It is time to think the unthinkable and raise interest rates

Allister Heath triggered an epic twitter debate when he called for the Bank of England to do the unthinkable and raise interest rates.

On the one side, represented by former Monetary Policy Committee member Danny Blanchflower, were those who argued that we continue to need near zero interest rates until such time as the economy recovers and unemployment drops close to pre-financial crisis levels.

On the other side, represented by Ros Altmann, an economist who focuses on retirement issues, were those who argued that zero interest rate policies hurt the real economy by stifling demand.

Regular readers won't be surprised that your humble blogger (tweeting @tyillc) joined in the debate.

Before going further, let me remind readers that unlike Ms. Altmann and Mr. Blanchflower, I do not have a PhD in Economics.  As a result, like Walter Bagehot, the Economist Magazine editor who invented the modern central bank, I focus on what is actually happening and providing a framework for understanding what it will take to end our current financial crisis and prevent future financial crises.

To his credit, Mr. Blanchflower presents an energetic defense of the indefensible.  He argues that given the current level of unemployment there is no empirical support in a peer reviewed economic article that supports the notion that interest rates should be raised.  The economic literature calls for aggressive monetary stimulus.

Hmmm...is this the same peer group of economists that failed to predict the financial crisis?

Hmmm...is this the same peer group that is making economic forecasts at both the Bank of England and Fed and since the beginning of the financial crisis has routinely predicted better economic performance than has occurred?

I called Mr. Blanchflower's position indefensible because the peer reviewed economic literature never considers that there might be an inflection point where the strong relationship between lower interest rates and lower unemployment no longer holds.

Regular readers know exactly where this inflection point is:  it is Walter Bagehot's 2% lower bound.  He observed in the 1870s that economic behavior changes when interest rates drop below 2% and as a result said interest rates must be kept above this level.

Once one realizes there is an inflection point, it is easy to explain why the Bank of England and the Fed are predicting better economic performance than has occurred.  Below the inflection point, economic behavior changed and this change in behavior is not incorporated into the models used by the Bank of England and the Fed.

On the other side of the debate, Ms. Altmann supported Mr. Heath's observation on the impact of the zero interest rate and quantitative easing policies.

Keeping rates artificially low for extended periods of time inevitably distorts economies and misallocates resources. 

It allows unsustainable projects to survive, pushes bond, equity and property prices too high, depresses the value of sterling without, in a modern economy, boosting exports, messes up the pensions market, and incentivises consumption over saving – and all of that even before inflation begins to rear its ugly head.

Ms. Altmann puts forth the arguments the regular readers are familiar with under the Retirement Plan Death Spiral.  Current consumption is reduced as savers, both individuals and corporations, offset the loss of earnings on their retirement plans by saving more money.

As you can imagine, the debate became show me the empirical proof versus here is the anecdotal evidence.

To see if Mr. Blanchflower might acknowledge that maybe zero interest rates and quantitative easing are not the appropriate policy response to a bank solvency led financial crisis, I introduced the WSJ interview of Anna Schwartz.

Ms. Schwartz observed that these policies were wrong, wrong, wrong.

Mr. Blanchflower asked if this was the best I could do.

Naturally, I responded with a yes.  After all, Ms. Schwartz was an expert on the Great Depression and co-authored THE book on monetary policy.

To see if there were a position of compromise, I introduced the simple fact that back when I was working at the Fed and the Fed was taming inflation the economy was not particularly sensitive to changes in interest rates of less than 1%.

Despite Alan Greenspan cutting rates by a quarter of 1% at a time, there is no reason to believe the real economy has gotten to be more responsive to changes in interest rates.  Does anyone really think a company doesn't move ahead with a project because the cost of debt goes up by 0.25%?  Does anyone really think people don't buy a house because the cost of debt goes up by 0.25% (hint: they buy a smaller house)?

Faced with this fact, Mr. Blanchflower offered the real reason that central bankers will never be able to allow interest rates to increase.

@tyillc @rosaltmann @asentance because mortgage holders have had falling real wages compensated for by low mtg payments so if rise disaster

Translation: central bank policy is held hostage by excess public and private debt in the financial system and the need to protect bank book capital levels and banker bonuses.

I would like to thank Mr. Blanchflower for a) his willingness to engage in the discussion and b) his insights.

I would be remiss to not share one other insight.  As Mr. Blanchflower observed, he and I can debate what the policy should be, but the policymakers need to get it right.

In two days, it will be six years since the beginning of the financial crisis and the policymakers have not gotten right.  As documented by the Dallas Fed, the cost of the financial crisis has now grown to well in excess of $12 trillion with no end in sight.

Retirement savings: the million-dollar myth explains why consumer demand not rebounding

In her Guardian column, Helaine Olen discusses how in today's low interest rate environment, $1 million in savings is inadequate for retirement.

