Satyajit Das: Low rates have caused the crisis – they are not the solution to it

Das Capital

Central bank policies have stabilised conditions but not restored growth or created sufficient inflation to address the world’s debt problems. As Helmuth von Moltke, a 19th-century head of the Prussian army, observed: “No battle plan ever survives first contact with the enemy”.

Now the spectre of deflation haunts financial markets. Deflation would mean general tax revenues would stagnate or even fall. Asset price falls would also reduce tax revenues. Businesses revenues also fall. There would be an appreciation in the real value of debt. The high level of borrowing would be increasingly difficult to service, with serious consequences for the banking system.

The premise was that expanding money supply would create inflation. In practice, the process is complex, with additional conditions needed to create inflation. Central banks control the monetary base, a narrow measure of money supply made up of currency plus the reserves that commercial banks hold with the central bank. The relationship between the monetary base, credit creation, nominal income and economic activity is unstable. While the money supply has increased, the velocity of money has slowed. The reduced velocity offsets the effect of increased money flows.

Inflation also requires an imbalance between demand and supply. Most developed economies have a significant “output gap” ranging from 2 to 8 per cent (the amount by which the economy’s potential to produce goods exceeds total demand), though the extent is uncertain due to drops in participation in the labour force which may have reduced capacity. The gap reflects lower demand but also excess capacity. This translates into a lack of pricing power and low price inflation.

While ineffective in achieving its targeted outcomes, current policies have toxic by-products. Expansionary fiscal policies have left many countries with large and growing levels of sovereign debt. The rapid build-up of government debt following the events of 2007-08 now restricts the ability of many governments to respond to new crises.

Monetary policy distorts normal economic activity. Citigroup equity strategist Robert Buckland argues that low rates and QE actually reduce employment and economic activity, rather than increasing them. They encourage a shift from bonds into equities. But as investors look for income rather than capital growth, they force companies to increase dividends and undertake share buybacks. To meet these pressures, companies shed workers and reduce investment to cut costs.

Low interest rates reduce the income of retirees living off their savings, decreasing demand. Low rates perversely reduce consumption and increase savings as people set aside cash for future needs. Low rates increase unfunded liabilities of defined benefits pension funds. These shortfalls ultimately retard growth as sponsors must divert earnings to meet these future liabilities.

Low rates “zombify” the economy. Low rates allow weak businesses to survive, directing cash flow to cover interest on loans which can never be repaid but which banks cannot afford to write off. This ties up capital and reduces lending. Firms do not dispose of or restructure underproductive investments. The creative destruction and re-allocation of resources necessary to restore the economy’s growth potential does not occur.

Low rates distort investment, encouraging excessive risk-taking in search of higher returns. Risk premiums have fallen sharply to uneconomic levels in equities, dividend paying stocks, corporate debt, high yield bonds, structured securities and other risky assets.

These risks are compounded by the continued high levels of leverage in financial institutions. Under new reporting guidelines, the five largest UK banks, among the best capitalised in the world, have leverage (which may be under-stated) ranged from 20 to 35 times their capital base, meaning a 3 to 5 per cent fall in the value of their assets would render the banks insolvent.

The monetary policies being pursued by developed nations also adversely affect emerging economies. Investors were encouraged to increase investments in emerging markets offering better returns and more encouraging growth prospects. These capital flows distorted those economies, creating major problems. Given that emerging markets have been a key driver of the tepid recovery in economic activity globally, this risks truncating the recovery.

The low rates, mispricing of risk and excessive debt levels that were the causes of the crisis are now considered the “solution”.

Satyajit Das is a former banker and author of ‘Extreme Money’ and ‘Traders, Guns & Money’