Tuesday, 19 March 2013

Cyprus - Beware False Equivalence


Empathy: The ability to imagine oneself in another’s place and understand the other’s feelings, desires, ideas, and actions.

When faced with an example of injustice it is a common psychological trait to relate the suffering of others to our own experiences. While this can be helpful in fostering greater insight into the personal hardships they may be undergoing it can also cause people to prioritise the similarities of their situations and underplay the differences.

It is in this light that I view attempts to liken the haircuts to Cypriot depositors to ultra-low interest rates in Britain. Yet to my mind this false equivalence does a disservice to understandably panicked depositors in Cyprus and causes undue concern for savers in the UK.

I first came across this particular line of argument on twitter in a tweet from Ros Altmann, former director general of Saga and pensions expert. She wrote:

“UK vs. Cyprus - Sterling devaluation +inflation +ultra-low rates have been stealth tax on savers, to help borrowers and banks”

Altmann went on to point out that UK monetary policy has cost savers more than 20% in real terms since 2008 inflation peak. And she is far from alone in her concerns. Many joined her in her staunch defence of savers against the clawing hands of the Bank of England.

Now I’m not actually disputing the facts as presented. Both savings and real incomes have been clobbered since the crisis by a combination of near-zero interest rates, modest wage rises and above-target inflation. The question is whether this combination of factors can be compared with a sudden seizure of deposits by the state.

This is an important question to answer as the critics are bringing into question the legitimacy of policies brought in to address the crisis. So is the UK really taking money from savers in order to pay for the pre-crisis excesses?

It is certainly true that saving and incomes have fallen sharply in real terms over the crisis. To my mind, however, the question misframes the problem and obscures the purpose of current monetary policy.

During “normal” times when the economy is growing interest rates are certainly higher. Yet the reason for this is not simply to reward savers for their frugality but to incentivise holding back cash in bank accounts and disincentivise heavy borrowing in order to prevent the economy from overheating and driving up inflation.

As a consequence of the so-called “Great Moderation” savers got used to these higher interest rates. This was understandable with politicians unwisely boasting that they had ended boom-and-bust economics. But the fundamental truth remained that high interest rates reflected the central bank’s attempt to hold inflation around target, not to protect the purchasing power of savers.

When the Great Recession struck, therefore, central banks responded to the economic shock by dropping interest rates. This had a number of potential benefits. Initially low rates prevented a cascade of disorderly defaults by allowing struggling companies to refinance at lower rates and encouraged stronger firms to take on more debt.

However, they also caused the rate of interest paid on cash held in people’s bank accounts to fall. This is quite a deliberate aspect of the policy as it should prompt savers to move some of their money either into current spending or investments, which helps boost the velocity of money in an economy (and therefore GDP).

That it is an intentional effect of monetary policy does not make it a Machiavellian plot to steal people’s savings. Instead it should be viewed as a good reason to move money into a portfolio of financial assets that should benefit in the case of an economic recovery or to bring forward already planned spending.

In fact some academics, including Professor Miles Kimball of the University of Michigan, believe that current interest rates remain too high. Kimball has advocated negative nominal rates whereby central banks could in effect impose a charge on cash holdings.

In a recent post on her blog FT Alphaville’s Izabella Kaminska says the Cyprus bank levy represents a harsh example of a negative interest rate. She writes:

“This is the ultimate negative interest rate because it shows that the privilege of having deposits (delaying spending) is associated with principal loss, from the offset.

Which is why negative interest rates, as I have long argued, are a bad omen for the banking model. They show banks have become redundant and that sound equity is more desirable than deposits or weak equity.

Deposits have always represented a store of value. Rather than spending (redeeming your money, which is national equity) on goods or assets which are consumed or depreciate or perish over time you can artificially extend the life associated with your share or the real economy’s wealth by turning your stake into deposits (loanable funds).

The fact that deposits are now depreciating more quickly than real assets only implies there is no longer any sense in delaying spending.

Better to spend now on good equity or goods than be lumped with disappearing equity.”

In terms of the implications of negative rates for the banking sector, Kaminska certainly raises some fascinating points but I don’t agree on the particular charge that the Cyprus levy is representative of what the policy would look like in practice. And this goes to the heart of the debate about UK monetary policy.

With a mix of above-target inflation and ultra-low interest rates UK savers are facing an environment negative real rates. Yet unlike their Cypriot counterparts British savers have the choice of where, when and whether to move their money out of their bank accounts. That they have not been doing so on a larger scale is indicative of a failure to explain the consequences of the current policy mix to the public.

Raising rates while the economy is still weak and companies (including banks) are in the process of deleveraging could raise the spectre of disorderly defaults and an increase in bankruptcies. Those campaigning for policymakers to protect savers need to look at the systemic implications of their proposed solutions.

Of course none of this should reduce our sympathy for Cypriot depositors who have found themselves caught up in a political standoff that they have no control over.

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