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The next impossible

Today, in an effort to punish me for musing that a short squeeze might be on into the weekend, the worlds G10 fixed income markets sold off all pretty much in parallel. Treasuries, Bunds, Gilts, JGB’s… It didn’t matter. Everything came off, both real (inflation adjusted) and nominal rates rose across pretty much ever market. Except the front end of the Euro curve – where whilst nominal rates rose a bit, real rates fell. I’ll come back to this. Remember that a few months ago – this was impossible. Rates were never going up anywhere.

Why are real rates rising across the world at the same time that stock prices are going up?  All other things being equal, higher real rates should mean lower stock prices – but the bullish sentiments unlocked by the “Trump = Reagan” narrative mean that this relationship has broken down. In fact, to say its broken down gives it a false credibility – it’s a relationship that’s more theoretical than practical. Investors don’t look at bond prices and use that to discount the future earnings of the companies they’re buying in order to assess whether equities represent good values or not – they simply buy into and out of narratives – “Risk on” means you need to sell bonds and buy stocks OBVIOUSLY – and no, it doesn’t matter whether you have a fundamental rationale to do either trade-  you just have to because the inverse correlation is self fulfilling – if you own stocks, you’re vulnerable to a rally in bonds. If you own bonds, you’re vulnerable to a rally in stocks. The market doesn’t know what’s driving the “animal spirits” of risk on risk off -but its damned if it’s taking its time to find out.

But whilst today we saw that the risk on narrative is raising real rates everywhere in the world, it can’t seem to touch the front end of the European market. “Ah but QE!” – yes I know that – but as you surely know, dear reader the ECB is running into a brick wall in terms of bonds to buy soon and anyway, the market is so desparately short of collateral that they’re mooting (and banging newswires with) schemes to lend out the bonds they bought. But wasn’t the point of QE to swap bonds for money to help the economy???? Quite. Anyway you can’t do impossible things for ever and the ECB will not – and who remembers what happened when the Fed tested the waters about tapering bond purchases back in 2013 ? Clearly not many people. 5y bunds are trading at -40bp – which is the same as the ECB’s deposit rate.

Now is the ECB going to withdraw asset purchases overnight? no. But is the market going to believe that they’re going to keep monetary policy accomadative when they inevitably have to change the rules either in December or January? History implies not. The ECB is an institution riven with conflict, the market is pricing the next 5 years with policy as loose and accomadative as is mathematically possible. All it takes is that probability distribution to shift and those holding 5y paper yielding the same as the overnight deposit rate are going to be 5years worth of worried all at once. That’s the magic of fixed income markets. God I love them so.

 

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How long before “Trumpenomics” is a thing…

In the strapline of my blog I claim that I’ll write about money, markets, people and power – so it’s high time to write somethig about a rich man, dominating the hivemind of the markets – driving people’s sentiments without purpose, and thereby exercising incredible power. I don’t need to tell you about the Donald Trump’s manifest unsuitability for any kind of elected office. His crassness , contempt for women and sexual boorishness, inability to run his businesses, and thin skinned temprament are well documented. What I do need to tell you about is how the men and women of the financial sector have welcomed the donald into their lives.

You see, when pressed for an answer as to where markets would go if he were elected – most people, including me, would say that it was impossible and that he would be a disaster for stock prices. Well, the first part is true of me. But as a Socialist I recognise that fundamentally, the value of finanical assets is determined by the confidence of market participants in the ability of those assets to generate cashflows – ideally in a currency people want to have – and that this is effectively done by creating systems of property rights, laws, norms and values that entrench the interests of the powerful and wealthy. Whilst I couldn’t have and didn’t predict the magnitude of the move in equities or interest rates, the direction was and remains obvious.

