SECULAR STAGNATION and the NEGATIVE INTEREST RATE CONUNDRUM: INTERNATIONAL ANALYSIS of the PERIOD 2010-2019 WARBURTON, Christopher E.S

Warburton, C.E.S. (2021) Applied Econometrics and International Development Vol.21-1

SECULAR STAGNATION AND THE NEGATIVE INTEREST RATE CONUNDRUM: INTERNATIONAL ANALYSIS OF THE PERIOD 2010-2019 WARBURTON, Christopher E.S. * Abstract: The negative interest rate policy (NIRP), which is an unconventional monetary policy, is increasingly being diagnosed for symptoms of secular stagnation as some central banks exploit anticipatory inflation to achieve full employment. Notwithstanding, the efficacy of the unconventional monetary policy (UMP) is precarious and rather ambivalent. This paper argues that NIRP is unsuitable for structural (long-term) macroeconomic problems and that its adoption generates inconsistent and precarious results that are transient and potentially harmful. Keywords: Ageing population, Expected inflation; Negative interest rates; Rational expectations; Secular stagnation; Poverty JEL Classifications: E02, E41, E43, E52, E58

1. Introduction The negative interest rate policy (NIRP), which is an unconventional monetary policy, is increasingly being diagnosed for symptoms of secular stagnation as some central banks exploit anticipatory inflation to achieve full employment. Notwithstanding, the efficacy of the unconventional monetary policy (UMP) is precarious and rather ambivalent. This paper argues that NIRP is unsuitable for structural (long-term) macroeconomic problems and that its adoption generates inconsistent and precarious results that are transient and potentially harmful. When central banks push real rates below zero (negative real interest rate), the monetary policy is generally characterized as negative interest rate policy (NIRP). This paper argues that NIRP cannot be sustainable when productivity is less prospective and aggregate absorption is weak. The absorption problem has diverse underlying preconditions—ageing population, income inequality, poverty, and paucity of innovation. The combination of weak absorption and stagnant or declining productivity induces secular stagnation, which by modest measures, can be too overwhelming for expansionary monetary policy to finance unemployment via anticipatory inflation or negative real interest rates. Proactive fiscal policy and flexible international labor mobility may well be the appropriate diagnosis. The same diagnosis cannot be extended to policies that target exchange rate stability or capital inflows because of perverse interest rate effects. While borrowers might misperceive the effects of changes in nominal rates (the money illusion symptom), lenders/investors are not typically deluded by changes in real rates and they can promptly react in pro-cyclical ways; that is, the manipulation of the real rates below the zero bound on policy is not inevitably and significantly stimulative for all occasions; precisely because of the risks and losses that are associated with procyclical expansionary monetary policy that is intent on curing secular problems—the structural problems that are associated with weak absorption and stagnant or declining productivity. This paper examines the negative interest rate dilemma and argues that NIRP is a misdiagnosis for countries with structural rigidities, ageing population, declining productivity, and inflexible international labor mobility policies. ____ *Christopher E.S. Warburton, [email protected], Houghton College, NY, USA 19

Warburton, C.E.S. (2021) Applied Econometrics and International Development Vol.21-1 In the next section, I take a look at the money illusion and frictions in the money market—when lenders react to real changes and borrowers respond to both nominal changes and anticipated inflation. Money illusion generally connotes that measurements of wealth and income are made in nominal terms rather than real. The structure of the paper considers: (i) the relevant literature, (ii) the money illusion friction, and (iii) interest rate and unconventional monetary policy. A conclusion is provided at the end of the paper.

2. Literature on NIRP The negative interest rate policy (NIRP) has generated a potpourri of cause-effect analysis in the literature. Understandably, economists have been generally reluctant to attribute the phenomenon of NIRP to a singular variable. The literature has not generally devoted a lot of time to the appropriateness of the policy as a general stabilization tool when macroeconomic structures are differentiated. This paper attempts to make a modest contribution to the literature in that framework. Some concentric themes for NIRP can be found in the work of Bean et al ( 2015) Based on the literature, they find three reasons (under broad categories) to explain the decline in interest rates: (i) an increase in the propensity to save, (ii) a reduction in the propensity to invest; and (iii) shifts in the demand and supply for different types of asset (Bean et al.). They note that policy rates in the US and Europe only attained their effective lower bound after the global financial crisis of 2007-2008. By that time, Japan had already spent more than a decade with the policy rate at or near its effective floor. The confluence of falling long-term real interest rates and slow output growth since the financial crisis has led several authors – most notably, Robert Gordon (2012) and Larry Summers (2013) – to suggest that the US, and the advanced economies more generally, may have entered a period of ‘secular stagnation’. This revives a hypothesis originally developed by Alvin Hansen in his 1938 Presidential Address to the American Economic Association (Hansen, 1939). Summers’ argument is more Keynesian in spirit. His argument rests on the idea that shifts in the propensity to save and invest – of the sort we discuss in the main text of this report – have driven the natural or Wicksellian (nominal) rate of interest consistent with full employment to below zero. 1 The literature reveals that the zero lower bound on policy rates and tepid fiscal policy can generate labor underutilization and excess capacity. Notable in the literature as well is the concept that increased longevity and declining fertility can cause ageing population almost everywhere. These demographic changes potentially affect both individual savings rates and aggregate savings by changing population composition (Bean et al.). Invariably, the propensity to save because of demographic reason and the distribution of income affect the national saving rate. The literature reflects that in many countries, the distribution of income has become more unequal over the past three decades or so. Estimates of the Gini coefficient for the distribution of net income (i.e. after redistribution through the tax and benefit system) for a selection of advanced economies reveals noteworthy disparities (Frederick Solt’s database, Solt, 2014).

