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How Long Can The Great Global Reflation Continue?

And what will happen when it ends?
Friday, May 19, 2017, 8:01 PM

Every now and again, it’s good to take stock of the Great Global Reflation that has been marching higher (with a few stumbles and scares) since early 2009, over eight years ago.  

Is this Great Reflation running out of steam, or is it poised for yet another leg higher? Which is more likely?

Keynesianism Vs The Real World

Let’s start by reviewing the systemic contexts of the economy.

This Great Reflation is embedded in two basic contexts:

  1. The dominant socio-economic structures since around 1500 AD are profit-maximizing capital (“the market”) and nation-states (“the government”).
     
  2. The dominant economic theory for the past 80 years is Keynesianism, i.e. the notion that the state and central bank must aggressively manage private-sector consumption (demand) and lending via centrally planned and funded fiscal and monetary stimulus during downturns (recessions/depressions).

Simply put, the conventional view holds that there are two (and only two) solutions for whatever ails the economy: the market (profit-maximizing capital) or the government (nation-states and their central banks). Proponents of each blame all economic and social ills on the other one.

In the real world, the vast majority of Earth’s inhabitants operate in economies with both market and state-controlled dynamics in varying degrees.

The Keynesian world-view is doggedly simplistic.  The economy is based on aggregate demand for more goods and services.  People want more stuff and services, and as long as they have the means to buy more stuff and services, they will avidly do so (this urge is known as animal spirits).

The greatest single invention of all time in the Keynesian universe is credit, because credit enables people to borrow from their future earnings to consume more in the present. Credit thus expands aggregate demand for more goods and services, which is the whole purpose of existence in this world-view: buy more stuff.

But credit, aggregate demand for more stuff and animal spirits make for a volatile cocktail.  The euphoria of those making scads of profit lending money to those euphorically buying more stuff with credit leads to standards of financial prudence being loosened.  In effect, lenders and borrowers start seeing opportunities for profit and more consumption through the distorted lens of vodka goggles.

Lenders reckon that even marginal borrowers will earn more in the future and therefore are good credit risks, and borrowers reckon they’ll make more in the future (i.e. the house they just bought to flip will greatly increase their wealth), and so borrowing enormous sums is really an excellent idea—why not make more money/enjoy life more now?

But the real world isn’t actually changed by vodka goggles, and so marginal borrowers default on the loans they should never have been issued, and lenders start losing scads of money as the value of the collateral supporting the defaulted loans (used cars, swampland, McMansions, etc.) falls.

Oh dear! The hangover of credit expansion is brutal, as lenders go bankrupt, wiping out their owners, and borrowers go bankrupt as they are unable to make their payments or sell the collateral to pay off the loan.

Just as credit expansion feeds on itself—everybody’s making a fortune buying and flipping houses, let’s go buy a house or two on credit—the hangover is also self-reinforcing: the value of collateral falling pushes more marginal borrowers into insolvency, and the lenders who made the loans are pushed into insolvency as defaults increase and collateral melts like ice in Death Valley.

In the Keynesian universe, this self-reinforcing contraction of imprudent credit and widespread losses of speculative wealth are Bad Things. Very Bad Things.  Important, Powerful People tend to own issuers of credit (banks), and losses are not something they signed up for.

If all the Little People stop borrowing more money, the Powerful Owners of the credit-issuing machines (banks) can no longer reap enormous profits from issuing more credit, and that is a Very Bad Thing.

As a nasty side-effect of the credit hangover, businesses that depended on people borrowing more money to buy more stuff also shrink, and this contraction is also self-reinforcing: as sales decline, businesses must cut costs to stay solvent, which means laying off employees, abandoning under-utilized offices, closing factories, etc.

The euphoria of credit expansion turns to painful contraction.  Nobody’s happy in the hangover phase, and people naturally cry out, Somebody do something to stop the pain!

The Keynesian answer is simple: the government should borrow and spend lots of money to replace all the money that the private sector is no longer borrowing and spending, and the central bank should lower interest rates and create a lot of new money that private banks can borrow cheaply to loan out to private-sector businesses and consumers.

