Low interest rates jeopardise affluence and stability

 Financial Group German Savings and Giro Association (DSGV) Statement

Low interest rates jeopardise affluence and stability By the Chief Economists of the German Savings Banks Financial Group 5th November 2012

Chief Economist Uwe Dürkop - LBB Chief Economist Folker Hellmeyer - Bremer LB Chief Economist Dr. Ulrich Kater - DekaBank Chief Economist Dr. Peter Merk - LBBW Chief Economist Dr. Cyrus de la Rubia - HSH Nordbank Chief Economist Dr. Jürgen Pfister - BayernLB Chief Economist Dr. Patrick Steinpaß - DSGV Chief Economist Dr. Gertrud Traud - Helaba Chief Economist Torsten Windels - NordLB Co-ordination: Dr. Reinhold Rickes - DSGV

 Financial Group German Savings and Giro Association (DSGV) The DSGV's Chief Economists take a critical view of the current low-interest-rate phase: the top priority must continue to be cementing confidence in a stable currency and thus averting threats to affluence and stability: A multi-year phase marked by very low interest rates poses risks: 

Asset erosion: Negative real interest rates eat into the value of monetary assets.

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Old-age provision: A low interest-rate level undermines the propensity to save. With interest rates at their current levels, however, the existing pension gaps can only be bridged with the help of higher savings volumes.

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Distortions in allocation, and the risk of a new bubble emerging: Low interest rates can trigger evasive reactions, which - in turn - will give rise to price distortions on the markets affected.

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Readiness to take risks: In the long term, low interest rates will endanger the financial stability which has been strengthened, in the short term, by interest-rate cuts.

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Inflation: Low interest rates can engender higher inflation.

The following triad of measures are therefore required to eliminate the root causes: 

Reduction of debt ratios in order to restore confidence in the financial system: Debt consolidation remains a matter of priority.

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Single-minded implementation of the concrete solutions which have already been come up with in order to restore confidence in the European Monetary Union: In this context, the new mechanisms enabling economic-policy and fiscal-policy co-ordination need to put into practice in a credible and sustained manner.

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Improving growth conditions in order to restore confidence in the European economy: Boosting growth potential and competitiveness are decisive pillars underpinning such an architecture.

Statement Berlin, 5 November 2012 page 2

Low interest rates jeopardise affluence and stability 1. Point of departure and background An unusually low interest-rate level has prevailed for quite some time now not only in Germany but also in other advanced economies. To a large extent, this has been brought about by the monetary-policy stance being adopted by central banks. In the USA, the Fed has kept the fed funds target range in a range of 0% to 0.25% since December 2008 - the lowest level since the Federal Reserve was set up in 1913; the Bank of Japan has already been pursuing a zero-interestrate policy since 2000, while the Bank of England froze its key rate at a historical low of 0.5% back in 2009. The European Central Bank, meanwhile, cut its main interest rate to 0.75% in July of this year, having already loosened the monetary reins last November. Almost all central banks are more or less clearly signalling that they regard the current interest-rate level as appropriate for a relatively long time to come - even though the ECB definitely emphasises again and again that it is not prepared to give clues about the future path of interest rates ("We never precommit“). In the Federal Republic, as in a number of other member states of the European Monetary Union, such monetary-policy influence on interest rates is being further amplified by capital movements sparked by the sovereign-debt crisis: the flight to safe investment vehicles such as government bonds and the banking system in Germany has caused the entire interest-rate spectrum across all market segments to ratchet down to an unprecedentedly low level, at which it still remains. Deposit interest rates, mortgage interest rates, credit interest rates, and bond yields are unusually low. In the case of safe-haven investments, interest-rate levels are so low in some cases that they do not offer compensation for inflation even now, at a time when prevailing inflation rates are moderate: Germany is witnessing negative real interest rates. Never before has the German financial system been exposed to such a pronounced and prevalent low-interest-rate environment. The counter-example repeatedly adduced in this connection - the high interest rates which are being charged for overdraft facilities - does nothing to alter this picture. For one thing, overdrafts account for just 1.9% of aggregate loans granted to private households, the reason being that they serve only to bridge short-term financing gaps rather than as long-term consumer loans. For another thing, the distinctly higher interest rates charged for this type of loan are justified similar to the situation on the corporate-bond market, where higher-yielding instruments can also be found - as a result of the considerably higher risks involved for the banking institution making such loans. State intervention at this point in the interest-rate-setting process would deactivate market mechanisms and would, in many cases, lead to the loan offer in question being discontinued.