This is a very important point because it triggers what your humble blogger has called the Retirement Plan Death Spiral.

Individuals saving for retirement or in retirement understand the million-dollar myth and are reducing their current consumption in response so they don't run out of money while they are retired.

This creates the interesting situation where central banks are trying through low interest rates to get individuals to loosen their purse strings and spend while at the same time individuals are cutting back their consumption to offset the loss of income while they are retired on their retirement savings.

As Japan passes the 2+ decade mark and the EU, UK and US pass the half decade mark, it is clear that individuals preference for not running out of cash when they retire overwhelms their urge to spend because central bankers keep rates low.

RBS' Stephen Hester ends myth that monetary policies pursued by central banks will end financial crisis

The Telegraph reports that the head of RBS, Stephen Hester, has said his bank is swamped with funds to make loans, but businesses don't want the loans as they don't see an increase in demand to generate cash flow to repay the loans.

Regular readers will recognize Mr. Hester's observation as exactly why your humble blogger predicted the central banks' monetary policies of zero interest rate and quantitative easing would fail when they were first announced.

When business looks to make an investment, its first consideration is whether there is going to be an increase in its top line from demand.  It doesn't look at how cheaply it can fund the investment until after it has determined there is demand.

The problem with low interest rate policies is that once interest rates drop below 2%, both consumers and companies don't respond to a drop in interest rates the way they did when rates were lowered from say 9% to 8%.

This change in behavior has been known since at least the 1870s when Walter Bagehot, who invented the modern central bank, observed this change and said that interest rates should never be lowered below 2%.

This change in behavior has been confirmed with the Retirement Plan Death Spiral.  Under the Retirement Plan Death Spiral current demand is lowered as both individuals and corporations are forced to save more to offset the lack of earnings on the money in their retirement plans.

In the case of businesses, money that could be used for reinvestment and growth is instead put into pension plans.  In the case of individuals, money that could be spent today is instead saved.  This includes paying down debt as well as putting money into savings.

This change in behavior from interest rates being below 2% has been shown in Japan for 2+ decades.  Deflation has set in as Japanese save rather than spend despite 2+ decades of zero interest rate and quantitative easing monetary policies.

Stephen Hester has waded into the controversy about an apparent lack of lending for smaller businesses, saying Royal Bank of Scotland (RBS) £20bn of cash it was “desperate” to lend out, but companies were not prepared to borrow as they lacked faith in the economic recovery.

“We are lending as much as we can,” Hester said. “We are not constrained by either capital or funding, Mr Hester told The Sunday Times. “The only way I could see for us to lend more would be for someone to say we did not have to operate by any commercial standard – that we could undercut everyone because we did not have to make a profit.” 

He also said that RBS had “deposits coming out our ears”, an apparent shot across the bow of Sir Mervyn King, governor of the Bank of England, who has called for RBS to raise more capital or be broken up. 

Banks have been accused to stifling the recovery in the UK by failing to lend to businesses. However, Mr Hester’s statement imply it is lack of progress in improving business confidence that is stopping companies from investing for growth, rather than banks constraining lending criteria. 

Mr Hester said he could not “force companies to borrow”.

Please re-read the highlighted text as Mr. Hester has has confirmed why low interest rate monetary policies are doomed to failure before they are even enacted.

Why low interest rates policies are not the answer

In her Guardian column, Ros Altmann explains why the the low interest policies being pursued in the EU, Japan, UK and US are not the answer to a bank solvency led financial crisis.

Her column is interesting for a number of reasons.

First, it comes out on the day after the Bank of England's Mervyn King said the Swedish Model under which banks recognize the losses on the excess debt in the financial system is the answer.  This comes from an individual who has tried low interest rate policies and seen that they do not work.

Second, she confirms what your humble blogger has been saying since the beginning of the financial crisis about why low interest rate policies don't work.

It is four years since the Bank of England cut the base rate to 0.5% and started its £375bn money-creation programme, quantitative easing.... monetary measures pushing lending rates lower in order to revive the economy have failed, merely resulting in stagflation. 

Yet, still the Bank believes the problem is that rates are not low enough, even floating the astonishing possibility of "negative" interest rates.

Good doctors, whose patient is not recovering, would not just continue prescribing more of the same medicine, they would look for a different cure....

To his credit, Sir Mervyn King suggested exactly what is needed.  If policymakers were to follow his advice, the Bank of England could immediately raise interest rates back up to the 2% minimum level set by Walter Bagehot and end the distortions going on in the real economy.

I believe the damaging side-effects of the monetary medicine may actually be undermining recovery. 

Yes, those with large mortgages have had a bonanza, and banks have benefited hugely, but ultra-low interest rates are hurting important sections of the economy. 

