We need higher interest rates...now!

This assertion may appear odd but I believe a key factor for an economic recovery will be higher interest rates, now.

If I take a step back and use the fundamental macroeconomic equation : MV=PY, where M is the money supply, V the velocity, P the general price level and Y the GDP in volume, then you can observe the following:

-          Money supply M has been increasing (see figure 1) in the most liquid portion (cash, notes, bank deposits) via the QE operations but you could argue that some of this increase was frozen by banks

-          Velocity (figure 2) has crashed and continue to do so

-          Inflation: core inflation remains around 2%, which is actually the margin of forecast error. But overall, the headline rate is a function of food and energy prices.

-          Volume GDP has been disappointing (figure 3) for a recovery. 

 

Figure 1: money supply increase

 Figure 2: Velocity of Money

 Figure 3: disappointing US GDP growth

I think the remedy to our woes lies in treating V first.

However, current policies are not addressing V. They are actually weakening velocity.

Thesis

“I think the current low interest rates, instead of spurring consumption, are forcing savings into either government bonds or property, where there is an illusion of return on capital.

Therefore, investment is being starved and capital mis-allocated.“

My demonstration

The case of property

The transmission mechanism as I see it: imagine you have been an employee able to save a portion of your income in the last 10 years. Say you have accumulated $100,000.

The cash returns being near 0 in nominal terms or at least -2% in real terms, you are looking at other options. You could buy government bonds and get a nil real return. Or you could try to get a 5% return in property (assuming all goes well, tenants pay the rents and do not damage the flat).

If you choose property, you may use $80,000 of those savings for a deposit and borrow and extra say $240,000 (25% deposit).

What is the result at the macro level of this rational microeconomic decision? Velocity collapses: before you are able to withdraw equity (assuming you are allowed to do it in your country), you will have to wait 9 years (see below)! For 9 years, $80,000 have been trapped and have not been used to provide valuable credit for investment.

Amortisation schedule on the suggested example

Now imagine you have been able to earn a real return on your money.

Then:

-          No need to invest in government bonds or property, trapping money for years: velocity rises.

-          Higher interest rates actually mean you can reduce your savings rate since your return on capital is higher. Lower savings rate imply higher consumption and higher growth. GDP rises.

-          Core inflation growth rate falls towards 0-1% as lower property prices reduce the costs for the entire economy. This in turn boosts investment (lower breakeven point) and consumption (more disposable income), hereby increasing GDP

The argument is also valid for government bonds

As bond yields race towards 1% for the US, Germany or even France despite budget balances and accumulated debts suggesting the contrary, those countries are not, I believe, beneficiaries of a flight to safety, but the direct consequence of a search for yield.

They get allocated vast amounts of capital unduly. Let’s face it, looking at the French or US numbers, would you ever think of lending money to a friend who outspends his or her income by 40% consistently?

This is absolutely not rational as the risk on your capital is not repaid by the income generated by the coupons.

So we are raising rates.

What are the drawbacks:

-          Corporate defaults will rise. They are very low: I quote S&P “Standard & Poor's expects the U.S. corporate trailing 12-month speculative-grade default rate to rise to 3.6% by March 2013, from 2.5% as of March 2012. Our baseline projection is still lower than the long-term (1981-2011) average of 4.5%.” => low rates are preventing bad companies to leave the market. Corporate margins are lower and do not provide enough cash flows for extra investments.

-          Personal defaults will rise: this will no doubt put pressure on banks, unless they are forced by the regulator to loosen lending standards

Conclusion

Raise IR now so a return on capital can be earned and valuable savings can be channelled to productive uses.

As velocity climbs back up, GDP can rise faster and inflation be contained.

Otherwise, we are Japan.