Singer Robert Palmer was “addicted to love”. The world is now addicted to low interest rates.
In Australia, businesses and unions, in a rare show of unity, urged the Reserve Bank of Australia (“RBA”) to cut interest rates aggressively. In early May 2012, the RBA cut the interest rate 0.50% per annum to 3.75%, with more cuts forecast by the pundits.
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 (a politically correct expression for printing money), are in vogue.
Low interest rates have become a panacea for economic problems. In part, this reflects the limited flexibility of governments to run budget deficits. This is driven by increasing scrutiny of public finances and the lack of willingness of investors 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 prices. But low rates point to a worrying lack of growth. In announcing the cut, the RBA’s press release noted:
“This decision is based on information received over the past few months that suggests that economic conditions have been somewhat weaker than expected, while inflation has moderated.”
Low rates also highlight the increasing risk of deflation and a severe contraction in economic activity. Given that growth and inflation are among the primary requirements for a relatively painless reduction in elevated debt levels globally, the enthusiasm amongst investors and citizens is curious.
The clear hope is that low rates will revive the “animal spirits” of the economy. The Australian Industry Group, whose former head is now a member of the RBA Board, provided extravagant praise for the decision:
“Today’s rate cut accurately reflects the state of the Australian economy and it is most welcome. It’s not a silver bullet but it will help industries on the wrong side of the resources boom. The size of this reduction is particularly important for non-mining trade exposed businesses in industries such as manufacturing and construction who are currently facing very difficult trading conditions…A full pass-on of the cut by banks to business and household borrowers is essential if the move is to play a part in lifting the economy from its slump.”
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.
In Australia, Reserve Bank research indicates that the savings from lower mortgage rates are simply being used to retire debt, rather than consumption. While the reduction in debt levels is necessary, a lower rate will, of itself, do little to boost demand and economic activity.
Stimulus from low interest rates is also temporary, with demand likely to revert to normal levels once rates increase.
Low interest rates can 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.
Low rates 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 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, Australian investors have increased investment in complex capital securities issued by banks and corporations, taking on additional risk, which they do 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 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.
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.
Internationally, low interest rates distort currency values and encourage volatile, short term, cross-border capital flows as investors.
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.
Low interest rates and quantitative easing have driven down the value of the US dollar, euro and yen. As currency reserves are invested in these currencies, emerging nations have suffered losses on their savings.
In Australia, advocates of low rates argue that it would assist in bringing down the value of the Australian dollar. In reality, currency values are affected by a variety of factors including relative growth rates, inflation levels and interest rates. In addition, trading the Australian dollar is a proxy for commodity prices and Chinese growth. Most of these factors are outside the control of Australian policy makers.
Even if rates in Australia are cut further the differential between local rates and foreign rates would be significant. There is no assurance that lower rates would have the desired effect of the value of the local currency.
Central banks believe that they 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.
In addition, as global economic conditions remain fragile, in expending its ammunition now, the RBA may be reducing its options for the real battles that may lie ahead.
Low rates do not address the real issues but central banks and investors seem to believe that there is no alternative. They 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.”
for Markets and Money
© 2012 Satyajit Das All Rights Reserved.
Satyajit Das is author of Extreme Money: The Masters of the Universe and the Cult of Risk (2011)
From the Archives…
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