots (including the speculative type of assets as well).

A Keynesian solution at this time would be to ask for fiscal measures by the government that would balance out this lack of investments by the private sector. But unfortunately that would mean the governments would have to take on more debt than their current levels. These debts would eventually have to paid for by the citizens of the country and if not now than later either the taxes must rise or the citizens must postpone some of their spending or consumption to be able to pay back. This does not make it easy in the current situation when consumption itself is dwindling in the developed world.

The other issue we cannot lose sight of is that the fiscal actions have remained pro-cyclical. That means when the going was good, the fiscal actions by the government were good. When the going is tough the fiscal actions also peter out. Counter-cyclical fiscal policy would have helped the current situation but unfortunately we have lost the bus.

So when fiscal solutions are not forthcoming, what one would expect is that a low interest rate regime further aggravates into an even lower interest rate environment. We have seen that the Zero Lower Bound interest rate helped to sow the seeds for a negative interest rate environment.

This is somewhat explained by the deflationary spiral as well: When government spending is down, the consumer demand is down and the business fixed asset investment is down the prices move even lower into a spiral that is called the deflationary spiral. No amount of monetary action will help to kick-start the inflation process that will help to recoup prices to the positive territory.

The Federal Reserve or for that matter any Central bank of the world works on the dual mandate of providing stability to prices and also look at lower unemployment. But with U.S. achieving a near full employment status (unemployment bordering around 5%), it faltered to spark off inflation anywhere above 2%. This is the classic disconnect we find in the current monetary stances across the developed world. The money supply acts to move into assets faster than it moves into goods or services. Thus we have mostly asset price inflation, that to in select areas which do not affect the general inflation or price levels in the economy.

The Central banks thus have failed somewhat to be successful in their attempt to meet the inflation targets. In such price levels to raise interest rates is a measure one would not find much support from academicians.

The fixed income instruments like insurance or re-insurance or the pension funds would beg to differ; that is where the banking industry diverges in its opinion.