It is a phenomenal thing to see the formerly impossible become accepted and normalised by intelligent people. The human mind is a rationalising engine – capable of accomadating anything and everything in order to get on with the job of self preservation. Things decried as impossible become the new normal – and narratives are spun. Before Trump’s ascendancy – the atlanta Fed’s wage growth tracker had been telling us quite inescapably that wages were going up. But no one was clicking that link prior to the narrative kick provided by what I’m going to unabashadly call “Trumpenomics” because why not – it’ll be retrospectively applied anyway to whatever garbled mix of “pro business” policies emerge from the eclectic mix of individuals comprise his regime. I put pro business in inverted commas not because I think that Trump is bad for businesses, but because I think that “bad for business” is a nonsense statement. Businesses –  companies -corporations – are abstractions, legal vehicles of convenience for the accomplishment of things that people need. “Pro Business” actually means “Pro Profits” – or rather, pro a bigger slice of purchasing power left over for the owners of capital to enjoy after labour has been paid. I suspect that – quite by accident – Trumps administration will prove enormously succcessful at increasing the profit share of american companies. In this sense, I am as invested in the narrative machine as anyone else. Trumpenomics FTW!

But in many important senses I am not and neither should you be. Policies and institutions that are “pro business” are not neccesarily “pro wealth”. Increasing the slice of the purchasing power pie that capital gets is only good for the holders of capital if the pie is made of something tasty – and hasn’t gone off. To extend the metaphor arguably too far – leavnig the pie outside of the refridgerator to make it easier to grab slices will shorten its lifespan. Decreasing the workforce, entering into trade wars, wasting resources on preventing imaginary threats, increasing wasteful subsidies for fossil fuels etc constitute things that fit that stretched metaphor well. For now I’ve moved a portion of my meagre savings into US Equities because I believe there’s a lot of ruin in a nation (as an economist once said) and the power of the narrative machine is in full swing. But it won’t stay there long. As soon as “Trumpenomics” becomes widespread in popular culture and imagination I’ll take my position off as at that point, the narrative will have been spun – but behind the scenes, an ignorant, self serving, venal man will have been destroying the very basiss of wealth in the US and world economy. No narrative will be able to overcome the fact of that.

 

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Arbitraging Japan – Some Reflections

This week I was encouraged to read “arbitraging Japan” – an ethnography of a group of arbitrage traders working in a Japanese securities firm in the late 80’s when Japan experienced something loosely equivalent to the UK’s big bang, through to the early 2000’s. I wouldn’t unhesitatingly recommend it to all – but it raised a few topics that I wanted to reflect on briefly because I’ve also wondered about them professionally and personally – if you have too you should read it.

The key concept of the book is arbitrage. In financial markets, this generally refers to the practice of going long and short very closely related instruments which are fundamentally economically related. One aims to buy a cheap version and sell a rich version of the same thing. The main example covered by the traders in the book is the practice of buying and selling stock index futures against the component stocks of the index in the expectation that the prices of the two will converge. As a fixed income market guy by trade the main similar activity I see in this vein is trading the government bond futures basis (see footnote). However whilst the instruments that are subject to arbitrage are normally related fundamentally – they can diverge in price (hence the possibility of arbitrage) – and the extent to which they diverge is arguably simply a matter of speculation. It’s hence my belief that so called arbitrage traders are engaged in a form of meta speculation – effectively selling options on structural breaks.

By this I mean, if there’s some event that perturbs prices such as it can be argued there’s an arbitrage opportunity – there’s no guarantee the phenomenon that displaced them won’t carry on. A classic recent example in markets has been the persistent richness of German government bonds relative to interest rate swaps, and government bond futures. The cause is simple enough – the EcB has pre announced that it will buy bonds regardless of price. Even though other instruments exist that do the same thing (ie, get euros in the future rather than now via interest rate swaps or futures) – they aren’t buying those – so the relative value of these bonds has become a thing that rv funds use to hedge their macro exposures, and macro funds use to take outright speculative, not arbitrage positions.

The point generalises – any difference between comparable securities that can be effected by ‘macro’ factors can go from an arbitrage trade to a macro trade. This phenomenon can of course become self fulfilling as markets are forward looking by nature. Some but not all of this is addressed in the book – which presents the tension between arbitrage (rv) and speculation (macro) as a kind of existential question that the traders involved grapple with. I think both the author and the participants interviewed come across as naiive when discussing this – it’s much more a practical distinction than an abstract one – but it is well worth a skim read to decide for oneself. I am a self declared arbitrage/rv sceptic – so i am biased. This book is an interesting perspective.