Statement Berlin, 5 November 2012 page 3

From a macroeconomic viewpoint, the current interest-rate policy being pursued is warranted as a response to the financial crisis which began brewing in 2007. The fact that, from this point in time onwards, the debt ratios of various sectors in individual countries (private households, states or banks) were no longer regarded by financial markets as being sustainable added up to an overall picture which - in spite of energetic countermeasures on the part of economic policymakers - led to a massive loss of confidence in the financial system, but also in the real economy. In the euro zone, this erosion in confidence precipitated a deeper debt crisis in a number of member states which - in the eyes of a number of observers - actually threatened the very survival of the EMU currency union. Taken together, all these factors are putting a severe strain on confidence in the future viability of the economy and therefore on its growth prospects. A low interest-rate level, engineered by monetary policy-makers, is admittedly the temporarily right answer in such a situation. On its own, however, this cannot resolve the problems bound up with excessive debt levels. The debt problem must continue to be tackled by the participants involved. Looked at in the round, the current constellation is also characterised by a scenario in which wealth which has come into being thanks to bloated asset prices rather than being built up in a lasting fashion is being destroyed once again, for example in Spain's real-estate sector. A contributory cause here are low interest rates, which are the result of an expansionary monetary policy in conjunction with a fiscal policy committed to consolidation but also geared to strengthening the factors affecting growth. In addition, inflation is eroding the real value of monetary assets. This interplay between monetary policy and fiscal policy, entailing low interest rates and inflation rates significantly in excess of interest rates, is distributing losses and is therefore preventing the world economy from collapsing. In this sense, the currently low interestrate level is appropriate and is progressively promoting consolidation. 2. The enduring consequences of low interest rates Extremely low interest rates involve substantial collateral damage if they are allowed to persist for years on end: 

Asset erosion: Negative real interest rates gnaw away at the value of existing monetary assets. In the Federal Republic, more than half of the monetary assets held by private households are accounted for by bank deposits and government bonds, which are currently offering the lowest yield and are thus most keenly exposed to losses in terms of real value. Even in the event of inflation rates of 3% in Germany, annual real losses incurred by private households could amount to more than EUR 50 billion (the interest rate would surely react to this!).

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Old-age provision: A low interest-rate level is a disincentive for the propensity to save. It will, it is true, stimulate consumer demand; but with interest rates at the current level, existing pension gaps could only be bridged with the help of higher savings volumes. Against the

Statement Berlin, 5 November 2012 page 4

backdrop of the demographic development in the Federal Republic, wealth accumulation for the purposes of old-age provision is indispensable. A low-interest-rate phase lasting many years results in far lower future levels of protection, with implications for the claiming of state benefits. It should be noted that this does not merely affect large fortunes but is particularly perceptible in the case of small and medium-sized fortunes, the accumulation of which needs to be promoted in a carefully-targeted way due to the burdens facing the state pension system. 

Distortions in allocation, and the risk of a new bubble emerging: Low interest rates can cause investors to take evasive action, provoking price distortions on the markets affected. By way of illustration, real-estate prices in certain regions of Germany have already risen noticeably over the past two years. Although this can still be explained in terms of a catch-up development in the wake of a long period of stagnating prices, there is nonetheless a growing risk of price overshoots. Warning signals would be sounded here if such an upward movement were to be accelerated by a higher level of borrowing or indeed by speculatively-motivated purchases. Admittedly, this is not yet the case in Germany, but it would be a probable scenario further down the line if the phase which we have already been in for some time now were to become enduringly entrenched. Moreover, switching operations designed to escape the current interest-rate environment in search of higher interest rates could, even now, prove to be a more serious development, for example because of the sharp price losses on bond markets which they would inevitably involve.

