Following the global financial crisis, policy interest rates in the US, Europe, the UK and Japan were reduced sharply. The US Federal Reserve has recommitted to holding rates around zero for an extended period. Normalisation of rates is a long way off in other economies. Low interest rates have become a panacea for economic problems. In part, this is driven by the unwillingness of governments to run budget deficits, reflecting increasing scrutiny of public finances and investor reluctance to finance such deficits, as highlighted by the ongoing European debt crisis. But, like all addictions, low interest rates are dangerous. They may be also ineffective in addressing the real economic issues.
Financial markets have generally reacted positively to low rates, pushing up stock and financial asset prices. But low rates point to a worrying lack of growth. Low rates also highlight the increasing risk of deflation and a severe contraction in economic activity. Given that growth and inflation are the primary requirements for a relatively painless reduction in elevated debt levels globally, the enthusiasm among investors and citizens is curious.
The clear hope is that low rates will revive the “animal spirits” of the economy. But the ability of low rates to boost real economic activity is unclear at present. The cost of funds is only one of the factors in the complex drivers of demand.
In the housing market, demand depends on many factors — the level of required deposit, existing home equity (price of house received less outstanding debt), the ability to sell a current property, income levels and employment security. Low rates do little, in themselves, to address these issues. In the absence of growing demand for their products, businesses might not borrow to invest in new capacity just solely on the low cost of debt.
Low rates also decrease income of retirees with fixed interest investments, reducing demand. Savings from lower interest rates, such as mortgage rates, are simply being used to retire debt, rather than increase consumption. While the reduction in debt levels is necessary, lower rates will, of themselves, do little to boost demand and economic activity.
Research by the Federal Reserve indicates limited impact of ZIRP (zero interest rate policy) and QE (quantitative easing) on the real economy. Stimulus from low interest rates is also temporary, with demand likely to revert to normal levels once rates increase.
Low interest rates distort economic activity, especially where real interest rates (nominal rates adjusted for inflation) are low or negative.
Low cost of debt encourages substitution of labour with capital in the production process. Given that 60-70% of activity in developed economies is driven by consumption, this reduces aggregate demand as employment and income levels decrease.
We all fall down
Low rates favour brrowing and increases risk
Low rates favour borrowing, encouraging substitution of debt for equity in financing structures, thereby increasing financial risk. Where companies and nations are over-extended, this decreases incentives to reduce debt. In fact, low interest rates are almost economically identical to a disguised reduction of the principal amount of the loan.
The effect of low rates on savings behaviour is complex. Low rates can discourage savings, creating a disincentive for capital accumulation that would reduce overall debt levels. Lower earning on savings should encourage spending, stimulating economic activity, but may perversely encourage greater saving to provide for future needs, reducing consumption and demand. Low rates also increase the funding gap for defined-benefit pension funds.
Low rates do not necessarily increase the supply of credit as risk aversion and higher returns on capital encourage banks to invest in government securities, eschewing loans. Low interest rates also provide an artificial subsidy to financial institutions, allowing them to borrow cheaply and then invest in higher yielding safe assets such as governments bonds.
Low rates encourage mispricing of risk, creating asset bubbles. Low costs of borrowing encourage investors to seek investments with income, feeding recent demand for high dividend paying shares and low grade debt. The equity markets have risen strongly, with stock markets in many countries, led by the US, having recovered to their pre-crisis levels. Desperate for capital appreciation, investors are chasing ‘blue sky’ technology and bio-technology stocks, which promise earnings and/or revenue growth that is faster than the industry or overall market. Many companies have borrowed at low current rates to finance buybacks of their own shares.
Property prices have risen, supported by low financing costs and the absence of yields from other assets. In market like the US and the UK, property prices have recovered and in some cases reached or exceeded 2008 levels. In other markets, like Germany, Switzerland, Canada, Australia, New Zealand and a number of emerging markets, especially in Asia, property prices have reached record levels.
Sovereign bond interest rates are at historic lows, fuelled by central bank buying and an artificially created shortage of safe assets. The most striking change has been the fall in rates for government bonds of beleaguered Eurozone countries, such as Greece, Ireland, Portugal and Spain, which, in some cases, have returned to pre-crisis levels. Driven by low rates, investors have increased investment in complex capital securities issued by banks and corporations, taking on additional risk that they may not fully understand, to generate higher income.
