Are low rates in the eurozone skewing private portfolio preferences?

Daily commentary

The German-language media have been voicing concerns over the ECB’s low interest-rate policy and its effect on savings and investment in the euro zone. This makes sense given the state of the economy in Germany and Austria is significantly more robust than in the eurozone periphery. The German Bundesbank has already warned of overheated housing markets. Another warning on housing from Ireland crystallizes for me the risks with using monetary policy for reflation.

I think this debate goes back to Swedish economist Knut Wicksell and his theory of a ‘natural rate of inflation’. The Economist explained Wicksell’s theory a couple of weeks ago. And Greg Ip followed up with some good insights that I recommend reading at the Free Exchange blog. Here’s my interpretation of Wicksell. Basically, every project,  every investment, every company, every saver, and every investor in an economy has a ‘natural rate of interest’. This is a rate of interest at which the project or preferred savings or investment vehicles are profitable over the medium- to long- term.

For example, if you are the owner of the Plaza Hotel in New York City and you know that residential real estate prices are being bid up, you realize you could convert your hotel into residential real estate if the interest rate for financing that conversion is low enough to make the conversion profitable. If you are a saver who has a bunch of 5-year certificates of deposit at a bank that need to be re-invested, you could roll them over if the interest rate is high enough. But if it is too low, you might move your savings to another investment vehicle to earn a higher return.

The point here then is that in aggregate, there is some sort of ‘natural interest rate’ that causes savings and investment to be equal or that causes investments to be allocated in a way that maximizes productivity and return on capital over the long-term. If interest rates are too low, investment outstrips savings, resources are misallocated and inflation spirals out of control. If rates are too high, savings outstrip investment and capital leaves the credit-starved economy and deflation could even become a threat. In Wicksell’s mind, this natural rate changes over time as the economy and savings and investment preferences and opportunities change.

Some economists take issue with the stylized nature of this abstraction because, clearly, there can be no one natural rate of interest for everyone. Greg Ip points out that “[a]s Greg Mankiw and John Campbell noted back in 1989, it’s hard to find a strong, empirical connection between movements in real interest rates and movements in consumption.” Nonetheless, I like the overall framework for thinking about how central banks’ interest rate policies affect the economy.

This is the theoretical background for the ECB’s recent interest rate cut.

In the real world, we see concerns in Germany about an overheating residential property market; recently Germany’s central bank has warned of local housing bubbles in language very reminiscent of the early 2000s in the U.S. And a German savings bank survey saw clear evidence that private portfolio preferences were shifting toward real estate as interest rates had come down (German link here). Though the Economist reckons Germany’s housing market is actually undervalued. After the ECB cut rates, I saw a number of articles in the German press talking about worries of house price bubbles (link in German). Given the Bundesbank’s warning, this should be a real concern.

Moreover, Germany’s households are generally risk-averse investors. There is no real equity culture there especially as the first time it began to develop in the late 1990s, many Germans were wiped out in the Internet bubble. And so the Sparbuch – savings account – is the preferred German household investment vehicle. The Sparbuch is getting savaged by the ECB’s rate cuts though. And I see here as well lots of commentary in the German-language press. Most of these articles have an angry undertone, with savers talking about theft, expropriation and confiscation, as if the ECB were reaching into German savers’ pockets and handing out free money to profligate spenders in the eurozone periphery (links in German here and here, here). This is the kind of thinking that colours not just thinking about the ECB, but also, bailout policies and Germans’ thinking about the Euro. The same is true in Austria. And note that the Austrian central bank head was against the rate cut (link in German). This ECB split has stoked German backlash fears, according to the FT.

That’s Germany and Austria.

But what caught my eye this morning was some commentary by Irish economist David McWilliams about the shifts in private portfolio preferences in Ireland, a place where we saw a huge housing bust and loss socialization threaten the country with insolvency. Ireland is only now getting out of the bailout caused by this bust. But austerity continues and the economic contraction has been wrenching.

Here’s what McWilliams writes in his post entitled “Draghi rolls the dice – and boosts the value of your house”:

Mario Draghi has ensured that the mini-boom in Dublin’s trophy houses will continue for a while. This is what happens when interest rates are cut to almost zero – the people with savings think there is little point saving any more, so they don’t bother any more. They think, what will I put my cash into?

In Dublin, in certain small areas, expensive houses have been rising in price, and it will not be surprising to see the savings of the already wealthy going into houses, pushing up house prices further and make the already wealthy, well, wealthier.

This has been the pattern over the past five years all over the western world, particularly in Britain and America. By reducing interest rates and printing money, central bankers have put themselves on the side of the financial markets. It is not that they love financial markets, but to achieve their objectives they have to go through financial markets. This bizarrely puts central banker and financial markets on the same side, less than six years after excesses in financial markets nearly destroyed the global economy.

It seems that memories are short and both in Britain and the US the central banks have used lower interest rates to boost asset prices. They are hoping that the ”trickle down” effect will drive consumption and spending, allowing the economy to achieve a lift off.

Given that the Irish economy displays many characteristics in common with the Anglo American economies, we can safely say that the same will happen here. The cheap money will encourage the banks to lend against trophy assets again and will encourage people with savings to draw down their cash savings and put it towards buying property, where prices are rising.

This might not be a bad investment decision in parts of Dublin and some other metropolitan areas in the country, but for the most part, interest rate cuts will have am ambivalent effect on borrowing and lending. This is because, while tracker rates will fall in tandem with the ECB rate, this will cause the banks to lose even more money on these trackers. This implies that the banks will have to claw back profits somewhere – and that somewhere may well be on variable rate mortgages.

I take a benign view of the situation at this point. Ireland’s housing market is back on track, just as it is in the U.S and the U.K., where we also saw serious housing booms and busts. For example, house prices in Dublin are up 10.6% in the last year. Just as in the U.K. and the U.S., low interest rates have underpinned asset prices, stopped the household sector deleveraging and reignited the economy. But the risk, of course, is asset bubbles and a misallocation of resources.

Clearly, low rates do skew private portfolio preferences and this is largely a desired effect. The question is whether this skew is dangerous. It’s hard to say if at this point we are already seeing resource misallocation that will lower future growth. However, I believe the skew to private portfolio preferences is inherently dangerous. For me, it goes to the over-reliance on monetary policy for policy stimulus. Basically, fiscal policy is neutral to contractionary right across Europe and North America. Monetary policy is the only game in town. And in the face of an epic financial crisis and economic downturn, monetary agents have felt forced to turbo charge monetary stimulus with ultra-easy monetary policy. There will be unintended and negative consequences. The question is when and where these consequences will be evident.