Savers' and pensioners' nominal and real incomes have fallen sharply, while companies providing pension schemes have had to pour billions into their funds rather than their businesses, as low rates push up deficits.

Your humble blogger has referred to what has happened to savers, pensioners and companies as the Retirement Plan Death Spiral.

The death spiral refers to the simple fact that savers, pensioners and companies make up for the lack of earnings on their retirement plans/pensions by cutting back current demand and saving more.  This creates an economic headwind that more than offsets any stimulative benefits from lower interest rates.

Since 2008, Bank of England policy has focussed entirely on bringing down interest rates in order to boost growth. 

Academic models predict lowering rates will boost bank lending and increase access to credit for purchases of homes or other goods and services, ensuring economic recovery. However, this hasn't happened here.

That is because the academic models are wrong!!!

Regular readers know that these academic models did not predict the financial crisis either.  So there is absolutely no reason to believe they should predict what is happening now.

Rather than rushing to spend their extra money, over-extended mortgage borrowers have taken advantage of lower rates to accelerate repayments and clear their debts. 

Meanwhile, older savers' and pensioners' incomes have been squeezed by falling rates and soaring pension costs, leaving them poorer. 

Savings rates have lagged behind inflation, reducing real incomes, eroding the real value of savings and lowering consumer confidence. Fearing for their financial future as their current or prospective income plummets, many have cut spending.

Nice description of the retirement plan death spiral that is left out of the academic models.

Of course, no one wants to see home repossessions, but artificially propping up house prices locks future generations out of the housing market, distorts rental costs and delays the banks and building societies recognising their losses. 

Around four in 10 mortgages are interest-only – with many having no strategy for capital repayment – so low rates are just a politically expedient short-term sticking plaster, not a solution....

Please re-read the highlighted text as Ms. Altmann has succinctly summarized how banks are the primary beneficiary of a politically expedient policy that is not a long-term solution.

Low interest rates act like a tax increase on savers and pensioners, by reducing their income. 

This quasi-tightening of fiscal policy has transferred national income from older savers, to younger borrowers and banks. For example, since 2008, borrowers with a £100,000 mortgage are over £2,400 better off every year. However, savers with £100,000 in Cash Isas or fixed-rate bonds are over £2,750 a year worse off.

If the Chancellor were to announce a huge tax increase on older workers and pensioners, particularly to help people who had borrowed or lent too much, there would be uproar. 

But, by doing this via monetary policy rather than fiscal policy, there has been no democratic debate....

Please re-read the highlighted text as Ms. Altmann has highlighted why the current policy responses to the bank solvency led financial crisis are undermining democracy around the world.

The policy response has benefitted the bankers at the expense of the voting taxpayers.  The voting taxpayers sense that something is wrong with how elected officials are behaving and Ms. Altmann has just spelled out what it is.

Parliament committee concludes that monetary policy experiments put taxpayers at risk for no known benefit

The Telegraph reports that Parliament's Public Account Committee has concluded that monetary policies like quantitative easing that are backed by the taxpayer put the taxpayer at risk for no known benefit.

The Treasury has put billions of pounds of taxpayer money at risk by sticking state guarantees on “a series of expensive experiments” that it does not fully understand, an influential group of MPs has warned. 

The Public Accounts Committee (PAC) claimed the Chancellor’s department does not have any clear goals for either the Bank of England’s £375bn quantitative easing (QE) programme or its £80bn Funding for Lending scheme (FLS), both of which are backed by the taxpayer, and had no means of monitoring their progress. 

Margaret Hodge, chair of the committee, said: “The Treasury has not convinced us it understands either the risks it has taken on by indemnifying the Bank against losses on QE or the expected economic benefits... The Treasury seems to be embarking on a series of expensive experiments, indemnified with taxpayers’ money.” 

Experiments that are likely to end badly.  After all, if these monetary policy experiments worked, why isn't Japan, which has implemented these policies, experiencing tremendous economic growth?

The Treasury has resorted to providing guarantees and indemnities in an attempt to drive the recovery without increasing public borrowing. However, such “contingent liabilities” carry a risk of loss as the state has pledged to bear some or all of the downside. 

With QE, the taxpayer has fully indemnified the Bank. Under the FLS, high street lenders can swap risky bundles of loans for low-risk Treasury bills. Both schemes were designed to help boost growth, but carry the potential for losses..... 

Giving evidence to the committee in October, Sir Nicholas Macpherson, the Treasury’s Permanent Secretary, described QE as “an experiment, and we won’t know the ultimate answer for many years”. Although the scheme was in profit in 2011/2012, he warned that there was a risk of losses from QE. 

“At some point interest rates will start rising... and at that point you could sustain quite big losses. My guess is that it will all wash out in the end, “ he said....