The other interesting part for me was the perpetual discussion of exit strategies by the subjects of the book, derivative traders who looked at their work as an engineering problem. As they could see that theirs was an engineering problem that didn’t solve any identifiable real world one, they were all anxious to make an impact on the real world by quitting and doing something proper. This is well worth reading for any of who who wonder what city folks sit and think about when they, as all of us, ponder there place in the world and the meaning of their work. These Japanese securities traders worry about exactly the same mix of existential angst about the usefulness of their work combined with the visceral fear that others are being paid more for the same work that pervades dealing floors across the world to this day. I encourage you to sift the book for these sentiments.

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No one is allowed to talk about costs without asking me first.

No one is allowed to talk about costs without asking me first. That is the new rule. I hereby enact it. Legally, it is higher in status than common law. Enforceable by the highest court of the land – my tiny readership’s exceptionally well informed opinion – clear, unbiased and objective. No one is allowed to talk about how much things cost without asking me first to check they are not talking total jibberish.

I’m prompted to enact this important new piece of legislation by an exceptionally awful piece written by the normally pretty decent @Capx. For died in the wool lefties such as I, its important to cultivate sources of well informed, articulate right wing opinion and most of their output is interesting in substance and in spirit. However one of their latest pieces is so naive and economically illiterate that I feel the need to lay down the law. Here it is in all its glory. Feast your eyes. Let’s lay some cards on the table. Yes I’m left wing. Yes I’m largely pro corbyn (in the same sense that I’m pro the England football team – tribally and noisily aligned but not entirely confident in). I still feel I’m absolutely qualified, in an objective sense, to declare this criticism of Labour’s economic policies as total and utter nonsense.

Followers of the inimitable @GeorgePearkes and hopefully many others will be familiar with the concept of chartcrime. I hereby introduce a related offence – table crime. This effort from Capx will be  a landmark stated case in establishing tablecrime legal precedent:

Pure, untramelled criminality.

It’s really difficult to know where to start with this so I’ll take one of my absolute pet peeves first. If you’re talking about macroeconomics, and this guy alleges to be, don’t talk to me about a billion here and a billion there. I sit in my comfy chair on the dealing floor and watch the UK Government merrily issuing, and also buying back through the bank of englands asset purchase program, billions of pounds worth of gilts every week. I have personally traded bigger notionals of UK Government bonds in one clip than some of the line items in this table – and it won’t surprise you to learn that I’m not that big of a player in the UK Gilt market!

Now let’s discuss an absolutely bog standard economic pet peeve – mixing up stocks and flows. I really can’t emphasise enough that this is just utterly unacceptable if you purport to be a serious person and talk about economics. “Capital cost of infrastructure borrowing” is a weird doublespeaky way of saying “This is how much extra borrowing there will be”. And what’s the next line item? The cost of servicing that borrowing. You cannot add those two things up. Whatever calculation your table is trying to get at, adding up the stock of new borrowing and the cashflow associated with that borrowing is not going to get you there. Unless the purpose of your calculation is “write down all the biggest numbers i can think of associated with policies I dislike” in which case – bang on.

However, the main and most galling and infuriating thing about this whole exercise is the attempt to apportion these costs to households. Let’s ignore the stocks/flows/conjectures etc and assume he’d done the exercise honestly and uncovered labour plans to spend £17500 per household across the next parliament. How, in the name of all that is holy, is that a “cost per household”? Most of the actual policies tallied in the table that involve actual government spending involve the state paying costs that are currently paid by households. If we’re to adopt the frankly ludicrous language of reintroducing the spare room subsidy – or as one might more honestly put it, “not fining people any more for living in houses that we’ve decided are too big for them” , this makes it even more glaringly obvious. How can a subsidy that is explicitly paid to households be counted as  a cost to households? It is so absolutely nonsensical and absurd that I can’t understand how it can have been written down by a thinking, feeling human being. But it was. I can almost forgive more the bizarre idea that the government issuing extra bonds is a cost to households, because on some level, it’s reasonable to assume that someone has to lend the government money and that households are the ones ultimately doing it. It’d be wrong to assume that – but it’d be reasonable. Declaring a government subsidy to households as a cost however is so stupid it needs some sort of new and special word to describe it.

