My column in yesterday’s Fin (over the fold) was about the idea, being argued by The Economist that the low interest rates currently prevailing are the product of monetary expansion rather than a real ‘savings glut’. Today’s Economist puts the point even more bluntly, arguing that capital markets are acting as a barrier to adjustment. It’s certainly striking when a voice of orthodoxy like The Economist reaches the conclusion that financial markets aren’t doing their supposed job.
Low interest rates are the centrepiece of the Howard governmentâ€™s political and economic strategy. The claim that a Labor government would produce higher interest rates was the core of the governmentâ€™s successful campaign strategy in 2004. Strong consumer demand, driven by low interest rates, has kept the economy growing through periods of weakness in the international economy, and despite stagnation in manufacturing exports.
The government claims credit for low interest rates on the basis that by keeping the budget in surplus, it has increased aggregate national savings. But if interest rates were simply determined the balance between national savings and investment demand, they would have to rise considerably.
In reality, national savings fall far short of our demands for investment capital. The difference is made up by capital inflows from overseas. In the national accounts this is measured by the capital account surplus, which is equal and opposite to the current account deficit of about 7 per cent of GDP.
The crucial factor leading to low levels of national savings is that, at prevailing interest rates, Australian households would rather borrow than save. National household savings have been negative for some years, largely because households have been able to borrow against increasing equity in owner-occupied homes. The rise in house prices has itself been driven by low-interest rates, creating an apparently self-sustaining cycle.
Australia has led the way to negative household saving, but others have followed. The household savings rate in the United States fell to zero for the first time recently, and would be negative if the statistics were calculated on the same basis as in Australia. In the US case, the government has joined the party, running consistent budget deficits, yet interest rates, particularly including the crucial 10-year bond rate, have remained at historically low levels.
The picture is the same in other English-speaking countries, and to a lesser extent in the eurozone. Although European households have not embraced debt to the same extent as their Anglophone counterparts, savings rates have generally declined, and most eurozone governments are in deficit.
If interest rates are too low to induce households in developed countries to save, how can they be sustained. One answer is that savings are coming from elsewhere. This is the ‘global savings glut’ analysis popularised by Chairman of the US Council of Economic Advisors Ben Bernanke.
Most of the discussion of this analysis has focused on Asian economies and particularly on China. In economic terms, however, this part of the analysis makes no sense at all. China is a rapidly growing economy with strong investment demand. On any standard analysis, Chinese households ought to be borrowing in anticipation of future growth in income, and China ought to be a net importer of investment capital.
A more plausible part of the story relates to the recycling of â€˜petrodollarsâ€™ arising from higher oil prices. Oil-producing countries often have limited opportunities for domestic investment, and it is unwise to increase consumption much in response to what may be a temporary increase in income. So the proceeds of higher oil prices tend to be deposited in international banks, who then have to find borrowers.
Even taking account of petrodollar flows, it is hard to explain low interest rates in terms of equilibrium between the demand for investment capital and the supply of savings. An alternative explanation, recently proposed by The Economist magazine is that interest rates have been driven down by an expansion of liquidity, particularly in the United States. This is reflected in high rates of growth in monetary aggregates like M3, as well as in low interest rates.
A standard analysis would suggest that an expansionary policy of this kind cannot be sustained indefinitely without leading to inflation. Yet, although there has been massive inflation in a range of asset markets, particularly housing markets, consumer price inflation has remained low and shows no obvious signs of acceleration. One important reason for low inflation has been the downward price pressure arising from import competition.
So, we seem to have a perfect virtuous circle. Low interest rates are driven by expansionary monetary policy which maintains the supply of credit needed to sustain demand and maintain currency values in the face of massive current account deficits. A strong currency holds inflation down and allows low interest rates to be sustained.
It all sounds a bit too good to be true. But itâ€™s worked so far, and we have to hope it keeps on working.
John Quiggin is an ARC Federation Fellow in Economics and Political Science at the University of Queensland.