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)

Voices
The Sumatran tiger, endemic to the Indonesian island of Sumatra, is an endangered species
voicesJonathon Porritt: The wild tiger population is thought to have dropped by 97 per cent since 1900
News
The Swiss Re tower or 'Gherkin' was at one time the UK’s most expensive office when German bank IVG and private equity firm Evans Randall bought it
news
News
Gardai wait for the naked man, who had gone for a skinny dip in Belfast Lough
newsTwo skinny dippers threatened with inclusion on sex offenders’ register as naturists criminalised
Sport
Van Gaal said that his challenge in taking over Bobby Robson's Barcelona team in 1993 has been easier than the task of resurrecting the current United side
football
PROMOTED VIDEO
Arts and Entertainment
The Great British Bake Off 2014 contestants
tv
Arts and Entertainment
filmThe Battle of the Five Armies trailer released
News
news
Arts and Entertainment
Beast would strip to his underpants and take to the stage with a slogan scrawled on his bare chest whilst fans shouted “you fat bastard” at him
musicIndie music promoter was was a feature at Carter gigs
Arts and Entertainment
Story line: Susanoo slays the Yamata no Orochi serpent in the Japanese version of a myth dating back 40,000 years
arts + entsApplying the theory of evolution to the world's many mythologies
Extras
indybest
News
Performers dressed as Tunnocks chocolate teacakes, a renowned Scottish confectionary, perform during the opening ceremony of the 2014 Commonwealth Games at Celtic Park in Glasgow on July 23, 2014.
news
Life and Style
Popular plonk: Lambrusco is selling strong
Food + drinkNaff Seventies corner-shop staple is this year's Aperol Spritz
Life and Style
Shake down: Michelle and Barack Obama bump knuckles before an election night rally in Minnesota in 2008, the 'Washington Post' called it 'the fist bump heard round the world'
newsThe pound, a.k.a. the dap, greatly improves hygiene
News
ebookA unique anthology of reporting and analysis of a crucial period of history
Latest stories from i100
Have you tried new the Independent Digital Edition apps?
Independent Dating
and  

By clicking 'Search' you
are agreeing to our
Terms of Use.

iJobs Job Widget
iJobs Money & Business

Senior Fund Administrator - Edinburgh - £22 p/hr

£20 - £22 per hour + competitive: Orgtel: Senior Fund Administrator, Top Four ...

Entry Level Fund Accountant (Edinburgh)

£17 - £20 per hour: Cameron Kennedy Recruitment: My client, one of the worlds ...

SQL DBA/Developer

£600 per day: Harrington Starr: SQL DBA/Developer
 SQL, C#, VBA, SQL Server, ...

Risk Analyst - VBA/EXCEL

£300 - £600 per day: Harrington Starr: Risk Analyst Access, EXCEL, VBA, RISK, ...

Day In a Page

The children were playing in the street with toy guns. The air strikes were tragically real

The air strikes were tragically real

The children were playing in the street with toy guns
Boozy, ignorant, intolerant, but very polite – The British, as others see us

Britain as others see us

Boozy, ignorant, intolerant, but very polite
Countries that don’t survey their tigers risk losing them altogether

Countries that don’t survey their tigers risk losing them

Jonathon Porritt sounds the alarm
How did our legends really begin?

How did our legends really begin?

Applying the theory of evolution to the world's many mythologies
Watch out: Lambrusco is back on the menu

Lambrusco is back on the menu

Naff Seventies corner-shop staple is this year's Aperol Spritz
A new Russian revolution: Cracks start to appear in Putin’s Kremlin power bloc

A new Russian revolution

Cracks start to appear in Putin’s Kremlin power bloc
Eugene de Kock: Apartheid’s sadistic killer that his country cannot forgive

Apartheid’s sadistic killer that his country cannot forgive

The debate rages in South Africa over whether Eugene de Kock should ever be released from jail
Standing my ground: If sitting is bad for your health, what happens when you stay on your feet for a whole month?

Standing my ground

If sitting is bad for your health, what happens when you stay on your feet for a whole month?
Commonwealth Games 2014: Dai Greene prays for chance to rebuild after injury agony

Greene prays for chance to rebuild after injury agony

Welsh hurdler was World, European and Commonwealth champion, but then the injuries crept in
Israel-Gaza conflict: Secret report helps Israelis to hide facts

Patrick Cockburn: Secret report helps Israel to hide facts

The slickness of Israel's spokesmen is rooted in directions set down by pollster Frank Luntz
The man who dared to go on holiday

The man who dared to go on holiday

New York's mayor has taken a vacation - in a nation that has still to enforce paid leave, it caused quite a stir, reports Rupert Cornwell
Best comedians: How the professionals go about their funny business, from Sarah Millican to Marcus Brigstocke

Best comedians: How the professionals go about their funny business

For all those wanting to know how stand-ups keep standing, here are some of the best moments
The Guest List 2014: Forget the Man Booker longlist, Literary Editor Katy Guest offers her alternative picks

The Guest List 2014

Forget the Man Booker longlist, Literary Editor Katy Guest offers her alternative picks
Jokes on Hollywood: 'With comedy film audiences shrinking, it’s time to move on'

Jokes on Hollywood

With comedy film audiences shrinking, it’s time to move on