Frankly, I think  there’s a much bigger issue in terms of people’s understanding of what “cost” means – and the problem, as so often in life, comes down to money. It is worth remembering that money is the one thing of which there can never be a shortage, unless deliberately orchestrated. Parliament could pass an act tomorrow giving every UK citizen £1000 in cash. We could do a special syndicated £64bio gilt issue – which for a modest fee I would be very happy to assist in arranging in my capacity as a market maker. I’d advise the UK government to issue a new 75y inflation linked bond – on which it would pay a real yield of around -1.8%. Ok, maybe they’d have to pay more like -1.6% to give it a bit of new issue premium – but given that the long end of the real yield curve is downward sloping I’d say there’s good demand for convexity out there so why not give it a go! Anyway I digress. The point is – money is not the problem. The problem is always how we allocate real resources. Houses, people, computers, copper, grain, pins, blue tac, prawn mayonnaise sandwiches – these are what matter. Their cost in £ is only relevant in so far as if it changes too much or too quickly – people get confused and spooked and might produce or consume less of them because they’re used to a certain structure of nominal costs which guides their decisions about how to allocate real resources.

So in reality, my policy idea of a special one time bonus of £1000 for everyone might have some real costs – because it might lead to some pretty wacky behaviour on the behalf of “real economic agents” – i’m sure my local corner shop does not have enough craft beers to cope with every area hipster being given a £1000 windfall. Things could get ugly. But the point is it’s just not good enough to note that some amount of money x has been borrowed by the government, or spent on something (especially if you’ve double counted it!) – you have to be able to explain why it’s going to be a cost in real terms. Even if you’ve gone one stage beyond who wrote this Capex piece and put some serious thought into how labour’s policies might affect economic aggregates – which he hasn’t at all – it’s not good enough. People deserve better. One has a responsibility as an economic commentator to explain to people what the impact of policies will be on their lives.Econmoic aggregates don’t tell you much about that at all. I personally guarantee you that in their current state, issuing an extra £70bio of gilts a year into starry eyed yield hungry financial markets will make feck all difference to the welfare of ordinary people. But repealing cruel and vindictive benefits reforms that have barely any impact on economic aggregates will have a massive effect on the financial and psychological wellbeing of thousands.

There’s a lot of ill informed and spurious nonsense in the piece that I’ve left untouched – but one final point needs addressing. I quote the bloke directly:
“However, today’s record-low bond yields are unlikely to stay for long. Yields have typically been between 2 per cent and 5 per cent in the recent past, and inflationary pressures mean that yields will likely return to these levels by 2020.”
The market unambiguously disagrees with him . He may well be right – but I don’t think so, and I’m happy to take his bet. If 10y UK Nominal Yields are above 3% on the 31st of October 2020, I will buy him a steak dinner if he agrees to buy me one if they’re below. I’m sure we will have a lively discussion on the day either way!

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Against corporate philanthropy

The internet has come on a long way since I started using it as a teenager. Back then, before governments and large businesses understood the benefits of using such a cheap and flexible means of communication – it was a more playful, free and anarchic space. Most people’s first email addresses are amusing little snapshots of attempts at self expression as of the late 90’s or early 2000’s. I think of mine as a charming relic of a more innocent time. Which is why this advert upsets me so much.  For me, it represents the forcing of corporate attitudes into a space that used to be expressive and vibrant.  This, to be clear, is not even the start of my argument against corporate philanthropy. It’s me laying my cards on the table emotionally. Corporate control of our cultural and intellectual landscape is troubling to me.

As Adam Smith memorably wrote and @CJFDillow likes, quite rightly,  to quote “We frequently see the respectful attentions of the world more strongly directed towards the rich and the great, than towards the wise and the virtuous.” A friend whose grandparents emigrated from the caribbean once told me about an incident that happened to her grandfather a couple of weeks after he arrived in the UK. A homeless white man asked him for change, and because he assumed that the man must really be in need, he handed over all the money he had. We have a natural tendency to respect and give weight to the demands of what we perceieve as “legitimate authority”. In Jonathan Haidt’s excellent book on “The Righteous Mind” he discusses at length the seemingly innate disposition we have to trust and respect legitimate authority –  and distrust and dislike illegitimate authority. I don’t want to go into his evo-psych justifications for this, because I think it’s important to consider ones everyday experience. As master Yoda might say, search your feelings, you know it to be true!

