October 2, 2019

Periodically, I write about interest rates. That’s because what’s happened to them – the fact that they’ve been reduced to near zero on a seemingly permanent basis – is a really important, through under-reported, story. Perhaps I also feel sorry for them. 

Interest rates used to be big news – capable of grabbing headlines with every move up or down. But now that they’re on the floor, no one wants to know – the news just steps over them, looking for where the action is.

Suggested reading
The global economy has gone mad

By Peter Franklin

Interest rates aren’t dead, of course, only sleeping. Indeed, economic policy has become a dream world, filled with financial phantasmagoria like quantitative easing and inverted yield curves. And there’s fevered talk of even stranger stuff – like Modern Monetary Theory, People’s QE and ‘helicopter money’.

And yet the weirder it gets, the more disconnected it becomes from mainstream politics – and thus democratic accountability. In the past, when interest rates (as in central bank base rates) were significantly higher than zero and liable to substantial cuts and hikes (sometimes by entire percentage points!), voters paid attention because each change had a direct and understandable impact on things that people cared about – like whether they could make that month’s mortgage payment.

These days, however, esoteric policy instruments like QE lack relatability and thus don’t get the attention they deserve.

Ultra-low interest rates have all sorts of nasty side effects that impact upon us all. Previously on UnHerd, I took a look at what they do to the corporate sector (they make big businesses bigger and lazier), but today I want to focus on the banking sector and a great Bloomberg article on the subject by Satyajit Das.

The point of cutting interest rates is to encourage borrowing, consumption and investment and thus pep up the economy. And yet, since 2008, we’ve gone through an entire cycle of crash, recession and recovery without interest rates ever really getting off the floor. In fact, they’re so consistently low that at times of slowing economic growth governments can get away with selling negative yield bonds on which the buyer is guaranteed to make a loss (a seemingly crazy form of investment that I try to explain here).

And yet ultra-low interest rates as set by central banks don’t necessarily translate to a borrowing boom:

“As interest rate margins contract and profits are squeezed, banks raise fees or turn to other revenue measures to boost earnings. This keeps actual borrowing costs relatively high, undercutting the whole point of a negative rate policy.

“As the economy continues to sputter, desperate policymakers slash rates more and more deeply. Government bond yields grow increasingly negative and the yield curve flattens. Banks, which hold substantial amounts of government debt, see their profits decline even further.”

Banking is a low margin, high risk business at the best of times – so when those margins are squeezed even tighter (thanks to very low interest rates), lending policy becomes super-cautious, which, as Das points out, “perversely reduces the amount of credit available”.

Suggested reading
Why low interest rates poison the economy

By Peter Franklin

Part of this pathological caution is refusing to pull the plug on failing businesses:

“Negative rates distort incentives. Facing declining profits, banks grow reluctant to foreclose on distressed borrowers. They extend lifelines to zombie companies, which can service their debt when interest rates are so low even if they have no prospects of repaying the principal.”

This might seem like a mercy, but it really isn’t. For fear of recording a loss, the banks leave capital tied up in moribund, low productivity firms when it could be invested in dynamic enterprises that fuel innovation, productivity, job creation and higher wages.

Another argument for ultra-low interest rates is that they persuade savers to spend more of their savings. But this doesn’t necessarily follow either. Das reminds us that because regulators require banks to hold a minimum level of savers’ deposits, the interest rates on savings accounts have to stay high enough to keep savers saving. In any case, the sullen weirdness of the economy doesn’t exactly encourage savers to splash their cash.

Ultra-low interest rate policy, suffers the same psychological drawback as expansionary fiscal policy (i.e. government spending like a drunken sailor in port). People aren’t fools and know that the central bankers and politicians wouldn’t be resorting to such measures if they weren’t desperate – and that they wouldn’t be desperate if the underlying situation wasn’t dire. Spooked by their leaders’ rictus smiles and sweating brows, consumers and investors go to ground instead of rekindling their animal spirits.

Is there anything that can be done? Well, it’s not all the fault of the banks – because they’re not the only source of investment capital. A lot of businesses (and wealthy private individuals) don’t need to borrow, they’re already sitting on massive cash-piles – but aren’t investing the money, not even in themselves.

This points to the real problem – a chronic lack of investment opportunities. For all the talk of technological revolution, especially robotics and artificial intelligence, it seems to be making remarkably little difference to the economy.

Suggested reading
Sod the singularity

By Peter Franklin

It’s a point well-made in another Bloomberg article by Noah Smith:

“…if robots were taking over, there would be plenty of additional evidence in the economic data. Businesses would be investing more, in order to build and install the robots. College-educated workers (who build and run the robots) would see a growing wage premium. And most importantly, labor productivity would be accelerating, as the amount of human labor shrank and machines assumed more tasks. Yet none of that is happening.”

The ultimate proof is interest rates. If the technological potential for productivity improvements existed in more than a few specialist sectors, then there’d be much more demand for investment capital – and thus much higher interest rates.

In short, persistently low interest rates are nothing to celebrate; there’s no clearer sign of long-term economic stagnation.