Howard Davies: Feeling deflated

MT DIARY: Low interest rates forever, falling prices and the post-Brexit haze.

by Howard Davies
Last Updated: 06 Jul 2016

Sometimes it helps to put some distance between yourself and your domestic problems, so I spent a few days in Singapore reflecting on the state of the world economy and the financial system. It was 32 degrees all week, and it rained from four to five in the afternoon. In Singapore, even the rain falls on time. It also helps if you can listen to someone with a very clear and cogent view of what is going on. Zhu Min, the first Chinese national to hold a senior position at the IMF, is one such. He tried to explain why inflation and interest rates are in the basement, and set to remain there.

His starting point was that the global financial crisis had caused a loss of 12% of world GDP, output that we seem unlikely to recover in the foreseeable future, as the world has settled on a lower growth trend since the beginning of the recovery. As a result, investment is perhaps 20% lower than would have been expected pre-crisis. It is therefore not a surprise that interest rates are lower. There is too much money chasing too few investment opportunities.

The impact on commodity prices is large, as they are heavily influenced by investment demand. And at the same time a dramatic increase in shale gas output in the US has added to the downward pressure on the oil price. Another consequence is that prices are not rising, indeed are falling, in about 40 countries.

Against that background, it is not an accident that the talk is no longer about when long-term interest rates will 'normalise'. One wonders how one ever believed such a happy outcome was in prospect. Even before Brexit, the central banking rhetoric had moved from 'lower for longer' to 'low for long', or even to 'low forever'. In financial markets anything beyond a two-year horizon falls into the category of never. Since Brexit, forecasters have been downgrading their estimates of growth next year, by quite a lot in some cases.

The consequences for banks and insurers of a low and more or less flat yield curve are serious, and since the turn of the year the stock markets have drawn their own conclusions, with the European bank index down almost 30% even before the Brexit shock.

Continental Europe's banks are particularly stressed because their profitability has not yet recovered from post-crisis lows. In 2007, Eurozone banks made around 20% of the profits of all the world's banks. In 2015, the comparable figure was just over 9%. UK banks' share also fell, but only from 5.6% to 4.7%. Who know what the future now holds? But we have held the position reasonably for the last decade.

So what is to be done to avert an even more serious dose of deflation? The central banks have an answer: pumping money into the system via one form or other of Quantitative Easing, combined, in some places, with negative interest rates.

In the short run, this makes the banks' problem even worse, as it is hard to persuade retail depositors to pay to keep their money on deposit. They can always hold banknotes instead, and no one has yet found a way of making a tenner worth £9.90 next month. In Germany, there is a boom in the sale of safe deposit boxes.

But does the policy work in the medium term? Zhu Min looked at the evidence in Sweden and Japan, which have tried similar measures. The answer? Yes and, er, no. In Sweden the experience has been reasonably positive, with growth moving up, and prices very modestly too. In Japan it is hard to conclude other than that the cure isn't working yet, and may never. The price of sushi is still on a downward slope.

Back in Edinburgh, the midsummer weather was just like Singapore's, except that the midday high was 22 degrees lower and it rained from four in the afternoon until four the next afternoon. You couldn't see the hills, and the political and economic prospect is similarly shrouded in Scotch mist. Another referendum? Who knows? Maybe the simplest answer is to resurrect the Auld Alliance, and make Scotland an overseas department of France, like Reunion.

Donald Trump might not like it, as the French are not exactly his tasse de the. When Americans ask impossible questions about a post-Brexit world, the best gambit is to respond quickly with a question about their forthcoming election. On the whole they don't want to engage. Any American with a passport finds that Trump generates, as the poet said, 'thoughts that often lie too deep for tears', while positive enthusiasts for another dose of the Clinton magic are also quite thin on the ground. Trump as the Republican candidate now seems a done deal, but there is a school which thinks, or perhaps hopes, that the State Department email saga, Googlegate, could yet do for Hillary, and that the Democrats, rather than defaulting to Colonel Sanders, would find a procedural way to draft Joe Biden.

When Biden, who has barely troubled the scorers in the last eight years as Veep, is seen as the solution, the problem must be pretty acute. How comforting it is to live in a country where politics is so settled, with a united government and an experienced and competent opposition standing in the wings. 'We happy few', 'This sceptred isle', 'Jerusalem', 'Land of Hope and Glory', and all that. (I think our diarist may have finally lost it. Ed.)

Howard Davies is chairman of RBS. Follow him on Twitter: @howardjdavies

Credit: Dave Herholtz/Flickr


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