In the simplistic Keynesian Universe, the credit contraction is like a temporary drought: all the government and central bank have to do to fix the drought is release a flood of new money onto the parched landscape of the credit-starved private sector, and aggregate demand and new loans will blossom like spring flowers.

Horray for central states and banks! Given the power to borrow (or create out of thin air) as much money as they need to flood the private sector with fresh money and credit, the drought ends, animal spirits are revived, people get to buy more stuff by promising to give their future earnings to banks and Powerful Owners of banks are once again earning great gobs of cash from lending to the Little People (i.e. borrowers in danger of becoming debt-serfs, whose earnings go largely to service their debts).

In the crayon-coloring book of Keynesian ideology, this is The Way the Universe Works. The problem is always a temporary drought of aggregate demand caused by a temporary drought of private-sector credit, and the solution is always a state-central-bank issued flood of money and credit: the government borrows and spends more money to replace declining private spending, and central banks make it cheaper and easier for private banks to issue new loans to enterprises and Little People.

That this coloring-book ideology no longer describes the problem or solution is incomprehensible to the Keynesians.  That neither “the market” nor “the government” can solve the current set of problems is equally incomprehensible—not just to Keynesians, but to everyone who unthinkingly accepted that the market and/or the state can always fix whatever problems arise.

Oops! The Flood of Money and Credit Didn’t Fix the Economy

The post-credit/asset bubble crashes in 2000 and 2008 and the state/central-bank responses--fiscal and monetary stimulus, a.k.a. flood the land with borrowed money—seemed to confirm the Keynesian world-view: marginal borrowers, lenders and collateral all went south and the stimulus restored animal spirits, which promptly inflated a new credit/asset bubble.

But this time around, the drought never ended, no matter how much money was poured into the economy, and the earnings of borrowers stagnated or declined. (Recall that debt is borrowed from future earnings; if earnings decline, it becomes much more difficult to service existing debt, much less borrow more.)

Federal debt has more than doubled just since 2009 (and tripled since 2001) as the government flooded the land with fiscal stimulus:

Central banks have flooded the global economy with trillions of dollars, euros, yen and yuan, and continue to do so to the tune of $200 billion per month:

Central banks have dumped over $1 trillion in new monetary stimulus in the first four months of 2017—eight years after the “emergency” stimulus began:

Meanwhile, wages are stagnant or declining for the vast majority of wage-earners—even the highly educated:

Household income has fallen across the board:

Stagnating incomes is not a new issue for the bottom 90%; it’s a structural reality going back four decades:

Clearly, fiscal and monetary stimulus policies that were supposed to be temporary are now permanent.  That isn’t what was supposed to happen.

Earnings were supposed to rise once private-sector credit and consumption returned to expansion.  As we see here, bank credit and consumer credit have surged higher, but the incomes of the bottom 90% have gone nowhere.

Meanwhile, total debt—government, corporate and household—has rocketed higher, more than doubling from 280% of GDP in 2000 to 584% of GDP in 2016:

As if these weren’t bad enough, wealth and income inequality have soared during the era of permanent fiscal-monetary stimulus:

In sum: nothing has worked as the Keynesians expected.  Instead, state/central bank measures that were supposed to be temporary are now permanent, and the expansion of private-sector debt has failed to “trickle down” to earnings.

The Keynesian solution—borrowing from future earnings to “bring consumption forward”—has expanded consumption at the cost of enormous increases in debt throughout the economy, which has exacerbated income-wealth inequality and declining real incomes.

Can we finally admit that eight years of following the Keynesian coloring-book plan have not just failed, but failed spectacularly, and not just failed spectacularly, but made the economy even more vulnerable and fragile, as more and more future income must be devoted to service the skyrocketing debts?

Isn’t it obvious that there are deeply structural problems in the economy that inflating yet another cred/asset bubble won’t fix?

Clearly, the real-world economy does not function like the simplistic Keynesian coloring-book model.

What Comes Next: Contraction

Given the extraordinary failure of both Keynesian stimulus and private-sector credit growth to create a self-sustaining cycle of expansion whose benefits flow to the entire workforce rather than to the top few percent, what can we expect going forward? Can we just keep doubling and tripling the economy’s debt load every few years? What if household incomes continue declining? Are these trends sustainable?

