Satyajit Das: We tell ourselves low rates are good for us, but in truth we are addicted
Midweek View: The ability of low rates to boost real economic activity is unclear. The cost of funds is only one factor
Following the global financial crisis, policy interest rates in the United States, Europe, the 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 such as 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 unwillingness of investors to finance such deficits, as highlighted by the eurozone debt crisis. But like all addictions, low interest rates can be dangerous, and they are 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. They 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 debt, the investor response is curious.
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 deposit required, existing home equity, the ability to sell a current property, income and employment security.
In industry, the absence demand means businesses are unlikely to borrow to invest in new capacity based purely on the low cost of debt.
Low-cost debt encourages the substitution of labour with capital in the production process. Given that 60 to 70 per cent of activity in developed economies is driven by consumption, this reduces aggregate demand as employment and income levels decrease.
Low rates favour borrowing, encouraging the substitution of debt for equity in financing structures and increasing risk. Where companies and nations are over-extended, this weakens incentives to cut debt.
Lower earnings on savings should encourage spending, stimulating economic activity, but may perversely encourage saving as people seek to provide for future needs.
Low rates encourage mispricing of risk, creating asset bubbles.
Low borrowing costs encourage investors to seek investments with income, feeding demand for high-yield shares and low-grade debt. A resurgence of structured products, where investors take on additional risk to generate higher income, is driven by low rates. In previous cycles, this has led to large losses and costly disputes between investors and the purveyors of these products
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, as seen in increased demand for commodities and alternative investments such as artworks. Money tied up in non-productive investments reduces the flow of capital and overall economic activity.
Low rates do not necessarily increase the supply of credit, as risk-averse banks 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.
Low interest rates and quantitative easing together have 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 in emerging nations, requiring higher rates and reducing growth.
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 seen their reserves shrink.
Central banks seem to believe that they will be able to give up low rates when the time is right. I am reminded of Ashly Lorenzana's definition in her journal Sex, Drugs & Being an Escort. Addiction is "when you can give up something any time, as long as it's next Tuesday".
Satyajit Das is the author of 'Extreme Money: The Masters of the Universe and the Cult of Risk' (2011)
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