1 See Bean et al., p. 21.

Warburton, C.E.S. (2021) Applied Econometrics and International Development Vol.21-1 Income disparities can be compounded by catastrophic events like stock market crashes and pandemics; perceptions of risk impinge on returns (risk premia) and the preference for investment grade assets (Barro 2006, 2009; Ben Broadbent, 2014; Miles, 2014; and Bean et al ( 2015): 38). A summary of multiple hypotheses can be found in Mankiw (2020), which includes market concentration that inhibits investment in favor of higher prices. Extending on the overview of the literature, this paper presents the view that NIRP is a misdiagnosis for secular stagnation when economies with pervasive poverty (or income inequality), structural rigidities, and ageing demographic deficiencies use NIRP to reverse diminishing aggregate consumption (increased saving) in a state of secular stagnation or increasing levels of unemployment. Evidently, increased saving is equally untenable when real rate is below zero and unemployment rate is high. In effect, expansionary fiscal policies provide more appealing arguments in such circumstances than misplaced monetary policy targets though the same policy is not well suited for exchange rate issues because of adverse interest rate effects. Of course, there has been a presumption that workers are less attentive to real prices (the money illusion symptom, or the thought patterns that delink nominal rate changes from actual price changes); pointedly, the presumption that people use nominal values rather than real values to measure wealth or price changes in the future; thereby missing the widespread effects of nominal rate reductions on actual or perceived inflation (especially during periods of low inflation).

3. The Money Illusion friction Conventionally, central banks routinely charge positive nominal interest rate when lending out short-term funds (policy rates) to regulate the business cycle, and engage in unconventional policies when stabilization problems become too refractory; especially during periods of stagflation and secular stagnation. Irving Fisher’s equation is traditionally used to track the relationship between prices of money market instruments and the inflation premium (expected inflation). The lender’s function (Equation 1) is a variant of the borrower’s or investor’s function (Equation 2), but the inflation premium is an unavoidable menace to both lenders and borrowers: (1) (2) Naturally, investors are excited when the inflation premium stays below notional value; rates of return become attractive (Equation 3), but friction arises (disequilibrium of expectations) when real rates become negative (Equation 4). (3)

(4) Even when real prices are presumed to be invariant, the discrepancies in rates theoretically induce more borrowing and less lending as real rates fall below the zero bound. Borrowers expect to repay loans in less valuable currencies but for lenders to support stimulative policies of central banks they must be willing to engage in the unusual behavior of absorbing losses that are attributable to negative real rates (ex post facto). Alternatively, for the lenders to be indulged in unconventional behavior they must exact 21

Warburton, C.E.S. (2021) Applied Econometrics and International Development Vol.21-1 costly fees to mitigate risk exposures and losses or exit local markets in favor of attractive extraterritorial ones (to coincide with the conventional behavior of Figure 1(a). Therefore, the perturbations of negative real rates can only generate natural results that are not entirely counterintuitive.

Figure 1: The inflation premium (πe) and natural readjustments (the money illusion problem)

(a) Free market operation (b) Mandated negative rate r r (%) S1 S2 (%) S1 S0

D1 D0 D0 D1 Loanable Funds (money balances, M/P) Money Supply

Figure 1(b) shows a wedge that emanates from the enforcement of negative rates when lenders prefer to not make funds available at negative rates. Borrowers demand more money to increase the level of indebtedness but lenders are unwilling to tolerate a loss. In effect, NIRP does not necessarily guarantee the liquidity that is expected to cure secular stagnation. Free market operations require a reversal of NIRP (Figure 1(a)); invariably, unsuccessful NIRP forces central bankers to move from the negative territory. Therefore, market reactions raise some probative issues about the stabilization strategies of NIRP: (i) Is negative real rate sustainable? (ii) Can negative rates expeditiously alter factor cost and increase productivity to neutralize supply-side shock? (iii) Is secular stagnation a monetary issue (a banking problem)? Central banks routinely consider full employment, stable prices (inflation), and stable long-term rates (mandated or unwritten policy benchmarks). Yet, these mandates are not without limitations for the purposes for which they were designed. Accordingly, fine-tuning or concerted measures of fiscal and monetary policies have been deployed to deal with unconventional stabilization issues. More so, secular problems are long-term problems; they are problems that have been generated over several years of adverse macroeconomic policies, which are accentuated by shocks that are too overpowering for short-term monetary policies. Realistically, the remedial Fisher hypothesis is a limiting if not deficient stabilization diagnosis to remedy secular stagnation. As a result, the general performance of a macroeconomy must be examined for extended information or rationalization of the monetary policy choice. That is, the combination of the real growth of an economy and inflation premium can also outpace the cost of acquiring money market instruments (nominal rate of interest), resulting in real rates that fall below the zero-bound (see Equation 5):

. (5) 22

Warburton, C.E.S. (2021) Applied Econometrics and International Development Vol.21-1 The real rate (i/P = r) is also contingent on the performance of a real macroeconomy (Y/P), real balances of money supply (MS/P), and the expected inflation (Equation 5). Similarly, expected inflation that outpaces the nominal rate and aggregate economic performance can also result in negative borrowing and lending rates (real rates/costs) and the expansionary objectives (targets) of monetary policy cannot be validated within the money illusion model of negative real rates (see Figure 2 for the theoretical friction). The Phillips equation attempts to account for some omitted variables in the inflation puzzle. Current inflation (π) is presented as a function of the unemployment gap ( ), changes in productivity (z), the borrowing rate (iB), anticipatory inflation (πe), and the exchange rate (ε):

(6)

The Phillips’ representation incorporates the cost-push production shock, Nevertheless, Equation 6 shows that productivity, anticipatory inflation, and production costs are significant stabilization variables for which a respecification of the traditional Phillips curve provides a better understanding of the parameterized expected inflation; the inflation estimator that is used to generate the negative real rates:

. (7) Therefore, Equation 7 respecifies a modified form of Equation 6 to capture the estimable parameters of anticipatory inflation; it reveals that people form expectations about inflation based on measurable attributes of current levels of inflation, the interactive nature of productivity and the unemployment gap (the cyclical nature of unemployment), and perceptions about supply-side shocks; where β is a sensitivity parameter that captures the change in anticipatory inflation associated with the unemployment gap. Evidently, the operational model of anticipatory inflation is objectionably deterministic (not stochastic) to deliberately capture the variables that are amenable to monetary policy considerations with some omissions. Once monetary policy makers are sufficiently informed about the endogenous parameters, they can voluntarily utilize short- and/or long-term instruments to target expected inflation and bring the nominal (policy) rate in alignment with expected inflation for macroeconomic stability. However, in recent years, an increasing number of central banks have resorted to low- rate policies. Several, including the European Central Bank and the central banks of Denmark, Japan, Sweden, and Switzerland, have started experimenting with negative interest rates—essentially making banks pay to park their excess cash at the central bank (Haksar and Kopp: 50). Remarkably, negative policy rates are intended to inadvertently deal with some of the problems that are highlighted in Tables 1 and 2, and Figures 1(a) and (b). The problems are persistent but by no means exhaustive. Further, the negative rates unintentionally transmit problems into the real and financial sectors without adequately salvaging the problems to mitigate subsequent secular and cyclical disturbances. Indeed, it is noteworthy that transient and temporary successes, when they can be registered, are not necessarily fully capable of resolving the inherent and prospective secular dynamics of supply-side shocks. 23

Warburton, C.E.S. (2021) Applied Econometrics and International Development Vol.21-1 For countries that have experimented with NIRPs and other forms of unconventional monetary policies, Table 1 presents some ocular indicators of the challenges confronting NIRPs when macroeconomic structures are rigid and less susceptible to rapid transformations.

Table 1. Macroeconomic Indicators (4 year averages 2010 to 2019, except otherwise noted)* Period Japan Denmark Sweden Switzer- Germany UK Canada US land Interest rate spread % 10-14 0.93 0.51 0.55 2.66 0.64 0.41 2.47 0.38 15-19 0.72 (-0.31) (-0.48) 2.9 (-0.29) 0.61 2.63 0.28 GDP growth % 10-14 1.59 1.20 2.48 2 2.23 1.94 2.64 2.15 15-19 0.98 2.69 2.47 1.71 1.63 1.79 1.70 2.4 Unemployment 10-14 4.3 7.53 8.08 4.65 5.68 7.47 7.37 8.04 15-19 2.82 5.65 6.87 4.72 3.80 4.44 6.35 4.42 Credit/ private 10-14 102.88 182.54 126.88 164.40 83.72 10.39 N/A 50.50 15-19 107.28 163.86 130.2 172.44 78.38 133 N/A 51.95 CPI 10-14 100.45 104.14 102.86 99.67 103.71 85.48 104.06 104.77 15-19 104.3 108.6 106.76 98.58 109.68 84.70 112.43 112.72 GDP Deflator 10-14 (-0.58) 1.63 1.14 (-0.02) 1.4 1.79 2.24 1.76 15-19 0.54 0.64 2.18 (-0.24) 1.68 1.72 1.21 1.67 Productivity 10-14 1.27 1.08 0.83 0.69 1.26 0.26 0.92 0.44 15-19 0.64 1.34 0.34 0.61 0.51 0.15 0.48 0.63 Data Sources: World Bank. World Development Indicators (WDI), Federal Reserve Bank of St Louis (FRED), and Organization for Economic Cooperation and Development (OECD)

Interest rate spread (lending rate minus deposit rate, %, WDI). Interest rate spread is the interest rate charged by banks on loans to private sector customers minus the interest rate paid by commercial or similar banks for demand, time, or savings deposits. The terms and conditions attached to these rates differ by country, however, limiting their comparability (WDI). UK Spread (2016/17, 18/20): 3-Month London Interbank Offered Rate (LIBOR), based on British Pound, Percent, Daily, Not Seasonally Adjusted. US daily TED Spread between 3-Month LIBOR based on US dollars (2016-17; 2018-2020.) Consumer price index reflects changes in the cost to the average consumer of acquiring a basket of goods and services that may be fixed or changed at specified intervals, such as yearly. The Laspeyres formula is generally used. Data are period averages (WDI). Inflation as measured by the annual growth rate of the GDP implicit deflator shows the rate of price change in the economy as a whole. The GDP implicit deflator is the ratio of GDP in current local currency to GDP in constant local currency. Unemployment refers to the share of the labor force that is without work but available for and seeking employment (ILO estimates).

