Deflation and very low interest rates



The guardians of monetarism are flummoxed. With almost no evidence, but supreme faith, they believe that there is a direct and (more or less) proportionate relationship between the stock of money and the level of prices. Thus, they assume that the ‘printing’ of money just creates inflation. Now, after several years of quantitative easing (QE), we can see that this supposed link between the money supply and inflation is obviously false. Rather than acknowledge their past errors, these merchants of monetary probity now interpret the present environment as a major break in the laws of finance, much as apples falling up would represent a reversal in the laws of physics. They were convinced that QE would lead to substantial inflation.

Yes, in individual countries, an increase in one kind of money (eg an increase in Pesos in Argentina) will lead to a fall in the exchange rate for Pesos, and inflation in that country (Argentina). It does not follow (contrary to monetarist belief) that an increase in the supply of US dollars or Euros or Yen would necessarily have a similar inflationary impact on world prices.

In reality, these beliefs about money were never anything like science. Rather they served particular interests over others. (Keynes would have said that ‘dear money’ served the ‘rentier’ interest; a scarcity of money would enrich people who already have more money than they can or will spend; and that cheap – abundant – money would be adverse to the rentier interest. So there was a systemic bias in favour of dear money.)

The real purpose of interest rates in market economies is to set a price that balances saving against investment. In the 2010s’ environment, to achieve this free-market purpose, interest rates would probably need to be around minus five percent. At or just under zero percent (as they are in the major world economies), interest rates continue to be substantially overvalued when considered in terms of this price mechanism that’s central to capitalist economics. At zero interest, the world economy in 2016 continues to experience a glut of saving and an aversion to the debt expansion that easy monetary policies seek to stimulate.

Yet (and ignoring the issue of people stashing cash under the mattress) negative interest rates cannot revive the world economy on their own. This is because, their direct effect on prices is deflationary; not inflationary as the present monetarist backers of zero-interest-rate policies believe. Very loose monetary policies (google ‘helicopter money’), in themselves, will not facilitate inflation climbing from zero to two percent. (See Bernard Hickey on helicopter money last week. I suspect that the New Zealand public, if adequately exposed to this phrase, will wonder whether economists were always from another planet.)

It’s not rocket science. Inflation (and deflation) may have both demand elements and cost elements. When interest rates rise (commonly associated with tightening monetary policy) costs also rise; the direct effect on prices is inflationary. However, rising interest rates also have an indirect effect on prices. They cause reduced business investment, economic contraction, and unemployment which further reduces spending. Thus, rising interest rates may appear to be counter-inflationary if they (indirectly) generate sufficient unemployment to more than offset their direct inflationary impact. To advocate raising unemployment as a means to counter inflation (which is what the monetarists did) is a somewhat cynical form of pseudo-macroeconomics.

The obverse of 1980s’ monetarism is what we see today; falling interest rates (through reduced financial costs) aggravating the deflationary forces that now grim the global economy. Very low interest rates can only counter deflation if there are strong demand forces (countering the cost forces) facilitating spending, reducing unemployment, and encouraging people to work fewer hours.

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Very low interest rates can become counter-deflationary if governments are willing to run very large deficits; even larger than present Japanese-style government deficits. As we (economists) say, fiscal policy is the key. Alternatively, very low interest rates can become counter-deflationary if we – the public – come to be able to finance some of our own spending on such a deficit basis. Counter-deflationary (also known as ‘reflationary’ in historical texts) conditions can only arise when saving (deflationary) is more than balanced by consumer, business and/or government borrowing. Increased consumer spending by poor people has no chance, however, when consumer credit remains very expensive. And when governments are pig-headedly striving for Budget surpluses despite their being able to borrow at zero (or lower) rates, deflation is as predictable as the sunset.

Deflation unheeded causes businesses in general (and banking in particular) to fail. And it aggravates indebtedness relative to GDP, creating the so-called debt-deflation spiral that characterised global finance in the Great Depression of the 1930s. Even zero-interest debts (such as student-loans) become near-impossible to service when deflation rates exceed five percent (as I think they will in many countries before the end of this decade) and when good income-earning opportunities are few.

Very low interest rates are part of the solution. But only a part. The bigger part of the solution is the indirect demand effect that must more than counter the falling costs directly associated with falling interest rates. Governments should spend the cheap and abundant money that is now available to them; or governments should become a conduit, channelling at least some of the unspent global hoards of cheap new money to their shareholders, the people. The people can then spend a bit more, choose to work a bit less, and can bargain more strongly for higher wages; effects that can help to counter or prevent deflation.