The size of the losses should the central banks try to resell the bonds they bought under quantitative easing will be orders of magnitude larger than the interest income generate on the bonds.

Fortunately, because central banks have zero "cost" to carry the bonds, they can hold the bonds to maturity and never realize the loss.  Of course, this assumes that the central banks have other ways of reducing the money supply that don't cost money.

In the US, Chairman Bernanke has continued to say that the Fed won't have to sell, it can manage the money supply by paying more interest on the excess reserves in the banking system and therefore control the potential inflationary impact of these reserves.  The problem with this is that it effectively recognizes the losses on the bonds purchased under QE (the alternative to paying interest is to sell the bonds and reduce reserves that way).

The PAC urged the Treasury to “provide more transparency on what QE is seeking to achieve”, and to work with the Bank to “understand and publish data on the effects and benefits of the measure”. 

The very last thing that the central banks want to do is provide more transparency on what QE is seeking to achieve and publish data on its effects and benefits.

Doing so will highlight that QE and its related zero interest rate policies are creating an economic headwind (recall the Retirement Plan Death Spiral) that is causing both consumer and business demand to shrink.

The conclusion will be that these economic experiments in monetary policy, while shown to be very effective by the central banks' models that didn't predict the financial crisis, are a real world disaster.

Low rates force companies to pour cash into pensions

The Wall Street Journal reported that low interest rates are forcing companies to pour cash into their pensions rather than invest in their core business.

This report confirms the Retirement Plan Death Spiral that your humble blogger first discussed many months ago when I first looked at the headwinds created by the central banks' low interest rate policies.  

Under the Retirement Plan Death Spiral, the low interest rate policies being pursued by central banks trigger a self-reinforcing downward spiral in the economy.  

Companies offset the lack of earnings on pension fund assets by diverting funds needed for growth and reinvestment to their pension funds.  This depresses demand in the economy which results in further downward pressure on pension fund earnings.  

Downward pressure that companies then have to offset by diverting more capital needed for reinvestment and growth to their pension plans.

Of course, the Retirement Plan Death Spiral could be stopped, but this would require that the central banks acknowledge that their low interest rate policies aren't working and raising interest rates to at least the 2% level recommended as an absolute minimum by Walter Bagehot, the father of modern central banking.

Ford Motor Co. expects to spend $5 billion this year shoring up its pension funds, almost as much as the auto maker spent last year building plants, buying equipment and developing new cars. 

The nation's second-largest auto maker is one of a who's who of U.S. companies pouring cash into pension plans now being battered by record low interest rates. 

 Verizon Communications Inc.contributed $1.7 billion to its pension plan in the fourth quarter and—highlighting companies' sensitivity to this issue—Boeing Co. now reports "core earnings" to separate out pension expenses. 

"It is one of the top issues that companies are dealing with now," said Michael Moran, pension strategist at investment adviser Goldman Sachs Asset Management. 

The drain on corporate cash is a side effect of the U.S. monetary policy aimed at encouraging borrowing to stimulate the economy. Companies are required to calculate the present value of the future pension liabilities by using a so-called discount rate, based on corporate bond yields. As those rates fall, the liabilities rise.... 

Today, many of the companies contributing to the pensions are struggling with the costs but don't offer defined benefit plans to new workers....

Andrew Liveris, chief executive of Dow Chemical Co., which posted a loss of $716 million for the fourth quarter, said the company faces a "massive pension headwind" because of the change in the discount rate that added $2.2 billion to its pension liability. 

Pension expense this year is going to rise between $250 million and $300 million. 

"Other companies have got it, and so we're not alone, but clearly those are big numbers for us," Mr. Liveris said. 

Pension experts: QE is a 'monumental' mistake

The Guardian reports that pension experts have gone before a Parliament committee and explained why the Bank of England's pursuit of quantitative easing (QE) has been a 'monumental' mistake and how the economy would recover if the BoE stopped pursuing all the related low interest rate policies.

Regular readers of this blog will be familiar with the arguments that the pension experts put forward on why QE should be abandoned as they were presented here first.

The Bank of England's policy of pumping money into the economy has been a "monumental mistake", pensions experts have warned . 

A committee of MPs heard that measures taken by the Bank to drive the economy had backfired by squeezing individuals' incomes – both pensioners and those in work – and forcing companies to divert cash into pension funds rather than investing.

I referred to these two economic headwinds as the retirement fund death spiral.  The trigger for the death spiral is the adoption of zero interest rate and related policies like QE.

Both individuals and companies move to offset the loss of earnings on their savings and reinforce the negative feedback loop.  Individuals do this by cutting back current consumption and saving more.  Companies offset the decline in earnings on pension funds by diverting cash rather than investing.

The actions by both individuals and companies reduce aggregate demand.  Since the BoE wants to boost aggregate demand, it pursues the low interest rate policies even more aggressively.  The result is a further drop in aggregate demand as both individuals and corporations move to offset the loss income.

