Low Interest Rates Do Not Guarantee Economic Growth

To all those investors looking forward to the Fed dropping rates, the bad news is that lower interest rates do not guarantee economic growth. This is a fact, and what many people fail to consider is that more goes into the economic "stew" than just interest rates. In some ways, easy money policies can impair growth and the quality of growth. An example of this is that they allow zombie companies to continue operating.

While many investors talk about the link between low-interest rates driving the economy and markets ever higher, this correlation is very weak. We only need to look at Japan to understand that low interest rates do not guarantee a booming economy. For decades, Japan has pursued super-low and even negative interest rates while drifting into and out of recession. In short, other factors have been driving Japan's economy rather than simply keeping rates low.

Yes, there is a big difference between 10% and 5% interest rates, but when you are talking about a quarter of a percent, it has little bearing on the overall economy. It can be argued that the only place where rate cuts make a huge difference is when you get down near two percent. At that point, a 25 or 50 basis drop creates huge sums of "speculative" money. Growth is often more about liquidity and the availability of money than low interest rates. We should question how much a couple of quarter-point drops in interest rates will really make. This is very important considering many consumers are completely disconnected from fed rates and paying well over 20% APR on charge cards.

The Eurodollar University YouTube Channel continues to hone in on slow growth across the world, claiming the global economy is in a synchronized slowdown and recession. He does this in part by repeatedly using the line, "forgot how to grow," while pointing out that true economic growth has faltered. Part of the problem is that low interest rates tend to pull spending forward, but there is a limit as to how far this can go.

Debt Has Grown Faster Than The GDP

Over the last decade, low interest rates have contributed to increased inequality. Not all people and businesses benefit equally from low-interest policies. The Fed has fueled inequality by feeding money into a system where "the big boys" and Wall Street soak up cheap, easy money, but small businesses saw lending standards rise. This resulted in making it more difficult for many small companies to get loans and resulted in many productive small companies closing their doors forever.

The legacy of Central Banks pursuing "low rate" policies has caused debt and bad debts to explode. By not demanding the right kind of growth and simply throwing money at problems, Central banks and governments have delayed and added to a much larger crisis in the future. This is becoming apparent in central banks' limited ability to directly determine rates at the long end of the curve. 

Circling back to Japan, for years, many economists claimed that only by letting its zombie banks and industries fail could Japan clean out the system and move forward. Instead, the Government of Japan ran huge deficits and ran up massive debt. The country languished in what has become known as "the lost decades," during which it avoided disaster only by the fact that for decades it enjoyed a large trade surplus. 

At some point, both investors and the public will realize that central banks can only do so much through printing money and lowering interest rates. America continues to spend far more than it takes in, and such deficits are unsustainable. Most of this money finds its way into the economy as "poorly crafted subsidies" that push data higher, creating the false illusion that all is well. The bottom line is that much of the world may well be looking at a version of the "Japan Syndrome" with stagflation. This translates into years of slow growth coupled with a protracted period of inflation.

Low rates are also supposed to encourage business borrowing and boost employment, but often it also encourages savers to take on more risk than they should, as they search for higher yields. History shows that when rates are held at an artificially low level for too long, capital is often misallocated and flows into speculative investments. The current low rates combined with our massive government deficit are creating a false economy that is also baking in a higher overall cost structure. Want to know where the real cost of things is going? Just look at the replacement cost from recent storms and natural disasters.  

Many of those already concerned about the strength of the economy find little comfort in the argument that conditions remain too fragile to begin a return to historic norms. Lower rates have almost been guaranteed and promised; however, we should never forget that liquidity is far more important. Liquidity is the lifeblood of commerce. It is difficult to envision how the world will handle the additional debt of governments if long-term rates begin to rise. As we look back years from now, the policies of ZIRP and NIRP are likely to be considered major mistakes.  

 

FOOTNOTE: The wealth effect is most likely a far greater contributor to growth, not necessarily "good growth," than low interest rates. Click here to link to an article that highlights using the wealth effect as an economic tool.  You can let me know your thoughts in the comments section. 

(Republishing of this article welcomed with reference to Bruce Wilds/AdvancingTime Blog)