  1. Low interest rates are very a much two-edged sword. Japan, the poster-child for ZIRP for well over TWO DECADES now, has seen only very low inflation if not outright deflation over the ENTIRE period. The reason is pretty obvious if you think about it for 2 seconds: if you’re saving for a comfortable retirement, what do you do, as a prudent saver, if the interest rates are zero? Right. You save MORE money – i.e. you don’t spend/lend it into the economy, you save it (in a mattress if necessary if the rates are below zero). There is NO INCENTIVE to lend the money out, which carries a tangible risk premium to the lender, when interest rates are zero. Capitalism cannot exist WITHOUT actual capital, but this is precisely the prescription of (apparently) clueless central banksters to kick-start a flagging economy. They’re trying to have their cake and eat it too: cheap loans when there are no lenders to be had… although I guess QE is designed to address that – but by definition this must also result in devaluing EVERYONE’S money, rich and poor (this obviously cannot provide actual “growth” in the economy if you think about it). Oscar Wilde put it best, these people “know the price of everything and the value of nothing”.

  2. It’s interesting: the government would be paying you to take out a loan.

    Fancy that.

    With such dumb ideas. No wonder debt spirals out of control

    • No. The government would be borrowing at negative interest rates. In this case, with both deposit and lending rates negative, it would be bank depositors nominally paying government borrowers. In Switzerland bank depositors still gain because deflation is at a bigger percentage than the negative interest rates. With a savings glut and a paucity of spending in the world economy, interest rates need to be lower than inflation rates. If inflation rates are minus one percent, then interest rates would need to be, say, minus two percent.

      • Correction: as Keith Rankin rightly says, it will be the government borrowing from central banks at low interest rates.

        I have to ask: when does the trickle down come into play and the quite obvious case of gerrymandering and pork barrel politics employed by most NZ governments. There is that novel idea of interest rate aphaithid. Where people or governments use low interest rates to coheres political opponents, and those on the other side of the apartheid wall get sicked on by mainstream media and there right wing bloggers.

        In my opinion: at face value low interest rates is a really expensive convenience of writing checks and issuing ATM cards.

        With some 180 billion in derivatives our government is already in the whole. It is us on the hook if the banks cock this up again, and our kiwi banks are looking really exposed what with all the housing and dairy bubbles.

        I don’t see any painless way out really. The longer we wait to rid our economy of bad economic actors the harder it is to unwind, the more people die. I think we should raise interest and the cost of borrowing to weed out all the bad economic actors while we still have a functioning welfare state.

    • I reckon its the other way around, SAM:

      Debt (at least GLOBAL debt) has already spiralled out of control. People are waking up to that and, if they’ve got any sense, they are pulling back on taking on yet more debt.

      The banks however, make their money out of pumping up the debt Ponzi (in the form of creating new money by issuing new mortgages, Credit-card debt also contributes).

      Therefore, faced with a decline in the demand for new mortgages, the banks push them by lowering the interest rates, to the point of “paying” people to take on new mortgages (via negative interest rates).

      Entities like the Federal Reserve, or the Reserve banks are thus over a barrel and do the commercial banks’ bidding. They have little choice.

      • Only about 10c of every borrowed dollar goes into the production, the other 90c mostly goes into property speculation.

        But all this assumes perfect information, and any floors in our arguments (your argument or mine) can be excused by simply saying all bankers are crocks. What we should be saying is banking monopolies should have similar levels of power (power in terms of legislation, wealth, productive capacity) as unions. Weather that means braking them down or building them up is a different conversation.

        We’ve pretty much turned the FED taps on full, and distributed the money around at the top, and it’s stuck up there because you have to show you can repay the money. Quite simply you need a political force that can demand a more equatable share.

    • These pension funds depend critically on economic growth. Yet the savings that go into them undermine the growth they require to give their subscribers the pensions that they expect. Because growth depends on spending.
      Sadly, these funds are little more than a con by today’s financial services industry. They promise compound interest returns that the world economy cannot deliver.

    • There are more options for pensions than saving and buying securities (a misnamed thing if ever there was one).

      I am sure there are option we haven’t thought of yet but one obvious one is the one we used in NZ for many years for welfare, ACC and pensions. Pay as you go means that you focus on building a decent society today, knowing that such a society will have the social resources and the ethics needed to ensure security in the future. We still pay welfare and health this way mainly (although mortgage insurance and private medical insurance are increasing) but with pensions NZers are being channeled into the false security of pre pay by saving and buying securities through Kiwisaver. Kiwisaver will also of course increase the demand problem

      • Kiwi saver is just another account Citi bank uses to compete for billionaire hedge fund accounts. Kiwi or Citi fund managers say if you invest with us, we will allow you to front run our trades ie ( ie billionaire buys a stock and kiwi saver buys it back) this is the only way Kiwi saver can outperform savers. It’s a catch 22

  3. The crash of the century is coming fast so prepare as these nuts have no tools left to fight the coming crash except rob and manipulate the commodities like a crazy monkey so when the bang comes there wont be “a new deal” but absolute destitution and misery they will leave behind.

  4. Over recent decades we have had major changes in society and the economy, on a global scale. Not only has there been massive offshoring, technological development has led to many products being made by highly mechanised processes, e.g. by machines and robots in the form of mass production.