In the near-term, is this Great Reflation running out of steam, or is it poised for yet another leg higher? Which is more likely?

In Part 2: Prepare For The Great Global Contraction, we detail why the economy’s structural problems languish unaddressed, and how the inflating of yet another speculative credit-asset bubble has not fixed these problems.  Instead, the current credit-asset bubble has dramatically increased the fragility of the economy by diverting capital from potentially productive investments to unproductive speculative gambles, and by increasing the unproductive burdens of soaring debt.

When the Great Reflation does finally roll over, there will be plenty of time to ponder what investments might do well—but only those who exit well before the rollover will have the cash to take advantage of the opportunities.

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17 Comments

richcabot's picture
richcabot
Status: Bronze Member (Offline)
Joined: Apr 5 2011
Posts: 62
You got a couple things wrong

You said "lenders start losing scads of money as the value of the collateral supporting the defaulted loans" but they don't really. They've sold much of these bad loans to others such as Fanny, Freddy or packaged them into securities that are sold to unsuspecting buyers.

You also said "the value of collateral falling pushes more marginal borrowers into insolvency, and the lenders who made the loans are pushed into insolvency" The first half is accurate but the lenders just get Congress and/or the Fed to bail them out. Most don't go insolvent.

With changes to bankruptcy laws the banks still won't go insolvent, they'll just steal the depositors money if they don't get bailed out.

Grover's picture
Grover
Status: Platinum Member (Offline)
Joined: Feb 16 2011
Posts: 696
Compost is better than Keynesianism

Keynesianism's simplistic fix for economic woes is akin to only using nitrogen fertilizer for your garden. The first few years, the garden does great. After that, all the other nutrients have been mined out by the plants. The resulting "growth" is spindly and susceptible to diseases. Any fruit that the plant bears will not have the nutritional value that we crave.

Compost may not give the same spectacular results (as pure nitrogen fertilizer) the first few years, but it will provide the nutrients the plants need to produce nutritious results. Of course, compost takes time to mature. Nobody seems to have the patience or discipline to make compost while the economy is doing great. That's why Keynesianism is so popular with politicians. Bottom line: They aren't worth shit.

Grover (channeling Chauncey Gardiner from "Being There")

niphtrique's picture
niphtrique
Status: Member (Offline)
Joined: May 16 2012
Posts: 5
And there is also a very obvious solution too

We have read about these problems so many times but Mr. Smith doesn't come up with a solution. But there is one.

Let me explain the predicament first:
1. there is too much capital relative to aggregate demand, and there is too much debt, so people with excess funds should be spending instead of saving because their savings end up as investments or loans to people that are already deeply in debt;
2. interest rates are artificially propped up by the zero lower bound (and the existence of cash) because the supply and demand for money and capital would probably clear at a negative interest rate;
3. subprime credit is a problem because interest is a reward for risk and the financial system is guaranteed by governments and central banks.

And the solution is:
1. a holding tax on currency (cash and central bank deposits) so that interest rates can go negative;
2. a maximum interest rate on money and loans so that risky lending is phased out.

The dynamic of this concept is intriguing and there are many issues that have to be dealt with. This is discussed in the following paper:

http://www.naturalmoney.org/feasibility.html

To make this work, interest rates must remain low and negative, but that is probably going to happen. This is explained in the following paper:

http://www.naturalmoney.org/endofusury.html

And remember, interest free money with a holding tax is going to be the next big thing in economics. If not, then you should prepare for the worst just like Mr. Smith advises.

PfMPE's picture
PfMPE
Status: Member (Offline)
Joined: Dec 4 2010
Posts: 2
We have no economy

We have no economy

ejhr's picture
ejhr
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Joined: Jun 28 2014
Posts: 24
Keynesiasm vs the Real world

Huge amount of nonsense in this blog. Sorry CHS, your knowledge of economics is faulty. Blaming Keynes for the sins of the mainstream economics models is just ludicrous.