That individuals change their spending and saving habits in the face of low interest rates has been known since the 1870s.  Walter Bagehot, the father of modern central banking, even stated that interest rates should never be less than 2%.

Ros Altmann, pensions expert and director general of Saga, said current policies devalued pensioners' incomes, making them less willing to spend: "Quantitative easing and ultra-low interest rates have hampered the spending power of those in the economy who were not over-indebted and who would otherwise have spent money." ...

Altmann said ending the QE programme was much more likely to herald a period of growth than its introduction had done. "History will judge this as a monumental mistake," she said. "If we do not have any more quantitative easing, the economy will be freer to grow than if we do."

Please re-read the highlighted text as Ros Altmann has nicely summarized what your humble blogger has been saying about why zero interest rate policies never work to boost demand and why abandoning these policies would actually produce the growth in the economy that central bankers want.

Under the QE programme, the Bank of England has bought £375bn of UK government bonds, or gilts, with newly created electronic money. It now owns almost a third of all gilts in the market. This huge influx of demand has driven gilt prices higher and means yields, or the effective interest rates on them – which represent government borrowing costs – are at record low levels. 

That has the unintended consequence of pummelling pension funds, which use gilt yields to calculate their future liabilities. When gilt yields plummet, pension fund deficits effectively balloon. 

The National Association of Pension Funds (NAPF) estimated last year that QE had increased pension deficits by at least £90bn over the past three years. 

Current regulations mean companies must plug those holes. Mark Hyde Harrison, the chairman of NAPF, said businesses are now having to contribute to their pension schemes instead of investing for the future, which negates any positive impact of QE....

Please re-read the highlighted text as Mr. Harrison has described the retirement fund death spiral triggered by zero interest rate policies.

QE has also reduced the incomes of recent retirees using their pension pot to buy an annuity, which sets the size of their income for life, as annuities are also linked to gilt yields. 

Altmann said monetary easing had acted like a "tax increase" on older people. She said the economy is in "unprecedented territory" and the gilt market had never been distorted in such a way. 

The Bank of England had not properly considered whether carrying out a policy which penalises certain sections of society is acceptable, because it has assumed that the path it has taken was the only option. 

QE is not creating growth and is hampering the spending of people who are not particularly burdened with debt because they are "worried about what's coming next," she said.

Please re-read the highlighted text as Ms. Altmann has made a very important point.  Specifically, the pursuit of zero interest rate policies including QE sends a message that undermines consumer confidence as these policies reflect the simple fact that central banks are still in crisis management mode.

Baby boomers blunt Fed easing while saving for retirement

Bloomberg reports that savers are cutting back on current consumption to make up for the shortfall in the earnings on their retirement savings.  As a result, they are blunting the impact of the Fed's zero interest rate and quantitative easing policies.

Regular readers know this is precisely what your humble blogger predicted would happen based on a) Walter Bagehot's observation in the 1870s that savers cannot stand interest rate below 2% and b) Mark Twain's observation that he was more concern about the return of his capital than the return on his capital.

I went further than predict this, I coined the expression "Retirement Plan Death Spiral".

Under the retirement plan death spiral, both individuals and companies reduce their current demand to offset the lack of return on retirement assets.  Companies do this by making up the earnings shortfall by contributing funds that would otherwise be used for reinvestment and growth.

Cutting back on current consumption feeds into a self-reinforcing negative cycle.  The more they cut back on current demand, the bigger the earnings shortfall....

What triggers the retirement plan death spiral is the sub-2% interest rate policies pursued by the Fed and other central banks.

John Rodwick cuts corners so he has money to spend on his seven grandchildren and cruise around the Rocky Mountains with his wife, Jean, in their blue-trimmed Roadtrek motor home. 

“My wife and I love to travel, so that is our one big expense, but we are very, very conservative,” cooking and sleeping in their 19-foot vehicle, said the 72-year-old former business professor. With the value of their three-bedroom home plunging 30 percent in the past six years, the Rodwicks have become “very cost conscious,” he said. 

Federal Reserve officials say they’re concerned that retirees like the Rodwicks are blunting the impact of record easing aimed at creating jobs. 

The reason: Older people are more likely to forgo purchases of houses, cars and other big-ticket items that the Fed is trying to encourage with near-zero interest rates. And their numbers are growing, making the Fed’s task ever harder. ....

People usually save more as they near retirement. Now, the effect is magnified because Americans’ wealth has been depleted by the financial crisis, which decimated home values and retirement accounts invested in stocks, according to Britt Beemer, chairman of America’s Research Group Ltd., a Summerville, South Carolina-based consumer-behavior research company.... 