    We have services also being delivered by machines and computers included, e.g. the banking transactions that few still do over the counter at banks.

    Payroll is done by technology offered by some firms, and many workers have been replaced by technology.

    Over the coming decades about 40 percent of still existing jobs will disappear. We already have many work only temporary or casual jobs, and this will also increase. A significant percentage of workers are paid just above or at the minimum wage.

    Business is also running on cut throat terms, and many employers running them try to save costs in Labour.

    So what will the future hold? We will have more machines, computers and so forth, but they do not consume as humans do, they definitely pay no taxes and do not spend any wages or salaries.

    This forces a radical rethink in economic management and also in financial management.

    When we have various instruments to use, they may nevertheless have only limited effect. That may show in the interest rates and quantitative easing policies we have in many countries. The old rules and teachings may have applied for conditions in earlier generations, but they no longer apply and work with the situation we have now.

    Hence desperate governments resort also to questionable economic measurements, such as the Key led government, allowing a relatively high net immigration gain over years, to boost up the economy, simply by increasing demand and also available workers and spenders. An earthquake rebuild was necessary, but that also boosted the economy.

    We have had the dairy boom and bust now, so that shows us other problems.

    What we need is new jobs for more people, and money for them to be made available to spend. With the trend we have, we will end up with more people, but not necessarily more jobs that pay a living wage, and not necessarily more money the spend.

    This is indeed a massive challenge, also while many resources will become more limited, as they will not be sustainable for an ever growing world population. In short, we are stuffed, unless we learn to address the challenges and issues we face.

  5. Keith:

    I’m no economist by any stretch of the imagination. However, IMO you don’t seem to have given sufficient credence of the current massive world-wide blowout of DEBT in your analysis.

    The current world-wide levels of both sovereign and household debt, it seems to me, are the defining and most distinctive feature of the current world economic situation.

    As far as I know, we have never been here before – the amount of debt sloshing around in current world economies is just staggering, especially in the large economies like the USA and China.

    No analysis of economic factors like QE, helicopter money and interest rates can properly ignore the role of debt.

    I wouldn’t mind betting that debt, in some perverse way or other that mainstream economists do not yet understand, will eventually turn out to be the main reason why interest rates are heading towards zero, and in some counties, into negative territory for the first time in history.

    The fact that present-day debt levels are unsustainable and cannot go on beyond their present absurd levels is the main problem currently underling the global economy. The ongoing effects of that debt cannot be ignored.




    • The problem that the monetary policy-makers are trying to fix is that there is not nearly enough debt in the system. There are far too many lenders and far too few borrowers.
      If we had public equity dividends (Universal Basic Income) then the world economy would not need nearly as much debt as it needs now. But as things stand, the aversity to debt has become so great that those with access to credit (eg governments) are reluctant to borrow and spend even when interest rates are zro or less.

      • Perhaps low borrowing reflects the degree to which people realise these days that their governments don’t believe in anything. It’s hard to have confidence in this environment.

        • The market is only learning now from Bernanke’s book that QE2 and QE3 were initiated because of fears of the European crisis.

          Greeks can’t pay, won’t pay. Italian banks burdened with debts from the Renaissance. Spain still no government.

          Ai Karumba!

  6. Every economist knows this equation:

    Prices = Amount of Money x Velocity of Money [how often money changes hands in a given time period]

    Too bad most of them forget about the velocity part.

    The more concentrated money becomes (i.e. high inequality) the slower it gets, because rich people spend less of their money than the poor do. Thus prices fall and deflation results.

    The only way around this is to take the richs’ excess money and give it the poor (i.e. tax the rich) or to force the rich to spend it by throwing regulatory hurdles into their way to crowbar the cash out of them.

    Money is like gravity, it attracts to itself, slowly coalescing until it’s all in one place. That is to say the rich get richer, or money “trickles up”. Only assertive human action can counteract that.

    • If you look at, you will see that New Zealand’s government debt to GDP ratio is 112th in the world. Government debt is not a problem in New Zealand.
      So, yes, world government debt to gross world product is high by historical standards. Nevertheless, and under existing income distribution arrangements whereby huge and increasing swathes of income are going to people who will not and largely cannot spend it (because they already have so much), the ratio of world government debt to gross world product will need to be vastly higher than it is now if we are to avoid a global depression in the next 20 years that is on a substantially greater scale than the global depression of the 1930s.

  7. Hi Keith just thinking
    >>>when deflation rates exceed five percent as I think they will in many countries before the end of this decade and when good income-earning opportunities are few.
    >>>But as things stand, the aversity to debt has become so great that those with access to credit (eg governments) are reluctant to borrow and spend even when interest rates are zro or less. –

    I think your saying that the workforce has so little faith in the future they don’t want to spend. (In my case I can’t walk into another job, I have no faith in this modern economy to create a bouyant job market; some idiot is trying to make things more “efficient” all the time.)

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