Just one example. I see you say "the government issues $1Trillion in new bonds to fund another $1 trillion in deficit spending" This is just plain NOT TRUE. The federal government can ONLY create money by buying what is for sale, debt. It has zero need to buy bonds. Bond purchases are simply investor deposits stored at the Fed, a completely voluntary option. The government does not spend the money and the interest it pays is just to attract bids on the bond auctions. It is also the safest place to store the investors money, being guaranteed. No money changes hands. The principal is simply recredited at maturity back to the investors' private accounts, or rolled over. 

Government spending is a net credit operation. It is interest free and for the economy much cheaper than getting the commercial banks involved with the loans. They double, even triple the cost. The banks hate that so they bribe the pollies to eschew the government as source of funds and let the banks fund the work! In any event no saving or borrowing is required by the central bank to fund anything. The choice is totally political.

ejhr's picture
ejhr
Status: Member (Offline)
Joined: Jun 28 2014
Posts: 24
Keynesiasm vs the Real world

Huge amount of nonsense in this blog. Sorry CHS, your knowledge of economics is faulty. Blaming Keynes for the sins of the mainstream economics models is just ludicrous.

Just one example. I see you say "the government issues $1Trillion in new bonds to fund another $1 trillion in deficit spending" This is just plain NOT TRUE. The federal government can ONLY create money by buying what is for sale, debt. It has zero need to buy bonds. Bond purchases are simply investor deposits stored at the Fed, a completely voluntary option. The government does not spend the money and the interest it pays is just to attract bids on the bond auctions. It is also the safest place to store the investors money, being guaranteed. No money changes hands. The principal is simply recredited at maturity back to the investors' private accounts, or rolled over. 

Government spending is a net credit operation. It is interest free and for the economy much cheaper than getting the commercial banks involved with the loans. They double, even triple the cost. The banks hate that so they bribe the pollies to eschew the government as source of funds and let the banks fund the work! In any event no saving or borrowing is required by the central bank to fund anything. The choice is totally political.

olenzekm's picture
olenzekm
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Joined: Oct 29 2010
Posts: 6
A slander on JM Keynes

What Mr. Smith describes may be what politicians do and what they think Mr. Keynes intended, but it surely is not the entire Keynesian program.

What is always missed is that when the economy is working well or over heating, Mr. Keynes suggested that the government take money out of the economy. In other words, the central bank should take the punch bowl away and governments should cut spending. 

This was always a problem, but with the supply-side "Keynesians" starting with Ronald Reagan and his sidekick Alan Greenspan, this "pump always" scenario was pursued on steroids. This has put us into a terrible hole.

The only thing that could get us towards a solution would be another Paul Volker type willing to put us into a horrible recession to drain much of the money out of the real swamp, the financial sector. 

Robinson's picture
Robinson
Status: Bronze Member (Offline)
Joined: Apr 29 2009
Posts: 36
The government, the

The government, the politicians, the central bank, are just puppets of the Real Elite.

CHS, is right.  You are missing the most secretive part of how The FED work, look the videos of mike maloney.

Robinson's picture
Robinson
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Posts: 36
Your solution is very good.

Your solution is very good.  Is the old model, of the sucessful experiment of Worgl http://www.lietaer.com/2010/03/the-worgl-experiment/  stopped by the banking cartel.

We also believe that this is a good source of money to implement, the universal basic income of 500$, with a educative model,  https://bienestarmutuo.org/en/ten-principles-of-the-new-education/

charleshughsmith's picture
charleshughsmith
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Posts: 591
thank you for comments and corrections

Thank you for comments and corrections. Yes, I refer to Keynesianism as the guiding ideology, not as Keynes intended. As for zero/negative interest and a holding tax being solutions--perhaps this will address some imbalances, but it doesn't solve the labor/automation issue or change the way money is emitted.

I simplified the model, and appreciate corrections/clarifications. But it is certainly true that the Treasury funds deficits by issuing bonds, and central banks are buying sovereign and corporate bonds with newly emitted currency.

The real structural problems are wealth/income inequality, declining earned incomes for the bottom 90% or 95% and stagnating productivity. I don't see how modifying interest rates, etc. can address these dynamics, as they are not solely monetary effects. Free money (i.e. zero interest) is not a substitute for increased productivity. So far, the evidence suggests zero-interest money fuels speculative asset bubbles.

