Absolute Zero

Submitted by Paul Warner on Tue, 04 Oct 2016 - 18:00

When speaking to Simon Ward last month we asked him whether there were any economic laws regarding the effects of zero interest rates. We asked because in other disciplines there are limits or restrictions that occur when you get to certain points. An appropriate observation in physics occurs as you get towards absolute zero, which is theoretically the lowest possible temperature you can reach. There are two possible relevant observations, as you get towards absolute zero you require more and more energy to get your substance down to that temperature. Secondly, as you get towards that level strange things start to happen. Many of us have heard of superconductivity, where all electrical resistance disappears, but many other unpredictable things occur, which scientists continue to explore.

The first point, the need for more and more energy to try and reach your goal is not dis-similar to the law of diminishing returns. Central Bankers may not be knowledgeable in other disciplines but this law is a fundamental principle of economics. According to the IMF China is suffering from this principle. It notes that at the end of 2008 less than 1.5 units of credit were required to generate an additional unit of GDP and at that time total debt in China was 147% of GDP. In March this year it takes three units of a new credit to create an additional one unit of GDP  and now debt is 255% of GDP.

It looks like central banks are just beginning to recognise that their actions are not only being affected by the law of diminishing returns but also by the unpredictable events that physicists are discovering as they lower the temperature to absolute zero. The problem is central bankers have extrapolated in a straight line the effects of lowering interest rates. They haven't taken into account that as you get closer to zero or go below it actions by economic participants will change. It has taken a long time for them to actually acknowledge that things are different and some like our Bank of England have still not recognised this. The Bank of Japan (BoJ) did not reduce rates further into negative territory as some had expected they might at their meeting on 21st September. Neither did they acknowledge that many of their actions were futile and leave markets to sort things out. They did acknowledge that their actions had caused the yield curve (the different interest rates of bonds plotted against the length of time to maturity) to be too flat. That is the longer term interest rates were too low in comparison to short-term interest rates. They propose to increase longer term interest rates and have the ten year bond rate yielding zero. They hope that this will induce the banks in Japan to start lending more money.

When a bank lends money it uses money, like deposits, on which it pays short-term interest rates and receives interest from the borrower based on longer term interest rates. When the longer term interest rates are higher, as they ought to be, banks can make profits and should therefore lend more. Whilst this may sound good in theory, the question is whether there will actually be any demand for borrowing. The BoJ have also decided to continue printing money until inflation moves above and stays above their 2% target. Since, with all its actions, The BoJ have failed to get inflation even up to 2%, so it seems unlikely that they’ll get it above 2%.