The Keynesian Contagion in the Eurozone is so Bad Investors are Paying People to hold their Money Elsewhere

Posted by PITHOCRATES - August 11th, 2012

Week in Review

The Keynesian answer to everything is more spending.  By any means possible.  By taxes.  By borrowing.  Or by printing.  Despite Jimmy Carter’s stagflation of the Seventies.  Japan’s Lost Decade in the Nineties.  And the current sovereign debt crisis in Europe.  All Keynesian failures.  And the Keynesian answer to why they all failed.  Because they didn’t spend enough.  It’s amazing.  No matter how wrong they are they keep insisting that they are right.  And now things are so bad in the Eurozone that investors are paying people to hold their money until the current Keynesian contagion spreading through Europe dies out (see Negative interest rates spell final defeat for beleaguered savers by Jeremy Warner posted 8/6/2012 on The Telegraph).

Ignore, for the moment, what has happened to bond yields in the troubled eurozone periphery. That is an unnecessary tragedy unique to certain members of the euro. The bigger story is that across large parts of Europe, nominal interest rates are turning negative. Germany, the Netherlands, Finland, Denmark, Austria and Switzerland are already there, and now there is even some possibility of the UK joining them.

Last week, the yield on two-year gilts reached a record low, and though it has come back a bit since – boosted by the possibly mistaken belief that Mario Draghi, president of the European Central Bank, is about to come riding to the rescue in the eurozone debt crisis – it still hovers at an almost unbelievable 0.05pc. Real yields on index-linked gilts have been negative for some years now, but this is the first time that nominal yields have looked like joining them.

The way things are going, investors will soon be forced to pay to lend the Government their money, a topsy-turvy, Through the Looking Glass world where the lender pays the borrower a rate of interest, rather than the other way around. The profligacy of government is rewarded, the thrift of its citizens is punished. For long something of a mug’s game, saving for the future becomes completely pointless, while pension funds, forced into gilts by solvency regulation, are further crucified.

As governments lower interest rates to try and stimulate economic activity that isn’t there (and won’t appear even with these low rates as proven by the fact that these low rates haven’t stimulated economic activity yet) this also lowers the interest rate on savings accounts.  So as the government pursues reckless Keynesian policies (lowering interest rates to stimulate the economy) those who live responsibly and save for their retirement see their savings shrink instead of grow.  Though this destroys lives it doesn’t necessarily bother Keynesians.  Who hate people who save their money instead of spending it.  Because in the Keynesian view savings reduce economic activity by pulling cash out of the economy.  Of course savings have typically been the source of investment capital that actually generates economic activity.  But the Keynesians ignore this fact.  As well as the one about destroying people’s retirement.  Which is why their policies destroy economies.

Ultra-low bond yields are a sign not so much of international confidence in the UK’s credit worthiness, but of a seriously impaired economy…

In the meantime, fear of a disorderly break-up continues to drive investors into safe-haven assets, which, in practice, means any half-way credit-worthy alternative to the eurozone periphery…

When a country’s bond interest rate falls it is typically a sign of a strong and healthy economy.  Things are going so well that people have little fear in loaning money to them.  And therefore the country doesn’t have to pay high interest rates to attract buyers for their bonds.  This is not what is happening now, though.  Money is flowing to Britain and the United States not because their economies are strong and robust (they’re not) but because their economies aren’t as horrible as in other countries.  Especially in the Eurozone.  Where interest rates are high because of the high risk of default.  Which drives investors to countries not with better and more robust economies.  But where the risk of default is lower.  The investors are basically saying that, yes, the economies of Britain and the United States are bad.  But they are not ‘Eurozone’ bad.  So they will park their money there.  And even pay (with negative bond yields) these countries to hold their money until some better investing opportunity comes along.  You see, it’s not about earning profits now.  It’s about trying to save what money they have until this current Keynesian contagion dies out.

Banks struggle to fund themselves at the same low rates as the Government because investors fear that a eurozone break-up would further undermine their solvency. Even in Britain, banks are once again seen as fundamentally unsafe…

When the economy is growing strongly, money changes hands with high velocity, creating a consequent demand for cash. To satisfy this demand, money is withdrawn from bonds, causing interest rates to rise. But with conditions as they are now, the reverse takes place. Low economic activity causes cash to flow back the other way and into bonds, driving yields into negative territory.

In such circumstances the Bank of England has little option but to carry on with quantitative easing, even though this has become something of a circular process. The Bank buys gilts to pump prime the economy with cash and investors use the cash to buy still more gilts…

Eventually, the Bank will need to go rapidly into reverse to prevent more serious inflation, a la 1970s. The velocity of money will rise, and all that freshly minted cash will suddenly start chasing goods, wages, assets and commodities, instead of sitting in bonds.

Before there was a large government debt market rich people invested in businesses.  Small business with venture capital.  And large businesses with corporate stocks and bonds.  Rich people got richer by investing in businesses that created jobs.  Increasing economic activity throughout the country.  They made greater profits.  And took greater risks.  With a large government debt market, though, they have another alternative.  Rich people can buy government bonds instead.  They don’t make as much but they don’t take anywhere near the same risk.  Unless they’re investing in the Eurozone.  Which they appear not to be doing these days.  In fact, with these bargain basement interest rates some are even borrowing money to invest in higher interest bonds of other countries.  We call this trading on the interest.  Or carry trading.  Borrow at low interest rates.  And using that money to buy investments with high interest rates.

This is the price we pay with high government debt.  It pulls capital out of the private sector.  Provides a safer, non-job-creating option for rich investors.  And all of this extra money in the economy will sooner or later ignite inflation.  As well as threaten the solvency of the banking sector when some of these bets on carry trades go bad.  As a lot of these investors borrow money to make these trades leaving the banking sector exposed to huge risks when things go bad.  And they often do.

This is what Keynesian economics does.  Has done.  And always will do.  Yet governments still play their Keynesian games with interest rates.  And their interventions into the economy.  So why do governments keep going down this same destructive road?  Because they can.  And they just love spending other people’s money.

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