When Alice falls down the rabbit hole in Lewis Carroll's Alice's Adventures in Wonderland, she finds herself in a world of paradoxes where you can believe "as many as six impossible things before breakfast".
Anyone following developments in the Eurozone since the start of the financial crisis may be forgiven for thinking they too have fallen down the rabbit hole where prudence is folly, virtue is vice and responsibility is irresponsible. But such are the paradoxes of an economy stuck in a liquidity trap.
Through the (distorted) looking glass
Modern macroeconomics is founded on a simple but powerful insight - that the aggregate behaviour of a system may be profoundly different to the behaviour of its underlying individuals. This is illustrated by Keynes' "paradox of thrift", which says that if everyone saves more this may perversely lead to lower total saving. This is because for the economy as a whole spending has to equal income. If everyone spends less so they can save more, incomes have to fall. If incomes fall then people have less money to save, and so to reach their goal of increased savings they have to spend even less. This causes a vicious cycle of falling spending, income and savings. Saving may be sensible and virtuous for each of the particular individuals, but collectively it is destructive.
Happily, in normal times a mechanism exists that stops the economy from falling into this perversely negative cycle. As desired savings increase, the interest rate falls and this encourages households and businesses to borrow money to spend and invest. This increased investment offsets the lost spending power from the higher savings. The more people want to save, the more interest rates fall and the more this should stimulate investment. Because of this saving is a socially productive activity, boosting investment and so over time productivity and growth. Individual and social virtues are aligned.
But there is a limit to this logic. Interest rates are not supposed to be able to fall below zero because there is always the option of avoiding a negative interest rate by just holding cash. Economists call this the zero lower bound on rates.
So what happens if savings increase so much that interest rates fall to zero but this is not enough to cause investment to increase? Then, an economy enters into a downward spiral of spending and income, a phenomenon termed a ‘liquidity trap'. Individual virtue has become social vice. This fate has befallen Europe since the start of the crisis and the successes and failures of its policymakers can only be understood in this context.
Falling down the Rabbit Hole
Due to very weak growth and a huge amount of spare capacity in the Eurozone economy, inflation has been incredibly low. While low inflation is generally a good thing, we are now in a world where higher inflation would be better. This is because very low inflation increases the risk of deflation, pushes real interest rates up, makes debt repayment harder and tends to encourage people to delay consumption. This has seen the European Central Bank (ECB) undergo a transformation from an institution dedicated to fighting inflation and bringing it down into one desperately trying to increase it.
In doing so, ECB president Mario Draghi has been able to not only imagine apparently impossible things but also deliver some. Despite the fact that interest rates aren't supposed to stay below zero for a sustained period of time, the ECB has cut interest rates to -0.2%. It seems that the lower bound on rates is not zero after all, as there are non-trivial costs to holding cash rather than money in the bank. By pushing rates below zero, the ECB has helped at the margin to confront the paradox of thrift.
The second component of Draghi's inflation-boosting strategy is EUR1.1 trillion of quantitative easing (QE), finally announced in January 2014 after almost a year of discussing the policy. Draghi's excuse for joining the QE tea party so late is that he was confronted with constraints that seemed at times to make the policy politically impossible. He had to fend off a challenge in the European Court of Justice protesting the legality of the ECB's bond buying program, and the resistance of the German Bundesbank to aggressive easing. Given the power of the Bundesbank within the ECB and Germany within the broader Eurozone, many had written off Draghi's chance of ever getting the policy passed. Impressively, he was also able to deliver this.
While the ECB's actions have been in the right direction it is important to remember it is incredibly difficult for a central bank to gain traction in a liquidity trap. To boost activity today the central bank needs to promise to keep policy very accommodative well into the future, even as inflation picks up. But because people believe the central bank will act ‘responsibly' and tighten policy as inflation starts to appear, they do not believe the central bank's promise to keep policy easy in the first place. The central bank's credibility for fighting inflation can work against it, as its promise to be irresponsible is not credible. In this topsy-turvy world, credible central banks are actually the least credible.
"Imagination is the only weapon in a war against reality"
In Lewis Carroll's finale Alice's sister wakes her up from a dream and Alice leaves her sister on the bank to imagine all the curious happenings for herself.
In our case, the curious happenings are playing out right in front of us. The distorted financial reality we live in requires no imagination. However, making sense of it is often a completely different matter. And in order to effectively navigate our economies through such strange times central bankers and policymakers require huge feats of imagination. As investors this all means that second-guessing policy decisions is becoming increasingly hard.
Eventually the ECB and policymakers will have to stand the trial of history as opposed to that presided upon by the King and Queen of Hearts. But what could have been done differently? It's impossible to accurately tell, we can only speculate. What we can say with confidence is that it would likely have been even more ugly...
Aberdeen Asset Management Investment Manager Luke Bartholomew
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