Retirees and older workers probably will reduce spending as they anticipate tax increases and cuts in Medicare and Social Security, said Dudley, who is vice chairman of the policy-making Federal Open Market Committee.

Talk about a one-two punch.

The cut in interest rates reduces earnings on savings and results in a reduction in current demand.

The anticipated austerity measures like tax increases and cuts in social programs also result in a reduction in demand.

Regular readers know that this one-two punch is the direct result of continuing to pursue the Japanese Model for handling a bank solvency led financial crisis and protecting bank book capital levels and banker bonuses at all costs.

This one-two punch would immediately go away if the Swedish Model were adopted and banks were required to recognize upfront the losses the will ultimately incur if the excess debt goes through the long process of default and foreclosure.

Meanwhile, retirement incomes are being hit by the very Fed policies that are intended to spur the three-year economic expansion ....

“All this money-printing hurts savers,” Republican Representative Paul Ryan of Wisconsin, his party’s vice presidential nominee, said during remarks at an AARP event in New Orleans on Sept. 21. “It threatens the future value of our money -- and seniors are bearing most of the risk.” 

Bernanke says the scant return for savers is preferable to the losses they may suffer if the central bank were to begin raising interest rates too early....

It is only too early if the Swedish Model is not adopted and the banks have not yet recognized all the losses hiding on and off their balance sheets.

The postwar generation is shifting spending toward education, mortgage debt and their adult children and away from entertainment, dining, furniture and clothes, according to a report last month from the National Center for Policy Analysis, a Dallas-based research group that advocates free markets. 

Retirees are consistently more frugal than younger age groups, said Pamela Goodfellow, consumer insights director at BIGinsight, a research company based in Worthington, Ohio. 

“If you’ve got to put your kid in college, you’ve got to spend,” she said. “Retirees have almost a luxury of not having quite so many spending demands put upon them.”

To ensure sufficient income later in life, Americans will need to increase savings, delay retirement and prepare for changes to entitlements such as Social Security and Medicare, according to a report by the National Academy of Sciences.

 This fact is not lost on anyone.  Hence, the lack of a rebound in current demand.

Will UK regulators crush current demand when savers are shown realistic returns on their retirement plan assets?

The Telegraph reports that UK's Financial Services Authority is requiring that more realistic assumptions about the return on pension fund assets be used to show savers what they can expect in retirement.

The question is will this accelerate the Retirement Plan Death Spiral.  Under the Retirement Plan Death Spiral, savers make up the shortfall in earnings on their retirement funds by saving more and deferring current consumption.

Naturally, the slowdown in current consumption reduce the return on the retirement fund assets and causes an even bigger shortfall to occur.  The negative self-reinforcing cycle continues as the saver responds by once again reducing their current consumption and saving more.

Millions of savers will see the predicted value of their retirement pots plunge by almost 40 per cent after the financial regulator ordered pension firms to cut their growth forecasts due to the global economic slowdown. 

The Financial Services Authority (FSA) said that from 2014 the predicted growth rates used to give investors an idea of what their pension pot will be worth when they retire must be significantly lower than they are today. 

Currently pension companies use a so-called “intermediate projection rate” of 7 per cent in statements to savers. This means that someone in their 20s who earns £30,000 and saves £2,000 a year into a workplace pension can expect to have a retirement pot when they reach 68 of £540,000. 

However under the new 5 per cent growth rate that firms will have to use, this pot will be valued at just £335,000. The change means that the person’s predicted pension income will fall from £10,400 a year to £6,430 a year, a drop of 38 per cent. 

Experts said that the lower rate will provide a “dose of cold economic reality” to savers and will give them a more accurate idea of the money they can expect to receive on retirement. ...

Tom McPhail, head of pensions research at Hargreaves Lansdown, the pension company, said: “This is a dose of cold economic reality for investors; the FSA is telling them to expect lower growth, which means that for a given level of pension they need to save more and that means making more compromises over how much they can afford to spend today.”

Please re-read the highlighted text as it summarizes the Retirement Plan Death Spiral.  No growth in demand, leads to lower investment returns, leads to individuals having to save more, leads to lower demand....

David Einhorn: Headwinds from quantitative easing and zero interest rate policies overwhelm benefits

David Einhorn weighed in on QE and zero interest rate policies and made a very strong case for why the headwinds created in the real world by these monetary policies overwhelm any benefits shown in the Fed's economic model.

Regular readers know that your humble blogger has been making this point since these policies were announced.  I pointed out Walter Bagehot's, the father of modern central banking, rule not to reduce interest rates below 2% and Mark Twain's statement that he was more concerned about the return of his money than the return on his money.

In case anyone listening to or reading Mr. Einhorn's speech missed this point, Tyler Durden at Zero Hedge hammers it home while discussing this speech in his usual understated style.

