It has become conventional wisdom that negative real interest rates are here to stay and that they are a good thing.
I argue below that, on the contrary, they distort economic activity, create inappropriate incentives and that dealing directly with the problems the financial crisis left us with would be better than fixing a very important price, that of money. Many might say we have become used to negative returns on our cash so why change now when the stock market is booming, house prices are rising, and the government can borrow all it needs and be paid to do so?
The reason is because two wrongs don’t make a right. Interest rates have been forced so low as a counter influence to the government’s repeated attacks on the banking system. The changes in regulation, increases in taxes, and special levies have led to huge reductions in lending by all the major UK banks. To offset the fall in lending (and we are talking about £400bn) the Bank of England purchased financial assets of almost the same amount – or to put it another way, banks have withdrawn from the lending business and been replaced by an arm of government. The government has created this situation by firstly creating huge and unmanageable banks and encouraging them to behave foolishly by a misconceived drive for openness and common accounting standards and secondly, after the inevitable (and predicted) coordinated collapse, applied unnecessary prudential rules (which force a reduction in lending) and extra taxes (which reduces equity and forces further reduction in lending). The problem with this side of the £400bn equation is that banks are quite good at lending – it is what they are designed for. Governments have neither the analytic structure nor planning horizons which allow them to make rational lending decisions. The pursuit of short term political advantage by parties will never go away – and it is inconsistent with making sensible economic decisions.
But the effective removal of the banks from lending is not the only consequence of recent government policy. The provision of huge quantities of financial assets at near zero nominal rates – which in an environment of 2% plus inflation means at negative real rates, has profound effects on behaviour in the private sector and it is this which is most damaging. Interest rates are a price, but a rather different price to most others, because the interest rate is effectively the benefit you receive for not consuming anything today but waiting until tomorrow – or alternatively, if you are borrowing, the cost you pay for taking resources today rather than waiting until tomorrow. When the government artificially holds down interest rates they affect every economic decision – so immediate consumption is encouraged, saving discouraged, projects with short term pay back discouraged relative to those with long term pay back; and capital intensive industries are relatively advantaged, and house prices and other asset price bubbles are likely. Speculation is encouraged and bubbles will be created.
All of this would be fine if we were in a Keynesian style depression but it is obvious that we are not, indeed on many measures we are four years into recovery. The private sector generally, and export industries in particular, have been expanding – it is just that the bloated oversized and out of control public sector has been reducing in size. What is needed is cheap finance for those who can deploy resources efficiently – what we are getting as a result of current policies is cheap finance for the government which is, of its very nature, incapable of making sensible investment decisions. For many profitable projects it is availability of finance, not its costs, which is the limiting factor and government policy is reducing price and availability – it should now do the opposite.
There are three immediate actions the government should take. Firstly, increase real interest rates at least to zero to remove the severe economic distortions caused by negative rates. Secondly, stop and review the unnecessary and financially unnecessary increases in reserve ratios which are and will be forcing banks in Europe to cut back their balance sheets for the foreseeable future, and thirdly introduce a sensible tax regime which allows banks to keep more profits, therefore create more equity and lend more. Even more useful would be a self-denying ordinance (which the rest of the financial world would like too) to keep a new set of rules unchanged for a minimum period of ten years. Consistent with these policy reversals, but equally needing a long term approach, would be to create an environment which encouraged competition and experimentation by banks which had significantly smaller market shares than today’s big 4. This would be brought about naturally by a graduated reserve and central bank deposit scheme which increased the required deposits and resources at an increasing rate up to the point where any bank with a market share of UK deposits above, say 10%, would have a 100% marginal deposit requirement with the Bank of England. This is again the precise opposite of current government policy – where the regulatory burden on financial start-ups is unimaginably high and the Prime Minister personally pushed Lloyds Bank into buying Bank of Scotland.
So, in a nutshell, at higher interest rates the economy would grow faster and function better as long as the government stopped persecuting the banks, stopped the new reserve requirements of Basle III and allowed the lending market to get back to work.