Saving-Investment Imbalances During the Great Depression and the Current Global Crisis Andreas Hoffmann / Gunther Schnabl Institute for Economic Policy, Leipzig University Brussels: May 27, 2016 May 2016 Andreas Hoffmann, Leipzig University

Andreas Hoffmann, Leipzig University The Great Depression Source: Crafts and Fearon (2010). Major Countries: US, UK, Germany, France May 2016 Andreas Hoffmann, Leipzig University

Andreas Hoffmann, Leipzig University Content Introduction: Monetary Policy Then and Now Saving-Investment Imbalances: An Overinvestment View Asymmetric Monetary Policy Long-term Implications for Investment and Growth Policy Implications References: Hoffmann, A. / Schnabl, G. 2016: The Adverse Effects of Ultra-Loose Monetary Policies on Investment, Growth and Income Distribution. CESifo Working Paper 5754. Hoffmann, A. 2014: Zero-Interest Rate Policies and Unintended Consequences for Emerging Markets. The World Economy 37, 10, 1367-1387. Hoffmann, A. / Schnabl, G. 2011: A Vicious Cycle of Manias, Bursting Bubbles and Asymmetric Policy Responses – An Overinvestment View. The World Economy 34, 3, 382-403. Schnabl, G. 2015: Monetary Policy and Structural Decline: Lessons from Japan for the European Crisis. Asian Economic Papers 14, 1, 124-150. May 2016 Andreas Hoffmann, Leipzig University

1. Monetary Policy Before and During Crisis May 2016 Andreas Hoffmann, Leipzig University

Government Securities held by the Fed (1920-1940) Source: Fed, Banking Statistic: in million dollar. May 2016 Andreas Hoffmann, Leipzig University

Monetary Policy Since the Recent Crisis Stylized Facts Decline in interest rates towards zero Expansion of central bank balance sheets Forward guidance to signal commitment to QE and low interest rates Reasons for Current Prolonged Period of Low Interest Rates Ageing population and a rise in household saving Declining investment Growing income inequality Globalization Asymmetric monetary policy (with unintended consequences on household saving, investments and growth) May 2016 Andreas Hoffmann, Leipzig University

2. A Mises-Hayek View on the GD Loose liquidity conditions and monetary policy mistakes triggered an unsustainable boom prior to the Great Depression (e.g. Borio and Disyatat 2011, Hoffmann and Schnabl 2011). During the crisis period, the initial cleansing effect, a fall in relative prices and wages in overinvested industries is a prerequisites for the economic recovery. Hoover’s nominal wage fixing and New Deal policies (Fair labor standards act) prevented such adjustments. Unemployment soared and investment was depressed. Liquidity crises and bank panics as well as a secondary deflation should have been prevented. As Hayek put it in (1935, pp. 108-9): ‘It is also a fact which has been established by long experience, that in times of crisis central banks should give increased accommodation and extend thereby their circulation in order to prevent panics, and that they can do it to a great extent without effects which are injurious’ Friedman/Schwartz have shown that money supply should have increased more to prevent panics and deflationary pressure. May 2016 Andreas Hoffmann, Leipzig University

Saving and Investment Mismatches Mises-Hayek View Hayek (1929, 1935, 1939) and Mises (1912) explain business cycles with distorted relative prices on capital markets that bring about a mismatch in planned saving and investments. Interest rate concepts ii = internal interest rate: profitability / real return on investment in = natural interest rate: long-term equilibrium rate (S=I) icb = central bank (policy) rate: interest rate set by the central bank ic = the interest rate set by the banking sector (usually we can approximate icb=ic). This financing interest rate is not only influenced by preferences to consume or save but by monetary and financial factors. May 2016 Andreas Hoffmann, Leipzig University

The Credit Boom: Monetary Policy Mistake I Starting point: A rise in profit expectations and investment demand i Iii2 Iii1 S I2=S2+ C in2 S2 in1 = icb1=ic1 = icb2 = ic2 positive interest margin I2 I, S I1 = S1 Source: Hoffmann and Schnabl 2011. May 2016 Andreas Hoffmann, Leipzig University

The Turnaround and Bust: Mistake of Type II Starting point: interest rate increase / credit defaults i Iii2 Iii3 S I3=S3- C negative interest margin icb3=ic3 in3 I3 I, S S3 Source: Hoffmann and Schnabl 2011. May 2016 Andreas Hoffmann, Leipzig University

3. Monetary Policy Mistake Type I & II: GD May 2016 Andreas Hoffmann, Leipzig University

Fed Credit in Million US Dollar May 2016 Andreas Hoffmann, Leipzig University

Monetary Policy Mistake of Type I and Recent Credit Booms “We find that a (..) lower overnight interest rate induces lowly capitalized banks to grant more loan applications to ex ante risky firms..” (Jiménez et al. 2014). Historically, “[empirical research] shows that changes in the short-term nominal interest rate are also a significant determinant of credit growth. When short-term interest rates fall, credit growth rises” (Bordo and Meissner 2012). “Monetary policy is found to have contributed considerably to the unsustainable dynamics in housing and credit markets that were observed between 2001 and 2006.” (Eickmeier et. al 2013). For a period of 140 years: “we .. demonstrate that loose monetary conditions lead to booms in real estate lending and house prices bubbles; these, in turn, materially heighten the risk of financial crises.” (Jorda et al. 2015). May 2016 Andreas Hoffmann, Leipzig University

G3 Asymmetric Monetary Policies May 2016 Andreas Hoffmann, Leipzig University

Household Saving Rates Source: Datastream 2016. May 2016 Andreas Hoffmann, Leipzig University

Andreas Hoffmann, Leipzig University Total Savings Source: Datastream 2016. May 2016 Andreas Hoffmann, Leipzig University

Investment and Growth in G3 Source: Datastream 2016. May 2016 Andreas Hoffmann, Leipzig University

4. Implications of Asymmetric Monetary Policy Credit bust Credit defaults and falling asset markets affect credit supply. When interest rates are slashed, large enterprises roll-over debt to reduce debt servicing costs. They are inclined to save. Small enterprises have less access to easy financing. Given low real investment returns, they won‘t get loans. Growth implications Asymmetric monetary policy provides an implicit bail-out insurance to financial markets. However, there is no implicit bail-out mechanism for real investments. The loan-deposit spread declines and makes traditional banking less attractive. Borrowing to the government increases. In firms, labor and capital remain bound in less productive businesses. Easy credit for large enterprises dampens the strive for investment and innovations (Kornai 1993). May 2016 Andreas Hoffmann, Leipzig University

Andreas Hoffmann, Leipzig University Productivity Growth Source: OECD 2016. May 2016 Andreas Hoffmann, Leipzig University

5. Summary and Implications Lessons learned from the Great Depression? Monetary policy mistake of type II is prevented by decicive actions (Friedman/Schwartz critique is addressed) Monetary policy mistake of type I undermines structural adjustment as did Hoover‘s wage fixing and the New Deal. Severity of GD prevented but decline in innovation, investment and growth. Further side-effects of downward-trend in interest rates Growing financial market investment rather than real investments Growing income inequality as not all participate in boom? Political polarization? (Bromhead et al. 2013) Ending asymmetric monetary policy could provide incentives to return to a traditional role of banking. incentives to increase household saving via higher real rates. incentives for real investment rather than financial investment. May 2016 Andreas Hoffmann, Leipzig University

Thank you for your interest! May 2016 Andreas Hoffmann, Leipzig University