The Paradox of Thrift

As you are undoubtedly aware, interest rates in the US and indeed throughout the developed economies of the world have been extremely low for nearly 7 years.  The US Federal Reserve has held short-term interest rates close to zero ever since the housing crisis of 2008-09 under the premise that low interest rates would stimulate large, capital intensive investments (such as housing, automobiles, factories, equipment, etc.) which would in turn spark a broader recovery in the general economy.  At the same time, long-term interest rates have remained very low as well.  At first, this was accomplished through the Federal Reserve’s massive Quantitative Easing strategy, but lately this has been more attributable to the much more classical idea that investors simply prefer the safety and security of bonds to the point that any real yield is completely secondary, or maybe even irrelevant given the bewildering level of interest rates today.    

 

Generally speaking, this is the purpose of monetary policy in a nutshell.  During economic contractions, the central bank (in the US, the Federal Reserve) works to bring interest rates down in order to stimulate consumption and investment.  Inversely, during economic bubbles, the central bank will work to raise interest rates in order to moderate or slow consumption and investment. 

 

Ever since modern monetary policy was put into use by the US Federal Reserve in 1913, economic peaks (or bubbles) have been controlled remarkably well when the Federal Reserve acted timely to start raising short-term interest rates.  Whether or not the Federal Reserve is very good at recognizing economic peaks and troughs is another matter, but to the extent the central bank can effectively get ahead of an economic boom with appropriate monetary policy, raising interest rates has typically been a very effective tool for curbing the economy and the price inflation that normally results from financial bubbles. 

 

The biggest reason that a central bank can ultimately contain a peak cycle and choke off price inflation is that there is no upper limit to interest rates.  That is, if an economy really got into a massively overheated state with high inflation, the central bank would simply keep raising interest rates to the point that any new investment in capital intensive projects (such as factories, equipment, and housing) would simply become uneconomical and these projects would be shelved.  I would cite the (Paul) Volker-led Federal Reserve of the late 1970’s and early 1980’s as the most recent example of the effectiveness of high interest rates in containing an economic boom and the associated high price inflation.

 

The extent to which low, or even zero, interest rates can stimulate a flagging economy is much more debatable.  Economists refer to this problem as the “Pushing on a String” dilemma.  Just as with a limp piece of string, the central bank can push all it wants, but the other end of the string (that being, economic growth) may not move at all.  The last seven years have been a very good example of this problem in that the Federal Reserve has been providing extremely accommodative monetary policy and still the US economy remains stuck in a range of 2-3% growth.  That kind of growth is really the bare minimum the US needs just to absorb new labor into the work force every year (largely from immigration and an aging work force).  

 

One obvious reason why monetary policy alone is prone to problems in this type of environment is the zero-boundary of interest rates.  That is, interest rates cannot go negative for any length of time where borrowers actually pay lenders to deposit their money.  It would make more sense for savers to just stuff cash under a mattress or in a safe than to accept a negative interest rate.  During this ensuing and ordinarily short period of time, the economy cools off and contracts while unemployment rises.  Essentially, the economy goes into the penalty box for a while until all of the excess capacity from the boom period is burned off (actually depreciated or relocated).  Keep in mind, even at 0% financing, lending will remain anemic until managers are confident that investments in new capital intensive projects and labor can be economical. 

 

This process explains the typical lag that we experience from the time that interest rates bottom out to that point where economic expansion resumes, unemployment begins to fall dramatically, and wage pressures and price inflation start heating up again thus renewing the business cycle.  So a time lag such as we seem to be grinding through now is nothing new.  What is new is the duration of the lag this time around.  The typical lag usually runs from 18 – 36 months.  As mentioned above, the current lag is at 67 months (+7 years) with no real sign of abating. 

 

It is true that economic recoveries after a FINANCIAL crisis do take much longer to develop.  Keep in mind, the last financial crisis of the magnitude of 2008-09 was the Stock Market Crash of 1929 and the ensuing Great Depression.  The US economy never really recovered from that crisis until 1942 with massive government spending on WWII (a mind boggling 42% of US GDP).  Until now, we have been somewhat satisfied to attribute the current long duration of low interest rates to this idea that we are still working our way through a post financial crisis.  After all, it was a heck of housing crisis.