Warburton, C.E.S. (2021) Applied Econometrics and International Development Vol.21-1 Domestic credit to the private sector refers to financial resources provided to the private sector, such as through loans, purchases of nonequity securities, and trade credits and other accounts receivable, that establish a claim for repayment. For some countries these claims include credit to public enterprises. The series is lagged by one week because the LIBOR series is lagged by one week due to an agreement with the source. Sweden/Denmark/Germany: 3-Month or 90-day Rates and Yields: Interbank Rates for Sweden/Denmark/Germany, Percent, Monthly, Not Seasonally Adjusted. Multifactor productivity (MFP) reflects the overall efficiency with which labour and capital inputs are used together in the production process. Changes in MFP reflect the effects of changes in management practices, brand names, organizational change, general knowledge, network effects, spillovers from production factors, adjustment costs, economies of scale, the effects of imperfect competition and measurement errors. Growth in MFP is measured as a residual, i.e. that part of GDP growth that cannot be explained by changes in labour and capital inputs. In simple terms therefore, if labour and capital inputs remained unchanged between two periods, any changes in output would reflect changes in MFP. This indicator is measured as an index and in annual growth rates (OECD, https://data.oecd.org/lprdty/multifactor-productivity.htm); productivity in Japan and Sweden ends in 2018. First, it is immediately apparent that since 2010 productivity has been declining or virtually stagnant across time and space for some of the NIRP countries under consideration; specifically, Japan, Denmark, Sweden, Switzerland, and Germany. Second, economic growth has stagnated below 3% since 2010. Third, the GDP deflator—a broader measure of inflation that includes production—has shown some variations, and the consumer price inflation has a spread across 1 and 12 percent in the US and Canada; but more significantly, about 7 and 8 percent in Denmark and Sweden. In effect, high consumption inflation corresponds to high anticipatory inflation for some of the NIRP countries. Between 2015 and 2019, interest rate spreads are in Denmark, Sweden, and the UK (on average) fall below zero. These spreads and monetary policies seem to suggest that workers and producers cannot revise their expectations of inflation upwards to accentuate supply-side shocks. What if producers and workers adjust their expectations for the discrepancy between anticipatory inflation and the policy rate when productivity is flat or constant? The realignment of expectations is reminiscent of Muth’s rational expectations. Muth (1961) had postulated that economic agents will form expectations based on the best guess of the future (optimal forecast) by relying on all available information from the past and present, and prospective information. In effect, current expectations of inflation can be expected to be consistent with scientific forecasts of inflation (excluding extraneous or unanticipated occurrences); that is, people can revise their expectations of inflation upwards when negotiating contracts, thereby increasing factor cost when real rates are negative (lower rates today mean higher rates tomorrow). This phenomenon is striking when a labor force is depleted. Figures 2 (a) through (c) reveal the ageing problem in Denmark, Japan and Germany (the results for other countries are reported in the Appendix). The ageing problem has made a steep ascent in most if not all of the NIRP countries. Of course, the ageing problem is compounded by poverty and income inequality (see Table 2).

Warburton, C.E.S. (2021) Applied Econometrics and International Development Vol.21-1 Figure 2(a) Denmark and the ageing population (65+) problem (percentages)

Source: World Population Prospects: The 2019, Volume II Demographic Profiles, p.469.

Figure 2(b) Japan and the ageing population (65+) problem (percentages)

Source: World Population Prospects: The 2019, Volume II Demographic Profiles, p.676 Figure 2(c) Germany and the ageing population (65+) problem (percentages)

Source: World Population Prospects: The 2019, Volume II Demographic Profiles, p.564 Poverty rates range from slightly more than 12 percent to approximately 19%. The US has the fourth-highest poverty rate of 17.8% in the general database. Though the US is the largest economy in the world, it is also known for a significant wealth inequality gap at the time of this writing.2 Poverty and income inequality interact adversely with an ageing

2 The current poverty threshold in the United States is $25,700 for a family of four. This means that households of four with a pre-tax income under $25,700 are considered to be living in poverty. Some states are more impoverished than others, and their poverty is exacerbated by high unemployment rates and a lack of high-paying jobs (World Population Review). 26

Warburton, C.E.S. (2021) Applied Econometrics and International Development Vol.21-1 population to provide robust employment, aggregate absorption, and reversals of supply- side shocks. Significantly, a Gini measure exceeding 0.35 is problematic and indicative of perverse income distribution. Japan, Switzerland, Germany, UK, Canada, and the US have distributive issues that are counterproductive for economies with weak absorption and virtually stagnant levels of employment and productivity.

Table 2: The poverty problem: (2017 and 2021) Ratio Ratio GDP per Gini Index 2017 2021 capita Japan 15.7* 15.70 48,194 32.9 Denmark 12.7 12.5 63,118 28.3 Sweden 16.4 17.1 57,304 29.4 Switzerland 14.6 14.6 77,981 32.78 Germany 16 16 46,535 31.8 UK 18.6 18.6 42,913 34.37 Canada 12.1* 12.1 50,938 33.23 US 17.8* 17.8 53,790 41.2 Notes: See definitions of Poverty Ratio and Gini Index in Appendix 2. * Estimates by author Source: World Bank(2017) and world Population Review (2021)

Can increases in employment reduce inflation? Can anticipated inflation be used to increase employment via the monetary policy channel? In the 1970s, some monetary policy analysts argued that there is no tradeoff between inflation and unemployment; that is, high inflation does not mean low unemployment and low unemployment does not mean high inflation. This analysis was ably captured by the Friedman-Phelps model:

; (8) (9) (10) Equation 8 relates the change in the wage rate to the current rate of unemployment and a proportion (α) of current expected inflation. Equation 9 excludes flat productivity and sets the rate of price inflation to wage inflation; where the productivity effect subsumes, . Therefore, Equation 10 shows that expected price inflation today is commensurate to inflation in the previous period (Suman). Stagnant productivity and growth, variations in unemployment and consumer inflation, high incidence of poverty and the ageing population problem (see Table 1) are more than mere causes of secular stagnation; in the absence of significant structural changes they become persistent structural problems that are beyond the reach of monetary policies in the NIRP countries. Implicitly, the variations in the fundamental macroindicators suggest that the adoption of NIRP can only provide transient and inconsistent results that can be occasionally procyclical and harmful to aggregate economic performance. So, how have the aggregate economies of the NIRP countries responded to unconventional monetary policies and the new monetary experiment?

Warburton, C.E.S. (2021) Applied Econometrics and International Development Vol.21-1

4. Interest rate adjustments and responses to unconventional monetary policy In recent times, nominal interest rate adjustments have driven real interest rates below the zero bound, especially in Europe and Japan. Multiple reasons can be associated with the policy choice. Pointedly, Krogstrup and others point to the deflationary situation. An obvious extrapolation is that the nominal rates must have been declining faster than the anticipatory rates of inflation. Currency linkages also complicate the situation. Figure 3 shows a time path for the three-month short-term rate for Germany. The short-term rates for Germany have broader implications because they are more symbolic or representative of what the negative rates look like for countries within and without the Eurozone.3 Since 2012, short-term monetary policies in Denmark have been linked to the exchange rate mechanism (Krogstrup et al.). Declining levels of inflation and stagnation of economic performance have encouraged expansionary monetary policy. Figure 3: Three-month rate for Germany (not seasonally adjusted in percentages)

Data source: Federal Reserve Bank of St. Louis (FRED). In Germany, banks are harder hit by NIRP than in most other European countries because Germans are big savers. According to the ECB’s data, about 30% of all household deposits in the Eurozone are from Germany. Banks have been targeting negative rates since 2014 (Helms). Curiously, Germany seems to have less of an unemployment issue relative to the other Eurozone countries, suggesting that the NIRP is intended to target currency valuation and/or capital movement. The practical impact of NIRP has been mixed. In Denmark, for example, Krogstrup et al. found that there was no sign of the reversal rate since the bank lending rates have moved concomitantly with negative policy rates (Adolfsen and Spange). Also, the negative policy rates increasingly impacted the bank deposit rates in Denmark. Further, they find that the data suggest that negative policy rates have sectoral implications; they helped to boost employment and investment in Danish non-financial firms.

