Thursday, September 12, 2019

Central Banks Low Rate Solution Remains Problematic

This Simplistic View Of Economy Is Problematic
One of the most remarkable features of our current economy is that interest rates are flat or negative in real terms and many people are advocating they need or should go lower. This is not completely unprecedented. Real rates were negative after the second World War and again in the 1970s. Across the world, the central banks have raced to the bottom lowering interest rates only to find little relief from the slow economic growth that has haunted their economies for years. What former Fed Chairman Ben Bernanke, started as a program to support and prop up the economy has over time morphed into the main driver of economic data.

It is becoming clear the actions Ben Bernanke took that enabled and even encouraged the central banks to go down this rabbit hole have had more than a few negative consequences. An argument could be made that the power of lowering interest rates is a one-off that has largely run its course and is largely behind us. The truth is a policy of creating debt and stacking layer after layer of it behind the curtain has dampened the ability of consumers to move forward. Even at super low-interest rates, a great share of income must now be used to service past obligations. This leaves less money available for new purchases which has a major dampening effect going forward.  

Between the low-interest rates that have propelled investors into high-risk assets in search of a positive return on their money, and money being pumped into the system, the markets have become distorted and disconnected from the economy. Frequently overlooked is that low-interest rates do not extend down to low-income individuals with poor credit and many people fall into this category. This tends to fuel inequality and punish the poor. Policymakers aided by the media thrive at presenting simplistic but flawed answers to solve both economic and society’s problems which will require little or no effort from the masses. Unfortunately, the concept that a rising tide floats all boats or trickle-down economics tends to heavily favor the rich.

We also face the "inflation factor" which nibbles away at our standard of living. Even as many economist claim inflation is not an issue for the many Americans forced to pay higher food, rent, and health insurance premiums little comfort is forthcoming. Currently, much of the recent economic data indicates lower-interest rates have been a "one-time" economic tailwind that is rapidly weakening and lost its kick. This puts both the central banks and the economy between a rock and a hard place. The big issue is where we go from here, regardless of what you name it, this is the box Ben Bernanke created when he painted both himself and the Federal Reserve in a corner. Adding to our woes is the Federal Reserve's failure to make any serious efforts in pushing the government to address structural problems thus delaying necessary adjustments to make America more competitive.

Debt Has Grown Faster Than GDP (Click to enlarge)
The level of interest rates is normally viewed as an effort to balances several forces at work within an economy such as the desire for saving with the demand for investment or consumption. Negative real rates reduce the incentive to save and indicate that businesses are reluctant to invest in new projects. Central banks attempt to offset this during a very weak economy by lowering rates. These policies aim to discourage saving thus boosting consumer demand.  

Sadly, the low rates geared to encourage business borrowing and boost employment also tend to encourage savers to take on more risk than they should as they search for higher yields. This can create a full "risk-on" mentality that can wash away common sense. It can also fuel what is known as "the fear of missing out." As stated earlier, the policy of rapid credit expansion while an interesting concept frequently is accompanied by negative consequences. Reports from the Bank for International Settlements point to a number of other problems that negative real rates can cause such as tempting borrowers into ignoring their balance-sheet problems. This tends to allow problems to fester making it more difficult for central banks to raise interest rates in the future.

This is being put to the test in China where we see the amount of GDP growth generated by each infusion of new stimulus decrease year after year. At the end of 2015, the Chinese debt to GDP ratio stood at 258%. This can be viewed as an indication of economic exhaustion and overcapacity results from continually priming the pump. Way back in 2014 Wei Yao Of Societe Generale warned the debt ratio of Chinese companies had reached 30% of GDP which is seen as a sign of financial crisis because it means companies are on the verge of no longer being able to pay the interest on their debt. This creates a situation known as a "Minsky Moment " where the debt pyramid can collapse under its own weight as the debt "snowball" keeps getting bigger without contributing to the real economy. At the time she pointed out the total credit in China's financial system was estimated to be as high as 221% of GDP and had surged almost eight-fold in just 10 years.

When an economy is growing rapidly, there is generally an abundance of profitable investment opportunities and businesses are happy to borrow at high real rates. Real interest rates set a hurdle by which profitable projects should be judged. If the rate is held at an artificially low level for too long, a big danger is that capital will be misallocated and flow into speculative investments. Banks may also become too optimistic about the ability of borrowers to repay, and fail to make adequate provisions for bad debts. It also encourages banks to borrow short-term from the central bank and lend long-term to the government. This is a public subsidy that should cause more taxpayers to scream foul!

Another problem is that pensions also invest in bonds using the income to fund future payouts. As yields fall it creates a situation that makes it harder for pensions to remain solvent while honoring future obligations. Low-interest rates in the developed world also spill over into emerging markets, pushing up exchange rates, increasing speculation, inflating commodity prices and causing asset bubbles. We must keep in mind that when rates do eventually rise we will most likely see a painful unwinding of these investments.

Savers also suffer from these low-interest rates because it means that every dollar of savings spent becomes more difficult to re-earn or replenish. Lower rates in effect cause many older people to hoard their wealth. This translates into baby boomers keeping that older car for an extra 50,000 miles, to cancel remodeling projects, and make the grand-kids fund their own education in an effort to extend the life of their savings. This often means that with less interest income they are purchasing a lot fewer electronic gadgets and spending vacations in the backyard. Tens of millions of Americans are either in this position now or about to become so.

On the flip-side, many people with little savings have rushed out to buy cars and expensive items they really can't afford and pulled consumption forward. Ironically, as the country's most responsible citizens hunker down we see lenders leaning into the wind and playing Russian roulette with high-risk loans to those with poor credit records that may never be repaid or have to be written down. The premise being that when you charge interest in the high teens even after the write-downs you come out ahead. The bottom-line is that all the above trends and reactions to lower interest rates feed into a situation that is not particularly healthy, fair, or logical. As a result of these low-interest rates this "recovery" has been built on a false base and been far less robust than originally hoped. The legacy of Central Banks pursuing the "low rate" solution may turn out rather ugly when all is said and done.


  1. Good article.

    If ABC Co Ltd 7% million loan use cost $70,000.00 per year a few years ago today at 1% ABC Co Ltd can now borrow $7,000,000 for the same $70,000.00 per year annual cost. Does any rational person think that rates can ever be normalized again without a kind of reset?
    It all comes down to: It was and it is still absurd and a contradiction to have central planing interference in a free market. We can produce and trade goods and services with a medium only as long as such medium is not being manipulated.
    We have consume the future and Central Banks problem is that today is the future. Good luck with that.
    Its important in a free and liberal democracy to have a referee but it's just as important that the referee is not participants.

  2. Low interest rates are simply a reflection of low inflation and abundant capital. You can't have the central-bank pay high rates either in it's refinancing rate or in it's IOR in an environment like this.