Why modern monetary policy doesn’t work – the models it uses are horribly out of date

Mark Carney © Getty Images
The Bank of England needs to update its models of how the economy works

There’s a note just out from the Bank of England that gives a neat clue into just why modern monetary policy might not be working as the models suggest it should.

The document in question is here and the key point this: “when asked about how they might respond to a hypothetical further fall in mortgage payments, households reported that paying off debt and saving more were likely to be a more common response than increasing spending” – 45% said they would save more, 50% said they would use money saved on mortgage payments to pay down debt and a mere 10% said they would up their spending.

This is not how it is supposed to be. As the Bank of England points out, “economic theory suggests that a fall in interest rates should lead to higher household spending because lower returns on savings decrease the amount of future consumption that can be achieved by sacrificing a given amount of spending today.”

That means that the lower rates go, the more it makes sense to spend today – either from cash you already have or from newly borrowed money – rather than tomorrow. Or the more the monetary models think it makes sense for you to spend today.

The fact is that reality doesn’t match the model at the moment (perhaps because uncertainty scares us, perhaps because pensions are so much less generous than they were, perhaps because we know the state is broke, or perhaps just because aging populations like paying off debts).

It is something we think about a lot at MoneyWeek. It leads us to think two things: it is time to update our models of how the modern economy works; and monetary policy is too loose – interest rates are too low.

And we can’t help but wonder why – given that this is its own research – the Bank of England constantly reaches the opposite conclusion.

  • david__r

    A few thoughts:
    1. responses to your question suggest that respondents are more concerned about the risks of future financial shocks, than about maximising consumption.
    2. your question may be suggesting to people that they need to be more prudent if they get the chance. many will agree in principle. fewer will follow through in practice when the competing demands of family life intrude – buy nicer food, fix the roof, new mobile, new bathroom, holidays, etc.
    3. I would encourage you to ask people a second version of the question – what they would do if things move the other way. ie if interest rates go up what would they do – move to interest only ? reduce their capital overpayments/repayments ? save less in their pensions and isas ? spend less on optional items like holidays? spend less on capital items (kitchen, car, extension, etc)? spend less on essentials ? the true answers are likely to fall inbetween these two versions of the question.

    • AAJ

      A lot of people spend what they earn, often without thinking about it. Maybe in this case money will go into the local economy. But, does this really help? So you put money into car washers, baristas etc. Does this help the economy? I am not convinces baristas are leading us out of recession.

      Some times people do think about it and then you end up with a situation where by a saving from lower mortgage repayments will allow an extra holiday or new phone/xbox/4k tv etc. I am still to be convinced that a holiday/iPhone etc will help the economy.

      Some people are smart and will put money away or pay off the mortgage.

      I think the way money is used by people is more complex now and the way it circulates is also multi faceted.

  • Kevin Hoque

    Merryn, as I am sure that you have mentioned before, when interests rates are reduced people and companies need to save more to achieve a certain level of savings at some future date. Also, if interest rates are reduced, it’s a very good time to pay down debt, so that in future years, when interest rates rise, debt is less of a burden.

    Peoples’ propensity to spend very little of their low interest rate bounty thus makes perfect sense. Add to this our demographics situation plus a feeling that ultra low interest rates are with us because of current general weakness in the economy (risk) and then our said intentions make perfect logical sense?

    Nonsense monetary policy, plus an overly simplistic model of our behaviour, produces rubbish economic forecasts at The Bank of England, ad nauseam.

  • Triple H

    As always, the cash hoarders here at MoneyWeek are at it, shouting out ‘increase those damn rates so we get paid more for doing nothing!’
    Frankly, I think it is the high interest rates that is the problem. Merryn, do you really think if ordinary folks’ mortgage and loan payments go up (taken out from their earnings BEFORE they spend on anything else), this will be a great idea?

    I cannot for the life of me understand why there’s a cry for ‘growth’ all the time. Why is stability such a bad thing, price stability, savings stability, loan repayment stability?

    Please don’t say ‘but for pensions we need higher rates’. Pensioners’ money should be invested in businesses who pay them good dividends (or are forced by legislation to do so). That way the money goes where it’s needed (real economy) and the pensioners are taken care of as well while being helpful to the nation (by being a partner in businesses). No one should simply expect money to grow on trees (which is effectively what high interest rates provide).

    The one thing highly literate people like you should do is to shout about the core problem of artificial inflation, where the state and its cronies in the form of banks and large corporations want to stoke it, at the cost of us common folk. But then you’d be fighting your friends so I don’t think we will see that soon.

    • Kevin Hoque

      Super low interest rates are a problem. They allow companies that generate very low profits to stay afloat. In ordinary times these companies would go to the wall and would in time be replaced by newer, more efficient firms. This creative destruction is at the heart of our economy. But that fundamental force has been tempered by the unorthodox monetary policy. It must stop, otherwise the productivity gains that propel real growth will not return. The Bank of England has been wondering for years why productivity has crashed. The answer has been staring them in the face. They just refuse to accept that they are the cause of what ails us.

      I understand that many people and companies are up to their eyeballs in debt. The BOE purposefully inflated a debt bubble. But that is not a reason to keep things forever as they are. All bubbles burst. All change has a cost. At some point we will all have to pay for the mistakes of the central bankers..

      • Triple H

        I’m sorry but I do not buy that. A bad business will be taken care of by the market. An example, Nokia. They didn’t go down because of low rates (their serious downfall started in 2010). They went down because people just didn’t like their products. Low interest rates have not kept them alive (nor BlackBerry and others).

        I admit I do not quite grasp the theoretical concept of productivity gains. To my simple mind, productivity gains are enabled by a combination of technology and people putting it to use. Again, I do not see any reason why high interest rates (rewarding the rich by doing jack s#!t) will help. Japan is a lot more productive than the UK. Last I checked they have had low rates for a long time. And yes, I admire the price stability over there (low inflation).

        • Kevin Hoque

          I’m sorry. You’re seeing things in binary terms. This is my fault. Bad businesses can go under for many reasons. But there are many businesses just getting by, because their products are just so-so or the way that they run their business is not great. Low interest rates are propping up many of these businesses. This keeps unproductive businesses going. We need businesses to go under. This frees up people and capital for new businesses that will move our economy forward.

          Regarding Japan, they do have absolute productivity rates much higher than the UK. However those rates have grown very slowly over the past 20 or so years.

          Low interest rates do not help the poor. All they do is increase the asset prices of the wealthy. Over the past 10 years the wealth gap between the rich and poor has grown dramatically directly because of low interest rates. The rich are laughing. The poor pay the same mortgage payments as they did 10 years ago but mortgages now often are for 30 years or more. All because of low interest rates, which were put in place to bail out the banks and the establishment. Don’t for a minute think that it was done to help the poor.