3 Notably, at the time of this writing, Denmark and Switzerland are not part of the Eurozone; Sweden joined the Eurozone in 1995, but Denmark pegs its currency to the euro and the three European countries have a trajectory of short-term rates that are similar to that of Germany.

Warburton, C.E.S. (2021) Applied Econometrics and International Development Vol.21-1 Yet the risks that are associated with negative rates—as a result of transmission— have not been generally discounted. Increased risk is associated with financial instability. Prolonged low interest rate has incentivized financial companies to intensify their search for higher yielding instruments, investments, or outlets; increasingly investing in alternative assets while expanding credits (Krogstrup et al.). Further, depository institutions can explore opportunities for national or international territorial relocation as a result of odious or unattractive rates of return. In the case of Japan, Japan has suffered from long-lasting but mild deflation since the latter half of the 1990s (Nishizaki et al., and Christensen and Spiegel). Estimates of a standard Phillips curve by Nishizaki and others indicate that a decline in inflation expectations, the negative output gap, and other factors such as a decline in import prices and a higher exchange rate account for deflation. Further they found that the expectations for long-run inflation declined but that it did not go below zero by 2012. Hence we may tentatively conclude that expectations certainly helped to drag the inflation rate down but not as far as to bring it into the negative regime, i.e. deflation.4 Deflation was associated with a negative output gap and negative interest rates, implying that negative interest rates can be positively correlated with unemployment (an unintended result). Deflation can also be linked to permanent productivity shock. Indeed, Table 1shows that Japan suffered a steep decline in multifactor productivity. When potential growth declines, without adequate consideration of the response of aggregate demand, a narrowing of the negative output gap is usually expected. Aggregate demand responds to perceptions of temporary and long-lasting shocks. Responses to temporary potential growth can be stabilizing because of intertemporal consumption smoothing, which should have regular impact on aggregate prices (improvement on the output gap)—shifting prices from deflation into inflation territory. On the other hand, Nishizaki and others found that if a decline in the potential growth were delivered by a negative permanent shock in productivity, demand would react more in anticipation of a future decline in income growth, leading to deflation. More so, risk averse depository institutions, can accumulate government securities instead of giving loans to private businesses, which could widen the output gap and lead to lower inflation. Bean et al. made similar observations more broadly, but found that the fall in yields, which began in the late 1990s could be attributed to lower real rates than decline in anticipatory inflation (Bean et al.:1). The past two decades have witnessed an extraordinary decline in both short- and long-term advanced economy interest rates, from levels of around 4-6% to close to zero. Although recent falls have been associated with the financial crisis and its aftermath, the decline in yields, particularly for longer-term rates, began in the late 1990s. Moreover, the fall in yields has been associated primarily with lower real interest rates, rather than a decline in inflation expectations. Finally, the phenomenon has been widespread, and not specific to particular countries. Rankine (2019) reports that Sweden—one of the pioneers of the NIRP—ended its experiment with negative interest rates in 2019. The Sveriges Riksbank, "the world’s oldest central bank, raised the main interest rate from -0.25% back to zero when inflation hit

4 Three hypotheses are associated with declining prices and anticipatory inflation: (i) the lowering of inflation targets by central banks, (ii) inefficient communication strategy by central bankers (iii) perceptions of higher prices in Japan relative to other countries. 29

Warburton, C.E.S. (2021) Applied Econometrics and International Development Vol.21-1 1.8% (≈ 2%) in 2019 after experimenting with the NIRP since 2015. Mihm (2019) dated the practice in Switzerland back to the 1970s when an effort was made to prevent the currency from appreciating excessively. But the lessons of that monetary experiment, he observed, should give pause to anyone who believes that negative rates can halt capital inflows and appreciation in countries where currencies are fundamentally strong." According to Mihm, the Swiss franc became an attraction after the then U.S. President Richard Nixon suspended the conversion of dollars into gold (convertibility) in 1971. The US dollar depreciated as currencies started to “float” against one another in the floating regime, which caused the franc to appreciate and invite capital inflows as investors started to buy Swiss francs. The appreciation meant costly exports that unfavorably impacted the net exports of Switzerland. In response, reserve requirements were imposed on non-resident deposits; a policy that proved to be ineffective and invited the much more stringent measure of banning interest payments to non residents and imposing further restriction on the purchase of Swiss francs (a 2% penalty per quarter). The restriction on currency purchases was relaxed in 1973 but the oil crisis of the 1970s (a negative supply-side shock) forced speculators to abandon the US dollar in favor of the Swiss franc; for which the Swiss government imposed negative rates on foreign depositors. The negative rate was subsequently increased to 12% in 1974, which caused a tentative appreciation of the US dollar (Mihm); the Swiss government imposed harsher reserve requirements on foreign depositors in December 1974 as a result of the depreciating US dollar and currency speculation. “But nothing could stop the influx of capital. In January 1975, the Swiss government held an emergency meeting and then took the extraordinary step of slapping a 41% annual penalty on foreign deposits. But even this failed to stem the tide. The franc continued to appreciate against the dollar — a total of 70% in nominal terms between 1971 and 1975 alone” (Mihm). The export sector stumbled, and the very impressive Swiss economy suffered a serious recession. Economic indicators became unattractive: Industrial production fell 15% in 1975, plants worked well below capacity (excess capacity), exports declined by over 8% in real terms, and unemployment changed by about 394%.5 Between 1974 and 1975, the financial sector became the only growth sector in the economy. This observation is consistent with what happened in Denmark in the twenty-first century (with bank profits increasing by 15% for the period). Despite the capital control measures, for the rest of the decade, Switzerland could not deter foreign capital. Research indicates that attempts to prevent appreciation of the franc by NIRP and capital controls “were fundamentally inconsistent with the thrust of tight domestic monetary policy, which was the ultimate source of the capital inflows into the country” (Mihm). The problem was subsequently mitigated by unsterilized intervention—the use of foreign assets to purchase the franc in order to alter the monetary base (combination of reserves and money in circulation). While the outcome became inflationary then, inflation has not been the problem with the more recent NIRP that was adopted. NIRP is also associated with the current

