Recently there was a weekend gathering of sports cars near my home. I will not go into the question whether it’s rational to drive a car which reaches the legal speed limit in second gear (what do you do with the five or six other gears?), but as an economist, it made me think. Are these cars a good store of value (some cars which are now vintage certainly have been)? Is it good for the economy (maintenance costs are high so owning one supports consumer spending) or bad (they’re all imported and they’re guzzlers of imported gas)? What gave me most food for thought was the instantaneous and brutal reaction of these engines when the driver hit the throttle. Seeing this as a metaphor for the impact of central banks on the world economy, I quickly came to the conclusion that steering an economy is not like driving a sports car: the global economy hasn’t shown a lot of oomph despite the efforts of the central bankers at the steering wheel (and the throttle).
There are several possible explanations. One is the presence of conflicting forces: admittedly repeated cuts in interest rate provide tailwinds but forced deleveraging of banks and fiscal austerity create strong headwinds. A second is lingering uncertainty: the Global Financial Crisis had such an impact that households and companies, under the effect of post-traumatic stress, may worry that even minor shocks could cause a relapse into recession. Though the environment has improved, the recollection of how brutal and deep the recession was still influences confidence and behaviour today. A third reason is access to funding: recession and weak recoveries imply a rise in bad debts, which instils greater caution among banks when granting loans, although this has now improved. Company short-termism as a fourth factor may play a role leading to a preference for share buybacks rather than increased capital expenditures. A fifth and final explanation is household diversity. Macroeconomic textbooks introduced, years ago, the concept of the representative household. It allowed deriving macro conclusions from microeconomic analysis (utility maximisation) based on the hypothesis that all households act in the same way. Today this doesn’t work anymore (did it ever?). The primary concern of very indebted households is to pay-off their debt, rather than using the opportunity of lower rates to load up even more. Households with positive though insufficient net financial assets (insufficient with respect to their target wealth at retirement age) are frustrated about the impact of low bank deposit rates and government bond yields, because they significantly slow down their wealth accumulation. Retirement planning may even force them to spend less and increase their savings today so as to reach their target wealth tomorrow. Finally, there are households with large net financial assets. They are the lucky ones. Wealth is already sufficiently high to live happily ever after so the decline in rates is not an issue and they will be sensitive to the opportunities this creates by investing in e.g. equities. This is good for financial markets but the real question is what happens to their consumer spending. How many fast cars can one drive? Moreover, they are in a minority (in numbers).
To conclude, forecasting the effect of monetary policy requires a granular approach: the ‘representative’ consumer or corporate does not exist and individual situations and reactions differ very much. Applying this to the current context, it is sobering to see how narrow is the base that shall provide a strong reaction to monetary impulses. It’s no wonder the reaction is slow and muted. Rather than driving a five litre sports car it feels like being in a 1200cc diesel powered car. Full throttle, lots of noise, no oomph.