Ought we to trust profitable companies or wealthy individuals as legitimate authority? I think not. If a company is making large profits because they’ve found a special way to do something that others find valuable, it’s reasonable for them to have that innovation rewarded. But in reality, it’s not innovative companies that neccesarily earn durable profits. Rather its companies that have effectively created ways of generating stable and enduring  rents – or as Warren Buffet, who’s apparently quite good at understanding how to command wealth, would have it:

“Our approach is very much profiting from lack of change rather than from change. With Wrigley chewing gum, it’s lack of change that appeals to me. I don’t think it is going to be hurt by the Internet. That’s the kind of business I like.”

So if he’s right, and the performance of Berskshire Hathaways stock would indicate he has been, the way to command and increase ones wealth, at least historically has been to just find sources of economic rent and try and keep hold of them. If one looks at a list of the worlds billionaires, its remarkable how many of them are heirs and heiresses. I recall an  article celebrating the fact that two thirds of America’s 400 richest people had NOT inherited their wealth.   That of course means that 1/3 did. As a side note, I don’t see much distinction between very wealthy indiiduals and very wealthy companies. Both are just entities capable of directing large amounts of resources and human activity as they see fit.

So the first troubling aspect of corporate philanthropy for me is that it provides legitimation for a system of laws and property rights that we have that greatly reward economic rent seeking. Preserving wealth is far too easy – and political support for making it harder is non existent. Corporate philanthropy further undermines the case against making it harder to get rich by legitimating wealth and allowing the wealthy to say, truthfully, that were it not for them, such and such museum would not be funded or these orphans wouldn’t be fed and clothed – or whatever schemes they’ve chosen to spend a portion of their profits or rents on.The argument here is very similar to the one for fossil fuel divestment by pension funds. Buying stock in BP is not in and of itself going to harm the environment – but by making the income of pensioners contingent on the profitabilty of an oil company –  political support is likely to be lower for changing the rules to make oil production and consumption less profitable or attractive.

Then there are the incentives at play. For every dollar spent, corporate and individual philanthropists may well be trying to do real good – and may even be totally convinced of thier own sincerity – but they have a powerful incentive to use each dollar to maximise their own reputation and goodwill, as ultimately this is what will allow them to perpetuate their wealth. And as they are already wealthy or profitable, we can fairly surmise this is something they are interested in doing! If we are to have the choice between the wealthy and powerful deciding which causes ought to receive their largesse, or some more democratic or needs means of allocating resources, it seems very obvious to me that the latter is better. On one level, it’s fair to argue this is irrelevant- because for a given configuration of the world, we’ll have a certain amount spent by wealthy individuals on corporates on philanthropic things and a certain amount doled out by more democratic means. But this I think is to consider only partial not general equilibrim effects. Clearly, charities ability to replace corporate funding with funding from other sources is not going to be 100% – but equally clearly it’s not going to be zero. I’m confident enough in asserting that some kind of says law for charitable work operates – whereby supply creates its own demand! Charities are good at lobbying and fundraising.

So how far would I take this argument, in terms of what actual policy prescriptions I would make. Not far. In my ideal world, corporate philanthropy would be of no consequence whatsoever because wealth would not be so concentrated and corporate profits would be low. Wealthy individuals and profitable companies would have no case to answer that would make them feel the need to redistribute to causes that they chose –  and in the corporate case, they’d be mainly owned by either their own employees or shareholders who wouldn’t tolerate such largesse. In the meantime, I’d be very satisfied if people would join me in my belief that big companies and very rich people window dressing their rent seeking with virtue signalling philanthropy is not a good thing.