5 Prior to the downturn, official unemployment figures showed that 81 people were unemployed in a country of about 6.4 million then. That figure jumped to 32,000, but it would have been higher if 150,000 foreign guest workers had not been terminated (Mihm).

Warburton, C.E.S. (2021) Applied Econometrics and International Development Vol.21-1 competitive debasement in countries with relatively stronger currencies like Denmark and Switzerland to fend off capital inflows. Therefore, NIRP may be adopted by countries for unusual and divergent reasons and the outcomes are not predictably identical. Despite what seemed to have been an attractive exchange rate policy to boost exports and force commercial banks to give out loans, private sector debt in Sweden rose to 285.7% of annual output in 2018 to become one of the highest rates in OECD countries. Evidently, the policy has been noted to undermine the profitability of depository institutions and damage the prospects of growth and productivity. In the case of Sweden adverse collateral consequences manifested themselves. The essence of unconventional monetary policy in the US is very much unlike that of Europe and Japan. While Europe and Japan has suffered from currency speculation and secular stagnation because of currency depreciations elsewhere and structural and demographic problems, the US encountered stagflation in the 1970s when inflation and unemployment were both high. In contradistinction to the US, Japan and Europe had high unemployment and low inflation, which made the negative policy an attractive tool for macroeconomic stabilization. Experiences with unconventional monetary policy in the US date back to the 1960s (under President Kennedy) and 1970s. Before stagflation of the 1970s, there was “Operation Twist” of the 1960s. In a very curious symmetry of events, Operation Twist (the use of long-term securities to drive real rates down) targeted the performance of the economy (business investment and the housing market) and the US dollar. The purchase of long-term securities was also intended to keep short-term rates intact to prevent the depreciation of the US dollar in foreign exchange markets. “Stagflation” is conventionally defined as the combination of high inflation and unemployment. Notwithstanding, variegated theories have been articulated to rationalize the causes of the rare manifestations of stagflation. Significantly, the evident theoretical, empirical, and ocular representations of economic models indicate that the unusual phenomenon can be more aptly associated with adverse supply-side shocks (Blinder and Rudd; Warburton: 49) even when objectionably conceding that aggregate demand (AD) can trigger stagflation. Figure 1 is instantly revealing of the thought.

Figure 4: Stagflation

$ LRAS AS1 AS0 $1

0 Y1 YF (National Output)

Warburton, C.E.S. (2021) Applied Econometrics and International Development Vol.21-1 The stagflation puzzle, as presented in Figure 4, is a practical revelation of the cost-push phenomenon; this is so because an adverse supply shock reduces national output from YF to Y1 (increase in unemployment) while simultaneously increasing in the general price level (inflation) from $0 to $1. Increases in aggregate demand (AD) beyond full employment (YF) cannot be diagnosed as recessionary and decreases in AD below full employment are deflationary rather than inflationary. On occasions when AD receives favorable shocks to trigger a stagflationary disturbance, an aggregate supply (AS) shock must overwhelm the favorable AD shock to cause the dual incidents of unemployment and inflation in a macroeconomy (see Figure 1). Therefore, the magnitude of the negative supply-side shock attracts attention and becomes insightful and pivotal in all situations when there is an actual challenge of dealing with stagflation. The long-run aggregate supply (LRAS) is indicative of the performance of a macroeconomy at full capacity. Accordingly, the preliminary model (Figure 1) is important for understanding the stabilization challenges confronting supply-side shocks and stagflationary situations; even in situations when anticipatory inflation is used as a tool to reverse economic stagnation. Policies that draw attention to unemployment and actual inflation are just as confounding as those that deal with the anticipatory version of inflation, which generate responses that are inconsistent with the targeted stabilization objectives of monetary policymakers. In the 1970s, the Fed did not quite get a handle on expected inflation or real rates as it targeted the money supply. Long-term interest rates were regarded as anticipatory inflation and inflation was rising before Paul Volcker became Chairman of the Fed in August 1979 (Goodfriend and King: 986). Between 1973 and 1981, real interest rate periodically fell below the zero bound (see Figure 5) before a period of disinflation, which Goodfriend and King dates to the late 1980 when the federal funds rate rose to 19%; because of restrictive monetary policy and strong recovery from the recession. Axilrod provides a crude characterization of the liberal policy. “The Fed seemed to be giving away overnight money in real terms when it should have been exerting more restraint on its ability to help suppress inflation” (Axilrod:36).