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Readiness to take risks: In the long term, low interest rates will endanger the financial stability which has been strengthened, in the short term, by interest-rate cuts. Not only private households but also financial institutions are tending to resort to more risky asset classes in order to make up for the poor investment yields they are generating elsewhere. It is therefore important that such investment activity should be underwritten by investments in the real economy which help economies to progress. For instance, Germany's turnaround in energy policy ("Energiewende") is offering scope for sustainable investment; by contrast, promotion of investments lacking an underpinning in the real economy and entailing higher risks should be avoided (where is this taking place?). It cannot therefore be ruled out, in phases marked by low interest rates, that loans will be extended to borrowers with poorer credit profiles, or indeed to bad debtors, and that unprofitable economic structures will therefore continue to be supported by the banking system.

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Inflation: Low interest rates can feed through into higher inflation. According to conventional thinking, however, this is only going to prove to be the case when an expansionary monetary policy coincides with an economy working at full capacity. This is not going to be the case, on average, in the euro zone in the foreseeable future. On the other hand, some parts of the euro area are relatively close to this particular brink. This applies to Germany too (albeit to a

Statement Berlin, 5 November 2012 page 5

decreasing extent!). At any rate, the negative real interest rates prevailing at the moment add up to an excessively expansionary monetary environment for the German economy. As a consequence, inflation rates in the Federal Republic could climb in the coming years to above the "close to 2%" level which the ECB regards as being compatible with medium-term price stability. It is also conceivable that oil prices could move up significantly within the framework of fresh asset-price bubbles (many investors see commodities as an asset class), with upside pressure on consumer-price inflation being generated in this manner. By comparison to the situation in other euro-zone member countries, the negative effects of a lengthy low-interest-rate phase are particularly conspicuous in Germany. Even now, the nominal interest rate in the Federal Republic is lower than in other member states. At the same time, the inflation rate in Germany could exceed those in the crisis-ridden states of Southern Europe in the years to come. This is desirable and necessary if Europe's southern periphery is to regain its competitiveness. Such an adjustment process will probably be speeded up if inflation rates decline again in the crisis-ridden member countries (after the inflationary effects of value-addedtax increases have dropped out of the picture) and prove higher in Germany on account of superior competitiveness and of a persistently better economic trend. It is true that negative real interest rates make it easier for the public sector in the Federal Republic to tackle the task of consolidation and therefore also promote the debt-reduction process. At the same time, however, they constitute a kind of "creeping redistribution", with wealth being taken away from those with smaller and medium-sized fortunes, in particular, and handed over to the debtors. It is important to recognise that extremely low interest rates are merely symptoms of deeperlying problems afflicting economies. The principal problems in this category at the moment are the high debt ratios of states, but also of other sectors of European - especially Southern European - economies. Such debt burdens are continuing to weigh on economic actors' confidence in the future of. Without such confidence in future growth, no investment activity is going to take place today. In this context, low interest rates do not constitute a solution to the existing debt problem; they merely facilitate debt sustainability for a certain length of time. The longer they are allowed to persist, the more new problems they create. 3. Putting an end to the current phase of low interest rates remains a matter of priority For these reasons, central banks would be right to seek to put an end to the current phase of low interest rates when confidence has returned on financial markets. From the monetary-policy vantage-point, the conventional and unconventional measures being adopted are an appropriate policy enabling a minimum of financial stability and real economic activity to be maintained at a time when huge asset-price bubbles are correcting. In view of this, the decisive precondition for putting an end to such an extreme interest-rate configuration is to eliminate its causes:

Statement Berlin, 5 November 2012 page 6 -

Reducing debt ratios in order to restore confidence in the financial system: This also involves detecting and writing down claims in danger of becoming non-performing within the European banking system (without risking a banking collapse in the process). The losses materialising as a result need to be apportioned, as far as possible, to those who caused them, and it would be wrong to shy away from bailing in private creditors in this context. In those cases where financial institutions are no longer viable, they would need to be wound up with due regard for systemic stability. At the state level, the solution to this problem would include single-minded consolidation but also, at the same time, using all available means to strengthen growth, through structural reforms in particular. At the beginning of such a process, there would be negative repercussions on economic activity, but these would wane over the course of a multi-year consolidation programme, provided that the latter were largely implemented via the expenditure side of the government budget.

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Single-minded implementation of concrete solutions - consisting, on the one hand, of national adjustments via consolidation and, on the other, of structural reforms designed to strengthen growth - in order to restore confidence in the European Monetary Union. The conditional credit facilities made available by the EFSF/ ESM as well as by the ECB ensure that member countries will receive the interim financing required for a multi-year adjustment process. On top of this, future disequilibria are to be avoided through closer co-ordination of economic policy and fiscal policy along with the constitutional requirement to balance the budget in the medium term. This path needs to be followed single-mindedly.

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Improving growth conditions in order to restore confidence in European economies: apart from repair work in financial sectors, the pre-eminent task facing European economic policymakers is to move the economy back on to a higher growth path even under changed demographic circumstances. Further reforms of labour, goods and services markets and of social-security and education systems are items on the agenda here. Germany is not exempt on this score.

4. It takes time for confidence to return In the light of the adjustment speeds in the case of such macroeconomic disequilibria, it will take some years - even on a best-case scenario - until such confidence has been regained. At that point, it will be time to plan an exit from the policy of extremely low interest rates and overly ample liquidity provision in such a way that growth and price stability continue to be safeguarded. If they are to maintain a minimum level of confidence in the financial system, central banks currently have no alternative to continuing with their low-interest-rate policy coupled with extremely weak money-supply growth. However, such a policy is not a "cure-all". Previous

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experience with unconventional monetary-policy measures in times of crisis shows that the effect of the instruments involved can fade over time. Were this to happen, there would be a threat of a further loss of confidence, with corresponding negative ramifications for growth and affluence. Political decision-makers are therefore called upon not to be satisfied with having managed to place the patient in "recovery position" but need instead to work energetically to cure the remaining ailments that are afflicting him.

 Financial Group German Savings and Giro Association (DSGV) Summary Memorandum and previous Statements by the Chief Economists of the German Savings Banks Financial Group

18 October 2012

Statement: "ECB bond purchases remain a problematic makeshift arrangement."

10 September 2012

Statement: "Stable fiscal policy for Europe."

28 August 2012

Statement: "Financial transactions tax: A critical appraisal."

25 June 2012

Statement: "After the election: Tackling the problems outside Greece."

21 May 2012

Statement: "European Monetary Union: Sticking to the reform tack - while widening flexibility."

23 April 2012

Statement: “The European Stability Mechanism is replacing the EFSF bail-out scheme but is not, on its own, a solution.“

19 March 2012

Statement: “After the haircut: No respite in the sovereigndebt crisis."

24 February 2012

Statement: “Greece: Not fleeing but standing one’s ground.“

13 January 2012

Statement: “Monetary policy needs to remain credible."

29 November 2011

Statement: “Sovereign-debt crisis: time to take action!“

3 November 2011

Statement: “After the euro summit: extensive measures to stabilise the financial markets.“

25 October 2011

Statement: “The haircut and the EFSF – giving them an efficient form.“

24 September 2011

Memorandum on current issues “Europe and the euro.“ Published on 24.9.2011, Washington D.C., on the occasion of the 2011 IMF/World Bank annual meeting.