 

 

 

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Rates people are smart

Nothing is more fun than tribalism. Watching a sports match is one thing, yelling abuse at those who happen to support the other team for no other reason  adds that extra little sizzle to the experience that really keeps us coming back. The human mind – forged in the nasty, brutish and short lives of antiquity, has a slot designed for loving those who share our practices and values – and hating those who don’t – regardless of whether there’s any merit or reason to that. And that, my friends, is the pinch of salt that you’ll have to take when you hear me say this: We in the rates market know what those equity monkeys can’t know – and don’t know –  that this economic cycle is almost done, and the great asset valuation bear market is about to draw down on us with a vengeance.

A bit of background for those of you who need a grounding in the different tribes here, let me lay out the two stalls. In the rates market, we try and figure out the fair valuation of a $ tomorrow vs a $ today. How and why those $ end up in different folks pockets is not something that interest us. We trade promises to pay later, made by governments or companies, or aggregated promises of individuals – but at the end of the day our intellectual muscle is spent figuring out the fair value of those promises. If the US government promises you a $ in 10y time, what’s that worth today? The zero coupon 10y yield is, according to ijamlon 1.789% – so about 84 cents.  5 years ago in 2011, the 10y rate was closer to 3.75%, so a dollar from the US government was worth 69 cts upfront. What changed? Did the US government get more creditworthy? Given they own the printing press that seems implausible. Did we all start saving more?

10y-us-vs-savings-rate

Eyeballing that chart, no, in 1011 the savings rate was about 5% and it’s about 5% now – yet we value $ in 10y time 20% more than we did back then. So what gives? That’s what I spend my professional life worrying about.

What Equity market professionals worry about is quite different. Rather than the price of a $ now vs that in 10y time, they worry about trying to buy up quasi ownership rights of what they believe are the good bits of the real economy. When you buy equities, you’re paying for the income stream that some particular arrangement of labour and capital – embodied in a company  is going to provide you down the line. Equity guys are all about the process of production – trying to anticipate the way the world will change, and trying to keep invested in those companies that will deliver returns. It’s not about when the $ come, because if you invest in the right capital/labour arrangement – you’re not buying cashflows you’re buying the right to participate in the cashflows that result from the success of those arrangements. And you know that in the background, the rates guys are hard at work making sure that whenever those returns are coming, they’re fairly discounted back into today’s money so that you get the benefit in price terms. It’s a very different activity. Equity guys aren’t thinking about when and how they get paid. The market takes care of that. They’re thinking about whether companies are succeeding or failing.

What prompts me to write this is a chart I made last week. I encourage you to go look at it yourselves. Plot the performance of any measure you like of “Growth stocks” (I used an ETF, DM me for the ticker, I don’t have it home) – and charted it as a ratio to the SPX to measure relative performance. I then put the slope of the 2’s10’s curve in $ on the same chart. Let’s back up. What’s a “Growth stock”? Well, basically, it’s a stock where you’re expecting that by investing a lot upfront – the company is going to reap substantial returns in the future. In other words, you’re paying someone to invest money in real assets for you to generate income. Those stocks have outperformed. At the same time, 2’s10’s – the slope between the 10y rate and the 2y rate in the US has crashed out of a range it held for a few years, and sits around 50bp where it was previously moving around between 100-250. What are those two things telling you?

In one sense, it’s the same thing. Both rates people and equity people are “long duration”! The rates people have decided that it’s only 0.4% worse, per year, to lock up your money for 10y rather than 2 – ie they’re happy to get their money later. The equitiy guys are thinking the same! They’re after growth stocks – stocks where the stream of dividends that are ultimately what the investors have to live on are a long way out. But then, in another very important respect, it’s not the same at all. Growth stocks are only going to pay dividends if they are allocating capital well-  and therefore future rates of return on capital are high. But the rates market is telling you that in the future, the fair rate of return on capital is going to be low. Historically, a flat yield curve is a good predictor of a recession.

My partisan read of this is that the equity market has been forced, in the absence of any real ability to predict future returns and especially recessions   to bid up duration. The difference is, we in the rates market know they’re doing it and I don’t think  they do. And the other difference is that their “duration” is “future claims on REAL returns” of companies – whereas our duration is just fixed cashflows. In summary, the rates market is telling them they’re about to fall and fall hard – yet due to myopia, optimism and unfounded bullishness – that very same force is pushing equity valuations to new highs. All of this unwinds in an ugly way.