Figure 5: Ten-year Treasury Rates (Jan.1970 to Dec 2015)

Data source: Federal Reserve Bank of St. Louis (FRED). 32

Warburton, C.E.S. (2021) Applied Econometrics and International Development Vol.21-1 Evidently, Figures 4 and 5 portray an anomaly in the monetary history of the US in the 1970s, which also reflected the unusual experience of high inflation and high unemployment. Accordingly, negative rates can occur in situations of high and low inflation, reflecting variations in stabilization challenges and expected results. In a very depressed economy, it is counterintuitive to use monetary policy to stimulate the economy. The prevailing indicators of economic prospects (see Table 1 and the Appendix) suggest that NIRP policy cannot be decoupled international labor mobility. Clearly Switzerland benefited from guest workers in the 1970s before the employment conditions of the workers were altered by NIRP. Countries that are plagued by the ageing population, lack of productivity, and sustained reduction in aggregate absorption cannot afford to sustain a declining labor force and productivity while expecting economic growth. Of course, exchange rate objectives fall into a different basket though they have unintended problems of their own. Unlike Europe and Japan, the ageing issue is not as debilitating in the US. The push factors abroad and the pull factors in the US increase the propensities to attract younger workers from all over the world. Apparently, the ageing issue is a common phenomenon problem to varying degrees. While the ageing population (as a percentage of total population) has not been increasing (see Figure 6), the immigrant to population ratio in the US has been fairly stable since the 1870s. Notably, there was a deep dive in the percentage of immigration during the depression years (till the 1960s), but it bounced back the median age of immigrants has hovered around 30 to 40 years between 1980 and 2013.

Figure 6: The US and the ageing population (65+) (percentages)

Source: World Population Prospects: The 2019, Volume II Demographic Profiles, p.564 This development generates some labor and consumption advantages for the US. Accordingly, the US has been able to stave off the temptation of adopting NIRP, even in a pandemic, since earlier than 2010 (see Figure 8).

"The immigrant population includes all current US residents born abroad, including naturalized citizens, green card holders, refugees, and unauthorized immigrants. It excludes tourists and others who may be in the US for short visits. Immigration accounts for roughly half of yearly population growth in the US and immigrants make up for nearly 15% of the US population" United Nations, World Population Prospects (2019).

Warburton, C.E.S. (2021) Applied Econometrics and International Development Vol.21-1

Figure 7: Immigrant population (15-64 years) as a percentage of the US population and median age

Note: Age rounded to the nearest old number by author. Data source: Migration Policy Institute

Figure 8: Three-month secondary monthly rate (not seasonally adjusted in percentages)

Data source: Federal Reserve Bank of St. Louis (FRED).

5. Conclusions There are variations in the preconditions for adopting NIRP; for example, some nations can adopt such a policy to stabilize exchange rates or prevent capital inflows. Others may adopt such a policy to cure unemployment or stagnant economic performance. Naturally, the structural conditions in each country are unidentical. Consequently, the effects of adopting the unconventional monetary policy cannot be expected to be identical; except of course, that—as a matter of commonality—some financial institutions have benefitted through the investment channel. Evidently, bankers have considered long-term financial instruments to be an effective mechanism for altering perceptions of inflation or anticipatory inflation. Accordingly, 34

Warburton, C.E.S. (2021) Applied Econometrics and International Development Vol.21-1 targeting long-term rates (Δr) is expected to alter inflationary expectations. Therefore, long- term rates become prime targets when negative real rates fail to ensure macroeconomic stabilization. While some European countries and Japan have used NIRP to cure unemployment and exchange rate problems, the US has traditionally targeted long-term rates to avoid negative real rates. This paper concludes that NIRP may well be a misdiagnosed monetary policy for countries with structural rigidities, ageing demographic problems, diminishing levels of productivity, and sustainably weak aggregate absorption. Invariably, expansionary fiscal policies and international labor mobility are proactively more suited for such situations. In the matters of exchange rate stability, expansionary fiscal policy becomes a less enticing proposal because of its undesirable interest rate effect, which can only attract further capital inflows. Therefore, Denmark was able to endure some amount of pain while stabilizing its currency by the use of NIRP. The US makes a more notable case as to why labor mobility is critical for the dynamism of the labor force and aggregate consumption. Nevertheless, fiscal policy is still required for investment and productivity growth to prevent the real rate from breaching the zero bound threshold. References Axilrod, S. H. (2013). The Federal Reserve: What everyone needs to know. Oxford University Press Adolfsen, J. F. Spange, M. (2020), Modest pass-through of monetary policy to retail rates but no reversal, Danmarks Nationalbank working paper no. 154. Barro, R. (2006). Rare disasters and asset markets in the Twentieth Century. Quarterly Journal of Economics 121(3), 823-866. Barro, R. (2009). Rare disasters, asset prices, and welfare costs. American Economic Review 99(1), 243–264. Bean, C., Broda, C., Ito, T. & Krosner, R. (2015). Low for Long? Causes and Consequences of Persistently Low Interest Rates. CEPR Press Blanchard, O. & Johnson, D.R. (2013). Macroeconomics (6th ed.). Pearson. Blinder, A. S. & Rudd, J.B. (2008, November). The supply shock explanation of the Great Stagflation Revisited. Center of Economic Policy Studies (CEPS). Working Paper176. Burton, M. & Lombra, M. (2003). The Financial System & the Economy (3rd. ed.). Thomson Christensen, J.H.E, & Spiegel, M.M. (2019, August 26). Negative Interest Rates and Inflation Expectations in Japan. Federal Reserve Bank of San Francisco [FRBSF] Economic Letters, 22, 1-5. Fischer, S. (2016, March 7). Reflections on Macroeconomics Then and Now: Policy changes in an interconnected world. 32nd Annual National Association for Business Economics Economic Policy Conference. Washington DC. Goodfriend, M. & King, R.G. (2005). The incredible Volcker disinflation. Journal of Monetary Economics, 52, 981-1015. Gordon, R.J. (2012), Is U.S. economic growth over? Faltering innovation confronts the six headwinds (Working Paper No. 18315), National Bureau of Economic Research. 35