I also left out some key dynamics due to space considerations, for example, that profits decline as automation and commodification of the tools of automation progresses. The possibility that energy costs might rise substantially is also not addressed in this piece, but as Gail Tverberg has shown, it's a core dynamic in the economy and labor's share of GDP.

charleshughsmith's picture
charleshughsmith
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Posts: 591
risk, profit, "capitalism" and the common good

At the risk of widening the discussion, I'd like to introduce some topics that I could not address directly due to space limits (I don't want to publish a book here :-) : risk, profit, "capitalism" and the common good.

These are profound structural problems with the status quo economy.  Risk is masked by the system's privatize-profits but socialize-losses backstops, central bank interventions, and central planning in general. Risk appears to have been made to disappear but it's only been driven out of sight.

Capital flows to the lowest risk for the highest profit. In the current system, that is financialization, which widens inequality and distorts asset valuations and capital allocations. This is one reason why Wallerstein (whom I've written about before here) concluded that "capitalism is no longer attractive to capitalists."  Speculative bubbles cannot substitute for investment in productive capital/assets.

An economy must serve the common good, or else it will spark a political revolt of those left behind. The current economy is failing to serve the common good, and I don't see any basis in history to believe that widening monetary and fiscal central planning --a process that is ultimately owned by self-serving elites in our pay-to-play iteration of "democracy"--will address these issues, much less fix them. I conclude an entirely new system is necessary.  I've written a lot about the outlines of such a system and won't repeat it here.

Uncletommy's picture
Uncletommy
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Posts: 355
And to think, I thought it was about oil and power!

http://www.independent.co.uk/voices/iran-election-rouhani-saudi-arabia-trump-bad-news-a7746146.html

What next? Perhaps bread and circuses? Nice graphs, however, Charles!

charleshughsmith's picture
charleshughsmith
Status: Platinum Member (Offline)
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Posts: 591
bread and circuses, for sure!

Agree, UncleTommy--it's gonna be bread and circuses paid for with free money, either printed by the Treasury or borrowed into existence. TINA--there is no alternative.

Miguelsilanes's picture
Miguelsilanes
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Joined: Mar 27 2017
Posts: 1
The FED´s B Sheet cannot grow forever

It seems the Fed realizes this and they are on their way - or so at least believes the markets - to start draining the liquidity back from the markets and reducing the Fed´s B Sheet. They may do so by letting the outstanding Treasuries on their B Sheet mature (it seems 50% of the outstanding amount does so in 2018-2023) and - supposedly - not buy newly issued ones. Additionally they may sell some of the ones they have in their B. Sheet, helping increase interest rates. For me the real question is about the true independence of the Fed; how will the Trump administration react when they can no longer issue Treasuries at the old rates, to finance the upcoming fiscal deficits, in a world that is no longer willing to buy the Treasuries as they once did (Chinese and Russians selling them aggressively). Plus interest on the 20 Trillion US Government Debt is so high the Fed will also be pressured not to hike aggressively. Plus everyone understands that the US needs a lot of inflation to start getting rid of the Debt...so all of this compounds to a) Mkts falling (no Fed created money overflowing markets), b) inflation, both phenomena compatible with Peak Prosperity´s and Charles Hughes Smith´s thesis, even if the mechanism differs (the author assumes the Fed money creating machine will go on forever).

Uncletommy's picture
Uncletommy
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Posts: 355
King sized fitted sheets?

Miguel; you are not too far off the mark. However, the Bernanke ghost of Christmas past will be clinking his money boxes and fetters into the future for sure. The really scary part is in order to keep nominal GDP positive, the world is going to need sufficient US reserve currency to keep trade humming along. As to my earlier post, an additional $100 billion for a Kushner negotiated US arms deal doesn't hurt the velocity of currency any ( straight from the pen of Mr. Bernanke himself (more at https://www.brookings.edu/blog/ben-bernanke/2017/01/26/shrinking-the-feds-balance-sheet/:

Couple that with more inflation helped by small increases in interest rates and all those CDO's on the Treasury's books, he might have a winning strategy. Won't do much for the wage gap, but then who cares about the little schmucks.