David Einhorn knocks it out of the park with his very first statement during today's Buttonwood Gathering, in a segment dedicated to one thing only: explaining how the Fed's policies are not only not helping the economy, they are now actively destroying this country. 

"Sometimes you have to look at what is the base assumption. because sometimes you have a groupthink around the base assumption and everybody agrees to the same thing and acts reflexively and doesn't really challenge what is going on. I think we have reached that point with the monetary policy. 

The assumption is that if you want the economy to improve, if you want more jobs, if you want more consumption, what we need is ever-easing monetary policy. My point is that if one jelly donut is a fine thing to have, 35 jelly donuts is not a fine thing to have, and it gets to a point where it's not a question of diminishing returns but it actually turns out to be a drag. 

I think we have passed the point where incremental easing of Federal policy actually acts as a headwind to the economy and is actually slowing down our recovery, and I am alarmed by the reflexive groupthink of the leaders which is if we want a stronger economy, we need lower rates, we need more QE and other such measures."... 

At one point in the interview, Einhorn observes that traders and economists now have diametrically opposing views on the effectiveness of QE (no need to explain whose view is what). 

The reason for this dichotomy is simple, if crucial: we are now at a point where the entire practice of new-classical economics - the bedrock thinking of all modern soecity - is at risk of being exposed for a sham "science" which is and has always been absolutely flawed.... 

But back to Einhorn, who presents one of the most coherent explanations why QE, contrary to the Chairman's "best intentions" does nothing to stimulate the economy at the consumer level, and why it effectively serves as a hindrance to future growth: 

"Lower rates drive up the cost of commodities: oil and food. And money that is spent on oil is sent out of the country to the Mideast and it doesn't help, and takes out income from people's pockets that could otherwise be spent on other goods. 

The second [ZH: and this is by far the biggest thing that the Fed refuses to acknowledge] is that not being able to earn a safe return on savings, is causing people to hoard savings rather than consume. 

In other words if I know I am going to earn 3% in the bank I can spend that income and I can have visibility towards that, but if I know I'm going to earn zero in the bank, in order to figure out how much I need to save for retirement I need to save a much bigger number. Which means I can't spend much now, I need to save more now, to build up those savings for retirement. If I am already retired and I am on fixed income, my income has now really gone down and I have to hoard money so I can spread it out thinner over a longer part of my life. 

So by denying individuals savings or interest on income on their savings, it is causing hoarding which is driving down consumption which is hurting the economy."

Mr. Einhorn has just described what I refer to as the Retirement Plan Death Spiral.  To make up for the lack of earnings on savings on the personal or pension level, individuals and companies need to put more money into savings and less into consumption.  This effectively deprives the real economy of the capital it needs for growth and puts it into a downward spiral.

As a reminder, in America consumption, not the government... is responsible for 70% of annual GDP. Is it any wonder that the Fed's own policies, done solely to protect the financial system, and to enrich those whose wealth is already primarily in the stock market (the infamous "1%"), are the cause of the ongoing catastrophe that is the destruction of America's middle class, which day after day sinks lower and lower?

Mr. Durden's comment describes the Fed's role in pursuing the Japanese Model and protecting bank book capital and banker bonuses.

Also, in direct debunking of all those Magic Money Tree (aka MMT) "economists" who say that government deficits are a great thing because the lead to higher savings, while maybe true on paper, Einhorn shows that the "expectations" component of behavior here is far more critical than what simplistic Econ 101 textbooks claim, especially the ones that were written long before anyone thought that the US would have a Zero Interest Rate Policy for at least 7 years (and likely more until the runaway inflation finally hits): 

In terms of the savings, I don't think it's a zero sum, because it's a multiplier on the behavior. It's not just the income I am not receiving now. It is the income I don't expect to receive in the future as well. Now we are four years into [ZIRP] with a promise of at least three more, so that's seven years, and you are getting a change in behavior on a multiplied basis.

Mr. Einhorn's describes a self-reinforcing negative dynamic.  The less money people expect to earn on their savings, the more they cut back on consumption and save.

Remember, one form of savings is paying down consumer credit.  This is effectively the risk-free rate of return for individuals.

Yes, some people are borrowing more.  Just look at student loans.  However, for people with the choice to consume or save (and these are the ones who drive the economy at the margin), Fed monetary policies are putting enormous pressure on them to save/pay off their debts.

Finally, and touching on the previous point of why theoretical economists' views differ so much from those who practically make a living by being right for a change, Einhorn is laconic: 

"It's very hard for economists with models, with very limited sample sets and empirical data to understand [that we've gone beyond the point of monetary policy diminishing returns.] I think you wind up with a different view from people like me in the real world who aren't just trying to figure out what do the models say, but how do people actually behave....  

