Lower Interest Rates May Reduce Consumption
Saxo Bank CIO and chief economist Steen Jakobsen made a few comments that other day that hit me in the face like a bucket of ice water.
Here they are again, taken from Steen Jakobsen Warns “Euro is Not a Good Idea and ECB About to Make Biggest Mistake in History”
Jakobsen says success stories like the three QE Federal Reserve (Fed) cannot be extrapolated to the Eurozone. His reason? The US is a net debtor and falling interest rates affects international creditors and rising national income. In Europe the opposite is true. Citizens of the euro countries are net savers, which means that falling interest rates deteriorates their income and does nothing to activate the economy.
That paragraph stood out because Michael Pettis at China Financial Markets has made similar statements about interest rates in China.
Pettis on Stains in China’s Banking System
Please consider this snip from Pettis on Strains in China’s Banking System; Avoiding the Fall (an excerpt from Taking Stock of China’s Transition by Michael Pettis – via email – no link available – emphasis in italics mine).Â
 In cases where consumption is a relatively small part of total demand, in which household savings are high and tend to occur in the form of bank deposits, and especially if most new credit is allocated to producers rather than consumers, lower interest rates actually reduce consumption by reducing household income (lowering the return on savings), and increase production by lowering financing costs for producers.
The same can happen with currency depreciation, which reduces disposable household income by raising import prices while subsidizing the tradable goods sector. In cases like China and Japan, the net effect is more likely to increase total production of goods and services by more than it increases total consumption, so that the pressure on prices is disinflationary, not inflationary.
For years we have seen massive monetary expansion in China accompanied by low consumer price inflation, and most of that inflation was anyway driven by higher food prices, which were caused not by loose money but rather by agricultural shortages. For the past three years we have also seen the yen depreciate by nearly 40%, and yet not only has there been no corresponding increase in Japanese inflation, but we are constantly surprised by much weaker-than-expected consumption. Disinflation and even deflation, in other words, is going to be very hard to fight.
Europe vs. China
I pinged Michael Pettis with this question two days ago. “Is Steen saying the same thing as you in a more concise way, or are there differences between Europe and China in regards to lower interest rates.“
Here is the reply from Pettis…Â
 Steen is pointing to one of the many factors that can change what we always assume is an inverse relationship between monetary easing and consumer demand. In the US, monetary easing is almost always positive for consumption and it is almost always inflationary, and so we assume that this is true everywhere, but it doesn’t have to be true. There are only two things to remember, but we rarely remember them:
1. Changes in household consumption (which is most consumption) can be fully explained by changes in household income and changes in household savings rates. By the way, when you are looking for the data, some call “household” what others call “personal” — it’s the same.
a) If monetary easing causes household income to rise (by increasing employment), or if it increases household wealth (by increasing the value of equity, bonds and real estate), or if it reduces the desire to save (by reducing the reward for saving, or by reducing the cost of consumer credit), it will cause consumption to rise.Â
b) If monetary easing causes household income to decline (by reducing the return on bank deposits), or if it reduces household wealth (because most savings are in the form of bank deposits, which now have a lower return), or if it increases the desire to save (by increasing income inequality), it will cause consumption to decline.Â
c) In the US, monetary easing seems to reduce unemployment, it seems to increase household wealth on average, because most Americans savings are not in the form of bank deposits, it seems to reduce the desire to save, by making credit cards cheaper, and while it may increase income inequality, on average it seems to have a strong positive effect on consumption. In China monetary easing has little effect on unemployment because unemployment is still low, it seems to reduce household wealth on average, because most Chinese savings are in the form of bank deposits, it seems to increase the desire to save, because Chinese households have a target savings amount for retirement or for their kid’s university and lower deposit rates force them to save more to meet the target, it makes credit cards cheaper but there is little consumer credit in China, and it may increase income inequality. On average monetary easing seems to have a weak or negative effect on consumption.Â
2. Monetary easing can cause consumption to rise or to decline, for the reasons above, and it almost always causes production to rise (businesses can borrow more cheaply to expand facilities). If monetary easing causes production to rise faster than consumption, it is disinflationary. If monetary easing causes consumption to rise faster than production, it is inflationary.
My point is about #2. I argue that although monetary easing causes consumption to rise faster than production in the US, it does the opposite in China because most credit goes to production and on average monetary easing seems to have a weak or negative effect on consumption.
Steen is discussing #1. He argues that because Europeans have higher savings than Americans, and because most of it is in bank deposits, monetary easing has a negative effect on consumption in Europe, and not positive as in the US. Changes in consumption, by the way, also affect investment because businesses are unlikely to expand production if consumption is weak.
In short, Steen’s point is very interesting and too-often overlooked. And yes, I agree with your comment that in the US QE “works†mainly by causing debt to rise – in the sense that reigniting the equity and real estate bubble simply encourages households to spend the additional wealth in the form of consumer credit. Instead of inflating bubbles we should either improve infrastructure investment or fix the trade problem. I suspect the bankers that seem to be driving policy prefer bubbles.
Michael