"The growth in the public’s demand for currency is one (completely uncontroversial) reason that the Fed will need a larger balance sheet indefinitely. The minimalist central bank balance sheet, consistent with providing the public’s desired holdings of currency and nothing else, would include currency as the primary liability and government-issued securities as the primary asset. That’s a pretty good description of the Fed’s balance sheet before the crisis: liabilities were about $800 billion in currency in circulation, and assets (almost all in Treasuries) were only slightly greater than that. However, today currency in circulation has grown to $1.5 trillion. Because of rising nominal GDP, low interest rates, increased foreign demand for dollars and other factors, Fed staff estimates that, the amount of currency in circulation will grow to $2.5 trillion or more over the next decade.[7] In short, growth in the public’s demand for currency alone implies that the Fed will need a much larger balance sheet (in nominal terms) than it did before the crisis."

niphtrique's picture
niphtrique
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Joined: May 16 2012
Posts: 5
on the issue of negative rates

I would argue that negative interest rates arise in the markets for money and capital because of the supply and demand picture. So, if we don't let supply and demand meet at the equilibrium, then we are in for a lot of trouble. I don't think that interest rates should be modified. They should be allowed to go where market conditions want them to go. Negative interest rates will at least fix this issue.

The idea of "asset bubbles" is a dubious one because they arise in a situation of abundant capital and low interest rates. So, if you think of scarce capital as the normal, then high debt levels, high asset valuations, and negative interest rates seem scary. But you can't have low interest rates, stability, efficient financial markets and low asset valuations. You simply can't. And it isn't bad. Think of it like this:

"Lower interest rates allow for more debt to be serviced. Higher debt levels give less room for interest rates to rise as higher interest rates will affect aggregate demand. This dynamic can contribute to lower interest rates in the future. If creditors keep on accumulating credits, interest rates need to go negative, and debtors will have no problem servicing their debts. An alternative is inflation. The drawback of inflation is that it erodes trust in money and the financial system. Low interest rates are a sign of trust."

http://www.naturalmoney.org/endofusury.html#dawc

The only way of ending irresponsible lending is setting a maximum interest rate because that would limit the risk creditors are willing to take. It would also reduce moral hazard in the financial system, hence reduce financial instability.

You maybe think this is crazy. But it isn't. The top 1% that is running out of things to invest in. Think of Capitalism as a game of Monopoly. We are in the End Game:

"One might compare the current situation with a game of Monopoly in its final stage where the winner owns more than half the streets, houses and hotels and the other players are running out of money. The options for the winner are ending the game, which is a kind of great reset, or handing out money to the other players to keep the game going, and enjoy being rich. A great reset in the real economy is not really an option because it could mean depression or war. And so the wealthy are probably going to opt for enjoying being rich once they realise what the alternatives are. They may not be so lucky in the next game."

http://www.naturalmoney.org/feasibility.html#potw

Negative interest rates are going to arise in the markets for money and capital unless the zero lower bound blocks this from happening. That is because capital can't be profitable without aggregate demand. And if the wealthy don't like the low interest rates, they are going to spend more of their income, so that aggregate demand picks up, and there will be more employment so that the labour share of GDP rises. But I expect that the wealthy have so much excess capital that negative interest rates will remain indefinitely so that we are going to spend their excesses for them, unless we let things blow up by not removing the zero lower bound.
 

niphtrique's picture
niphtrique
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Joined: May 16 2012
Posts: 5
On the issue of the common good

The problem with "common good" often is that different people have different views on this issue. And that is why libertarianism is such a popular form of cynicism. But lower and negative interest rates work to the common good as perceived by most people in the following ways:

* We can all be wealthier with lower interest rates. That is because more capital is profitable at lower interest rates. For example wealthy countries like Switzerland have negative interest rates while poor countries like Venezuela have high interest rates.
* We can make the economy sustainable with lower interest rates. Interest promotes short term thinking. Because of discounting the future has a lower value than the present. With negative interest rates, the future has a higher value of the present.
* We can reduce income inequality with lower interest rates. The top 1% doesn't make their money with labour but with capital. If interest rates go lower, their share of GDP is likely to drop.
* And low interest rates require financial discipline. And it would be great too. That is why Germany can borrow at negative interest rates and Greece can't.

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