We've opened up enormous tail risks of what happens if the Fed loses control, what happens if the Treasury loses control and these scare people and drive up risk premiums, and drive down P/E multiples and make companies defer long-term investments in the country because they are worried about significant tail risks these very aggressive policies are creating."... 

None of the what Einhorn said in today's Buttonwood gathering of course is news, as he simply reiterated everything he said in his letter to investors from Tuesday, which is just as effective at explaining how the Fed's solipsistic illogical methods are bankrupting America. The key section in that letter is the following excerpt:

 

It seems as if nothing will stop the money printing, and Chairman Bernanke in fact assures us that it will continue even after the economic recovery strengthens. Specifically, he says, “Even after the economy starts to recover more quickly, even after the unemployment rate begins to move down more decisively, we’re not going to rush to begin to tighten policy.” Apparently, anything less than a $40 billion per month subscription order for MBS is now considered ‘tightening’. He’s letting us know that what once looked like a purchasing spree of unimaginable proportions is now just the monthly budget.
Chairman Bernanke concedes that this policy hurts savers, then offers some verbal sleight-of-hand worthy of a three-card monte hustle: He says the savers are helped by low rates because low rates support higher asset values and promote a healthy and growing economy. He then goes on to say that because savers benefit from a healthy and growing economy, we must therefore have an accommodative policy. This in turn begs the question: Does an accommodative policy promote a healthy economy?

 As monetary policies are currently implemented, Mr. Einhorn, Walter Bagehot and I would argue no.

Chairman Bernanke argues that higher asset values create a wealth effect, which he again describes, “if people feel that their financial situation is better because their 401(k) looks better or for whatever reason, their house is worth more, they are more willing to go out and spend.”

We have just spent 15 years learning that a policy of creating asset bubbles is a bad idea, so it is hard to imagine why the Fed wants to create another one. 

But perhaps the more basic question is: How fruitful is the wealth effect? Is the additional spending that these volatile paper profits are intended to induce overwhelmed by the lost consumption of the many savers who are deprived of steady, recurring interest income? 

We have asked several well-known economists who publicly support the Fed’s policy and found that they don’t have good answers.

Deepening pension deficits leave UK companies diverting more capital from the real economy

The Telegraph carried an interesting article discussing how the lack of return on savings under zero interest rate and quantitative easing policies has triggered the Retirement Plan Death Spiral for both companies (aka the Pension Plan Death Spiral) and for individuals.

This article confirms your humble blogger's analysis that current monetary policy generates its own headwinds which make recovery from a bank solvency led financial crisis impossible.

It also confirms the observation made in the 1870s by the father of modern central banking, Walter Bagehot, that interest rates should never be set lower than 2%.

JLT Pension Capital Strategies ... said the total deficit stood at £55bn on June 30 compared to £33bn a year earlier. 

Eleven FTSE 100 companies have pension liabilities that are greater than their equity market value; BAE Systems, BT and RBS are committed to paying out pensions that are worth more than double their market value. 

The deepening deficit hole has been caused by factors including poor returns on equities and the Bank of England’s quantitative easing programme, which pushes up the price of government gilts, creating lower returns for pension funds.... 

Please note the cause of the pension plan assets not generating the expected returns.

“We have reached the stage where scheme deficits are widening substantially on an annual basis,” he said. 

Blue-chip companies are trying to plug the gap with capital injections while looking for alternative sources, such as property investment, to fund their pension schemes. 

If the FTSE 100 companies are staring into an abyss, smaller companies are going bust on a regular basis because they can no longer finance their pension schemes.... 

Please note the damage done to the real economy as companies shift funds from reinvestment in the real economy to paying for pension liability.  Demand is lowered and a negative feedback loop is established.

Companies have generally shifted towards defined contribution pension schemes, where a company makes contributions or matching contributions to a pension but doesn’t guarantee future payments to the employee, as they can’t afford defined benefit schemes where the employee has a fixed amount guaranteed on retirement. 

Some companies are responding by making the employees responsible for saving enough for their retirement.

This feeds into the Individual Retirement Plan Death Spiral.

“We have to face up to the fact that DB’s gone and DC’s coming,” said Mr Cowling. 

The auto-enrolment scheme, which kicked off on October 1, is a defined contribution plan which will see millions of workers gradually included in an automatic pension scheme, although a report from JLT launched at the Liberal Democrats’ party conference in Brighton said minimum compliance with the scheme would not secure a comfortable retirement. 

The consultancy estimated that an employee paying the 8pc default contribution would have to work eight years beyond the current retirement age – to 76 – to achieve the recommended pension of two thirds of final earnings. 

The government has said the contribution rates were set to ease people into saving and individuals should aim to save more if they can. 

To have enough to retire on, individuals have to cut back on their current demand.

Given that individuals account for almost 70% of demand, their cutting back current demand puts tremendous downward pressure on the economy.