With around 40-50% of government bonds returning less than 1%, bond investors desperate for yield have moved beyond emerging to frontier markets, embracing less well known African and Asian borrowers. The reason? These countries have better growth rates and prospects than the BRIC nations and other better known emerging nations that face significant challenges.
The rush to re-risk has reduced general lending standards. Practices that contributed to the global financial crisis, such as covenant lite loans, with low protection for lenders, are driving a resurgence of private equity activity. Borrowing to pay dividends to investors in private equity transactions has also risen. Even sub-prime loans and securitisations, in automobiles and commercial real estate, have re-commenced.
Minimal opportunity costs allow investors to hold assets that pay no income price in the hope of price increases, evidenced in demand for commodities and alternative investments such as art works. Money tied up in non-productive investments driven by artificial low rates reduces the flow of capital and economic activity.
Investors are assuming that authorities have no option but to maintain abundant liquidity conditions in the face of low growth and the risk of disinflation or deflation. In the worst case, investors have faith in their ability to anticipate changes in the environment and exit positions.
But higher capital and liquidity requirements, as well as regulations such as the Volcker rule, mean that the ability of dealers to hold inventory of unsold securities has reduced sharply. The ability of investors to exit positions without creating sharp price falls and volatility is also now heavily constrained, increasing risk.
Whatever its effects on economic activity, the policy of low rate and central bank purchases of sovereign securities have been effective in helping finance government borrowing and also weakening the currency.
For example, the Federal Reserve has directly or indirectly been the purchaser of around 60-70% of all US Treasury bond issuance. The policy has helped weaken the dollar. The weaker dollar allows the US to enhance its competitive position for exports — in effect, the devaluation is a de facto cut in costs. This is designed to drive economic growth.
As the US dollar weakens, it also improves America’s external position. US foreign investments and overseas income gain in value. But the major benefit is in relation to debt owned by foreigners. As almost all of its government debt is denominated in US dollars, devaluation reduces the value of its outstanding debt, making it easier for the US to service this. It forces existing investors to keep rolling over debt to avoid realising currency losses on their investments.
Internationally, low interest rates distort currency values and encourage volatile, short term, cross-border capital flows as investors seek higher returns.
Low interest rates and quantitative easing has led to a significant shift of money into emerging countries. This has created destabilising asset bubbles and inflationary pressures. Higher commodity prices, driven by low rates, exacerbate inflation pressures requiring higher rates and reducing growth in emerging nations.
As currency reserves are invested in US dollars and other developed currencies, emerging nations have suffered losses of their national savings as these reserve currencies fall in value.
But a policy of seeking to lower the value of the US dollar or any currency risks retaliation. Countries may be forced to implement competitive QE programs or engineer competitive devaluations of their currency to protect trade and financial interests. It also risks imposition of restrictions on free movement of capital and goods and services, reducing the effectiveness of ZIRP and QE policies.
The experience in Japan over an extended period suggests that such policies damage the structure of the economy. The policies significantly distort the cost of capital and finance and impede adjustment.
Low interest rates encourage “mal-investment”. Companies do not make necessary adjustments to strategy or business practices as the low funding costs enable them to continuing operating. Unproductive investments are not restructured or sold and additional low returning investments are made due to the artificially understated cost of capital. The ability to issue low cost debt allows governments to make unproductive investments or expenditures.
Subsidised by low rates, banks may not write off bad loans, preferring instead to restructure debt as low rates allow zombie companies to continue operations. Research studies by the IMF indicate that such policies increase the ultimate loan losses to banks. Resolution of the banking problems ultimately absorbs significant government financial resources. It also restricts the supply of credit to the wider economy, affecting economic activity.
A sustained period of low rates, such as the one the world is experiencing, makes it difficult to increase the cost of borrowing. Levels of debt encouraged by low rates would become rapidly unsustainable at higher rates. The desperate dash for trash also threatens financial stability. In effect, the policy compounds existing issues, making the problems ever more intractable.
Low rates delay essential restructuring to remove the detritus of previous crises. Misallocation of capital deepens the malaise and makes ultimate resolution more costly and difficult.
One oft quoted definition of madness is repetition of a series of actions and expecting a different outcome. Given that low rates and loose monetary policy were at the heart of the problems of the global economy, it is curious that the disease is now seen as the cure.
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