Singer Robert Palmer was “addicted to love”. The world is now addicted to low interest rates. Central banks also display signs of acronym-o-mania, an addiction to acronyms: ZIRP (Zero Interest Rate Policy), QE (Quantitative Easing) etc.
Following the global financial crisis, policy interest rates in the USA, Europe, UK and Japan were reduced sharply. The US Federal Reserve has committed to holding rates around zero for the foreseeable future. Faced with deep-seated economic problems, other central banks are following a similar strategy. Where interest rates are zero and cannot be lowered further, novel forms of monetary accommodation, quantitative easing are in vogue, to keep rates low.
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.
The US has undertaken 3 doses of QE to date. Based on the experience of Japan (which is up to QE 8 or 9), further doses may be administered. Federal Reserve may even undertake direct purchase of risky assets such as corporate debt or even stocks, following the precedent set by the Bank of Japan
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. The cost of funds is only one factor 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 are unlikely to borrow to invest in new capacity based purely 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 itself, do little to boost demand and economic activity.
Research by the Federal Reserve indicates limited impact of ZIRP and QE 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 60-70% of activity in developed economies is driven by consumption, this reduces aggregate demand as employment and income levels decrease.
Low rates favour borrowing, encouraging substitution of debt for equity in financing structures, increasing financial risk. Where companies and nations are over extended, this decreases incentives to reduce debt. In fact, low interest rates are 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 which 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. Driven by low rates, investors have increased investment in complex capital securities issued by banks and corporations, taking on additional risk, which they may not fully understand, to generate higher income.
Low rates also feed asset price inflation. 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.
Announcing QE3, Federal Reserve Chairman Ben Bernanke indicated that the plan was directed at boosting house and asset prices through purchases of mortgage backed securities. The comments were astonishing, failing to acknowledge the fact that a housing bubble caused by excessively low interest rates under his predecessor was a major contributor to the present economic problems. The suggestion was also startling in that it acknowledged that QE, of itself would not significantly increase economic activity directly.
Whatever its effects on economic activity, ZIRP and QE have been effective in helping finance government borrowing and also weakening the currency.
For example, the Federal Reserve has directly or indirectly been purchasers of around 60-70% of all US Treasury bond issuance. The Federal Reserve purchases Treasury bonds as part of their QE programs. Reserves within the banking system created by the Fed system allow financial institutions to purchase additional Treasury bonds.
ZIRP and QE have helped weaken the dollar. Despite bouts of dollar buying on its safe haven status, the US dollar has significantly weakened over the last 2 years. On a trade weighted basis, the US dollar has lost around 20% against major currencies since 2009. The US dollar has lost around 30% against the Swiss Franc, 25% against the Canadian dollar, 35% against the Australian dollar and 20% against the Singapore dollar over the same period.
The weaker US 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 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 its debt.
It forces existing investors to keep rolling over debt to avoid realising currency losses on their investments. It encourages existing investors to increase investment, to “double down” to lower their average cost of US dollars and US government debt. As John Connally, US Treasury Secretary under President Nixon belligerently observed: “Our dollar, but your problem.”
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.
Experience in Japan with ZIRP and QE policies over an extended period suggests that such policies damage the structure of the economy. The policies significantly distort the cost of capital and finance in an economy 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. 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 the debt as low interest rates allow zombie companies to continue operations.
Research studies by the IMF indicate that such policies increase the ultimate loan losses to banks. Low rates also encourage excessive risk taking by banks increasing risk and may ultimately resulting in additional cost to the government and taxpayer.
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.
In effect, essential restructuring, removing the detritus of previous crises, is delayed. Misallocation of capital deepens the malaise and makes ultimate resolution more costly and difficult.
One oft quoted definition of madness is repetition of a serious of actions and expecting a different outcome. The Japanese experience points to the limits of ZIRP and QE over a prolonged period of time. Yet central bankers and policy makers in developed countries believe that this is the correct medicine for current economic problems. They fail to recognize that if such policy were effective, Japan’s economic position should have returned to some semblance of normality by now.
Central banks also convince themselves that ZIRP and QE policies are temporary. They believe that will be able to exit from a policy of low rates when appropriate. It is reminiscent of Ashly Lorenzana’s definition of addiction in her journal Sex, Drugs & Being an Escort: “When you can give up something any time, as long as it’s next Tuesday”.
A sustained period of low rates, like 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. In effect, the policy compounds existing issues, making the problems ever more intractable.
ZIRP and QE do not address the real issues but central banks and market participants believe that there is no alternative. Celebrity policy makers are relying on the advice of celebrity Russell Brand: “The priority of any addict is to anaesthetise the pain of living to ease the passage of day with some purchased relief.”
© 2012 Satyajit Das All Rights Reserved.
This paper is based on the ideas first published as “Low rates: the drug we can all do without” Financial Times (31 January 2012)