Hypotheses fall under two broad headings in diagnosing the cause of low rates and low growth; a savings glut and a financing glut. Trouble is that not only are the symptoms easily confused, but the policy remedy for one glut may serve only to deepen the other.
Michala Marcussen, Group Chief Economist and Head of Economic and Sector Research
The idea of a savings glut, caused by insufficient demand in Asia and fast ageing economies, first emerged as an explanation to the conundrum of long-dated American Treasury yields remaining low even as the Federal Reserve tightened policy over the course of 2004-06. Post the Great Financial Crisis of 2008, secular stagnation, with a chronic lack aggregate demand (consumption and investment), again fuelling the savings glut, won ground in explaining both why growth remained lacklustre, and this despite aggressive monetary easing, and why asset prices still soared as excess savings chased too few assets.
Curing secular stagnation is, on paper at least, quite straight forward. Given that investment, in theory, expands as long as its marginal return is above the cost of financing and depreciation, then all it takes is to boost investment and lower excess savings is to simply to cut rates even further. And should private demand still resist, then fiscal stimulus can take over. Indeed, public balance sheets also win capacity from low interest rates and some economists even suggest that fiscal expansion could be funded directly by central banks’ monetary printing presses.
However, if the root problem instead is a chronic lack of supply, then ultra-low rates could become part of the problem fuelling a financing glut. Recall that credit expansion does not require savings expansion ex-ante. Banks lend deposits, but lending capacity is determined by required reserves, regulation and borrower capacity. New lending, moreover, creates new deposits, further increasing capacity as the money multiplier speeds along. Over on financial markets, there is a corresponding collateral multiplier. While spurring a financing glut can be arguably positive for growth in the first round, over time the risk is one of unproductive capital and labour allocation, depressing trend growth. This backdrop could in turn encourage households to save more, and one glut can thus lead to another in a spiral of ever lower rates. Ultimately a reversal rate, when low rates turn to an outright drag on the economy is reached with risk of ultimately deflating asset prices, again excessively inflated by the glut.
The financing glut diagnosis offers a far less comfortable policy conclusion. The required remedy is one of structural reform (education, labour markets, service and good markets, pension systems, judicial systems, etc.) to boost supply and such reforms are often unpopular with electorates.
History seems littered with numerous, intertwined and at times geographically coexisting episodes of twin gluts, explaining why economists often struggle to agree the root cause and politicians, given the option, choose to remedy only the politically most comfortable diagnosis, often pushing at bay structural reforms and leaving central banks overburdened.
With both the Federal Reserve and the European Central Bank engaged in strategic reviews, the challenge of correct diagnosis of the current low growth and low rate environment is once again centre stage. Already there are hints that future monetary policy could take greater account of more structural issues, such as climate change and inequality, and consider stronger co-ordination with fiscal and structural policy. If realised this would mark a brave and welcome move, and place significant demands also on governments to engage the right mix of spending and reform. The alternative of these strategic reviews merely delivering new tools allowing the central banks to keep rates even lower rates for even longer offers only the prospect of a new glut, risking even lower future growth.