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Interest rates and savings

When I interview candidates  – I like to ask them to talk me through how the central bank controls the economy using interest rates. A good candidate will normally answer by saying that when inflation and growth are too low, the central bank will lower interest rates. Lower interest rates mean that households consume more and save less, stimulating demand. Businesses will find that more potential projects have expected returns higher than the rate of interest on loans, and thus investment will pick up. My next question normally catches people pretty well off guard. What evidence do we have that this works? How do we know that households save less and consumer more in response to a fall in interest rates?  It’s not an unreasonable question. If I were interviewing someone to be a physics teacher – I would expect them to know about Rutherford’s experiments to determine the nature of the atom. As I’m interviewing market participants who are responsible for setting interest rates, making predictions about interest rates, and understanding the nature of the relationship between interest rates and the macroeconomy – It’s reasonable to expect them to have some kind of grasp of the evidence, isn’t it?

Well actually no – it isn’t – for many reasons. The first is one of ontology. Economics, at least as stated by my interview question, is many layers of abstraction removed from what one could conceivably run lab style experiments on. The evidence will be less pithy than, say, Rutherford’s alpha particles being bounced off onto his detectors.  But the second is that just amazingly little work has been done by professional economists to uncover just how this causal mechanism of lowering and raising interest rates actually feed through to the actions of households and businesses. This St Louis Fed paper from 2012 takes it as read that the effects of interest rates on economic actors are pretty much undetectable -and the paper it chooses to reference that stance, co-authored by a former Fed Chair no less, says the same in a roundabout why. And this was written in 1995! Have we come a long way from there? If any friendly economists reading have links to send me – I should be glad of them. After all, one day one of my candidates might actually answer the question and then I’ll be in real trouble! But my own amateurish investigations indicate to me that we haven’t.

There are a couple of aspects to this debate that I think particularly are never discussed enough, and I want to air them here that others might engage on them. Firstly, it’s not obvious to me at all that people save because they intend to consume that money in the future. It seems to me instead that people save because they are intending to earn interest income – which is why stocks and shares are so unpopular but savings accounts and houses are. There is a massive industry within finance of taking risky assets and repackaging them for retail consumption so that they look more like conventional savings accounts. For example, one can buy all manner of equity linked instruments that pay a steady coupon if the underlying stocks perform according to certain conditions (a typical contract will entitle to saver to a fixed coupon of an equity index goes up in a given year, but pay nothing if it does not). Most long markets in long dated options are dominated by the weird and wonderful exposures these products throw off for their issuing banks. The broader point is, if people are investing for income not for future consumption, lowering rates could very well raise the desired savings rate.

FF vs Saving Rate

The behaviour of US savings rates since the recession is not inconsistent with that idea at all.

Another aspect that’s underappreciated is that this behaviour is  institutionalised in pension arrangements that pay a percentage of final salary – for whom lowering interest rates simply raises the pension providers liabilities – resulting in a greater need for the provider to put capital into the fund. In other words, we’ve managed to institutionalise lower interest rates leading to higher savings rates-  just by the corporate not the household sector. Indeed, the corporate sector has been running substantial positive financial balances with the rest of the economy in the UK for years (i use the UK because Neil puts that nice sectoral balance chart on his blog and i’m too lazy to do my own). There are other reasons for that to be the case, but it’s not inconsistent with the fact that corporates have to effectively save more and more in order to meet their pension liabilities. British Airways is a pension fund that has an airline arm.

Anyway, the point of all of this reflection is that we’ve built an apparatus for monetary policy that takes this understanding of the world – that lower rates stimulates demand and vice versa – as read – or publicly says that it does. I quietly suspect that in private, central bankers are pretty sceptical about their own abilities to understand or forecast economic variables – and the extent to which they can influence them via policy. When looking at the relationship between markets and central bankers, it’s always good to bear in mind that both are looking uncertainly at the real economy trying to work out what’s going on. The fact that one set of actors cares about the outcomes and one doesn’t does not mean that their actions are more effective.

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