 

However, a new theory has been put forth that seems to be gaining traction with a lot of money managers and economists, and perhaps a few Federal Reserve governors.  This is the idea that, in addition to the factors discussed above, extremely low interest rates may actually be contributing to the long lag we are experiencing and that low interest rates may actually be retarding investment and capital expenditure at this point so late in the business cycle. 

 

There could be two forces at work associated with this theory that traditional monetary policy may be overlooking.  The first is that, because of unexpected low interest rates, savers may actually be cutting their consumption in order bring their budget in line with the reduced income they receive in the form of interest income.  On a micro level, this makes perfect sense.  Most sensible people simply call this living within your means.  However, on a macro level, this “Paradox of Thrift” flies completely contrary to the prescription of low interest rates.  As discussed above, low interest rates are supposed to stimulate investment and capital expenditure.  However, if enough individuals are cutting back their spending, there obviously won’t be the necessary demand to justify capital improvements and other investments to increase output capacity.  The argument here is that individuals may be cutting their spending because of the reduced interest income they receive on their savings, in addition to the other more commonly accepted reasons (such as unemployment and general uncertainty).     

 

We have absolutely seen this phenomenon at work in the energy industry.  Enough consumers around the world have discovered more fuel efficient vehicles and other ways to cut their energy consumption which has dramatically reduced the global demand for crude oil.  This phenomenon has also worked its way into the markets for iron ore, copper, and several other commodities in recent years.

 

The second force that may be at work is later retirement ages.  Because those workers nearing retirement may be looking at retirement income considerably less than they had planned for through their working career, many of these individuals may be delaying their retirement.  Again, at a micro-level, this makes perfect sense.  However, at a macro-level, if a large enough segment of the population is delaying retirement, this may actually be contributing to the stubbornly high unemployment rates.  Ordinarily, workers take retirement around age 65 which translates to approximately 3.0% of the labor force or 5 million jobs coming available just through natural attrition.  To the extent that these workers may be delaying retirement, there are conversely going to be fewer job openings for the younger, new entrants to the work force.  The result will be higher unemployment rates which is pretty consistent with what we seem to be seeing.  This relationship will have an impact on interest rates in that the Federal Reserve takes a big cue on its interest rate policy from unemployment rates.  High rates of unemployment are viewed as excess slack in the labor markers that need to be reemployed.  The Federal Reserve’s primary tool to stimulate hiring is low interest rates under the assumption that new businesses and investments will be created.

 

This notion that low interest rates may be contributing low growth and unemployment is a very interesting contradiction to the time tested monetary policies that most central banks employ.  And it is one of the best empiric explanations I have seen, apart from the zero-boundary for interest rates, for why monetary stimulus simply does not seem to work too well during periods of economic recovery. 

 

The bottom line in all of this is the direction of interest rates.  As mentioned above, there is a growing debate about the validity of this Paradox of Thrift dilemma and what it means for monetary policy, especially this late in an economic cycle.  The Federal Reserve is in a difficult position in that while they would certainly like to raise interest rates for a variety of reasons, they seem to be caught in a Catch-22.  They don’t really want to raise interest rates until there is better evidence of a recovery (lower unemployment and higher growth and price inflation).  But to the extent that the above described negative feedback loop may be in effect, an economic recovery can’t really take hold until interest rates do move higher.

 

For the time being anyway, we are going to take the Federal Reserve at their word that they are “data dependent” and that any meaningful move on interest rates will not take place until the economy improves.  This suggests that interest rates will stay low for a considerable period of time more.  Therefore, we have made the decision to continue to hold bonds of very short maturity simply because there is virtually no reward for accepting longer maturities.  In addition we have decided to underweight bonds altogether in all of the balanced or fixed income accounts that we manage and overweight equities. 

 

Our feeling is that as long as the Fed is going to continue to re-inflate asset prices with low interest rates, there really is no very good reason to stay in a normal- or over-weight bonds position and a normal- or under-weight equities position.  Obviously, if a few more Federal Reserve governors start lending credence to the above described low interest rate “trap,” we will re-evaluate this decision.  But we should have a very long lead time to make any adjustments in this respect as the Federal Reserve is typically very open and transparent with its communications any more.

 

 

Sincerely,

 

Mark P. Culver

Managing Partner

 

 

 

 

 

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