Warburton, C.E.S. (2021) Applied Econometrics and International Development Vol.21-1 www.nber.org Haksar, V. & Kopp, E. (2020, March). How Can Interest Rates Be Negative? Central banks are starting to experiment with negative interest rates to stimulate their countries’ economies. Finance & Development, 50-51. Hansen, A. (1939) Economic progress and declining population growth. American Economic Review 29(1), 1-15. Helms, K. (2021, March 3). Banks Turn Away Customer Deposits due to Negative Interest Rates in Germany. Finance. https://news.bitcoin.com Krogstrup, S., Kuchler ,A., & Spange, M. (2020, October 2). Negative interest rates: The Danish experience. https://voxeu.org/article/negative-interest-rates-danish- experience Mankiw, G.N. (2019). Macroeconomics (10th ed.). Worth. Mankiw, G.N. (2020, December 4). The puzzle of low interest rates. New York Times. www.nytimes.com Mihm. S. (2019, August 22). Switzerland Tried Negative Rates in the 1970s. It Got Very Ugly. Bloomberg. www.blommberg.com Muth, J. (1961). Rational Expectations and the Theory of Price Movements. Econometrica, 29, 315-335 Nishizaki, K., Sekine, T, Ueno, Y. & Kawa, Y. (2012, July). Chronic Deflation in Japan. Bank of Japan (Working Paper Series, 12-E-6).Bank of Japan. https://www.boj.or.jp/en/research/wps_rev/wps_2012/data/wp12e06.pdf Rankine, A. (2019, December 26). Sweden ditches negative interest rates. Money Week, https://moneyweek.com/520010/sweden-ditches-negative-interest-rates Spiegel, Mark M. (2001, November 2). Quantitative Easing by the Bank of Japan.” FRBSF Economic Letter 2001-31 (November 2). https://www.frbsf.org/economic-research/publications/economic- letter/2001/november/quantitative-easing-bythe-bank-of-japan/ Stiglitz, J.E. (2012). The Price of Inequality: How Today’s Divided Society Endangers our Future. Norton Suman, K. (n.d.) Friedman-Phelps Model of Stagflation: Equations, Curves, criticisms, and conclusion. https://www.economicsdiscussion.net/stagflation/friedman-phelps- model/ United Nations, Department of Economic and Social Affairs, Population Division (2017). World Population Prospects: The 2017 Revision, Key Findings and Advance Tables. Working Paper No. ESA/P/WP/248. United Nations, Department of Economic and Social Affairs, Population Division (2019). World Population Prospects: The 2019, Volume II Demographic Profiles. https://population.un.org/ Warburton, C.E.S. (2018). The Development of International Monetary Policy. Routledge.

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Warburton, C.E.S. (2021) Applied Econometrics and International Development Vol.21-1

Appendix 1

Table 3: Age brackets (percentages) 1950 1970 1990 2000 2005 2010 2015 2020 2030 Japan 25-64 40.1 49.8 54.5 55.6 55.3 54.1 51.5 49.9 48.9 65+ 4.9 6.9 11.9 17 19.7 22.5 26 28.4 30.9 Denmark 25-64 50.9 48.4 52.5 55.2 55.1 53.1 50.9 51.3 49.8 65+ 9 12.3 15.6 14.9 15.2 16.7 19.1 20.2 22.6 Sweden 25-64 53.9 50.3 50.6 52.7 53 51.7 50.8 51.3 49.1 65+ 10.2 13.7 17.8 17.3 17.3 18.2 19.6 20.3 22.2 Switzerland 25-64 52.4 49.4 54.2 55.77 56.1 56.2 55.9 55.4 51.6 65+ 9.4 11.3 14.6 15.3 15.8 16.9 18 19.1 23.4 Germany 25-64 52.7 50.1 55.4 56.8 55.1 54.8 55 54 50.1 65+ 9.7 13.6 14.9 16.5 18.9 20.6 21.2 21.7 26.2 UK 25-64 53.6 48.4 50.5 53 52.9 52.8 52.2 52.2 52.2 65+ 10.8 13 15.8 15.9 16 16.6 16.6 18 18.7 Canada 25-64 46.7 43.5 53.4 54.7 55.6 55.9 55.1 54.6 51.3 65+ 7.7 8 11.3 12.6 13.1 14.2 16.1 18.1 22.8 US 25-64 50.2 44.5 50.9 52.1 52.5 52.6 52.3 51.9 49.9 65+ 8.2 10.1 12.6 12.3 12.3 13 14.6 16.6 20.3 Source: World Population Prospects: The 2019, Volume II Demographic Profiles.

Warburton, C.E.S. (2021) Applied Econometrics and International Development Vol.21-1

Appendix 2

Poverty ratio and Gini Index

National poverty headcount ratio is the percentage of the population living below the national poverty line(s). National estimates are based on population-weighted subgroup estimates from household surveys. For economies for which the data are from EU-SILC, the reported year is the income reference year, which is the year before the survey year (WDI). The OECD defines the poverty rate as the ratio of the number of people in a given age group whose income falls before the poverty line, determined as half the total population's median household income. GDP per capita is the average value from 2015- 2019. GDP per capita is gross domestic product divided by midyear population. GDP is the sum of gross value added by all resident producers in the economy plus any product taxes and minus any subsidies not included in the value of the products. It is calculated without making deductions for depreciation of fabricated assets or for depletion and degradation of natural resources. Data are in constant 2010 U.S. dollars.

Gini index measures the extent to which the distribution of income (or, in some cases, consumption expenditure) among individuals or households within an economy deviates from a perfectly equal distribution. A Lorenz curve plots the cumulative percentages of total income received against the cumulative number of recipients, starting with the poorest individual or household. The Gini index measures the area between the Lorenz curve and a hypothetical line of absolute equality, expressed as a percentage of the maximum area under the line. Thus a Gini index of 0 represents perfect equality, while an index of 100 implies perfect inequality (WDI). The Gini index values are average values from 2015 to2018 (except Germany, which is for 2015 and 2016). Japan’s Gini index is for 2013 (FRED).

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