The United States Federal Reserve made news last week by raising its benchmark interest rate. However, even if the Fed continues with modest hikes, globally, rates close to and even below zero are here to stay, especially in the eurozone. Some observers explain this unusual state of affairs by citing economic trends (long-term stagnation), while others blame monetary policy. Whatever the reason, the consequences for investment allocation, savings and political reform will be negative. European economies may end up in permanent sclerosis.
In the wake of the ‘Great Recession’ central banks around the world brought their policy rates close to zero, where they have remained for nearly seven years now. Some – like the European Central Bank (ECB), as well as the Swiss and the Swedish national banks – have even instituted negative interest rates for commercial bank deposits. Additionally, about 2 trillion euros worth of short-term government bonds are now priced with negative interest rates. If you lend 100 euros to, say, German Finance Minister Wolfgang Schauble for two years, the German government will hand you back 99.40 euros when the loan period is up.
Some institutional investors are forced by law to buy such ‘risk-free’ assets, foreign investors speculate on currency gains, and others find that ‘parking liquidity’ in such bonds is still less costly than holding a deposit at the central bank. Even the ECB itself buys government bonds with negative interest rates as low as -0.2 per cent.
Bloated balance sheet
On December 3, the ECB held the interest rate on its main refinancing operations at 0.05 per cent and decreased its rate on the deposit facility by 10 basis points to -0.30 per cent (the Swiss National Bank’s rate is -0.75 per cent). In addition, the ECB will extend its monthly purchases of 60 billion euros of securities (mostly government bonds) until the end of March 2017. This additional ‘quantitative easing’ will bloat the ECB’s balance sheet by another 1.46 trillion euros, bringing the total to more than 3.5 trillion euros.
Still, market participants complained that ECB President Mario Draghi had over-promised and under-delivered. That very day, the German DAX stock index lost 3.1 per cent and the euro appreciated by 4.5 per cent against the US dollar (its largest intraday move since 2009). Nevertheless, the dollar has appreciated by 19 per cent against the euro since mid-2014 on expectations that US interest rates must rise.
The Fed’s quarter point increase on December 16, 2015 finally ended seven years of zero interest rates, but it will not reverse the worldwide trend of extremely low interest rates. What this very modest, long-awaited and economically justified decision may do is trigger a massive reallocation of capital from emerging markets back to the US. Countries with current account deficits used capital imports based on cheap dollar loans to fuel domestic booms – these could now easily turn into busts.
As Prince Michael of Liechtenstein pointed out in a recent GIS Statement, ‘the ECB is trying to resolve a trilemma. It wants to spur economic growth through low to negative interest rates, hit its targeted inflation rate of 2 per cent by increasing money supply, and relieve the fiscal pressures on member states by a huge bond purchasing programme.’
So far it has failed on the first two goals. According to economics textbooks, investment responds to interest rates. Lower borrowing costs make it cheaper to finance by credit and thus improve the return on investment. But this is only one of many variables in an investor’s calculation.
In today’s circumstances, confidence is more important. Entrepreneurs need confidence that the market and political conditions will remain stable. Banks require confidence in borrowers, the business climate and their own future. The latter is still under threat from non-performing loans, which make up close to 6 per cent of commercial lending portfolios in the EU.
Concern about the quality of their balance sheets might be one reason banks are using the ECB’s cheap new money as liquidity, to roll over bad loans or fuel new asset price bubbles in stocks, bonds and real estate.
The value of achieving the second goal (hitting the 2 per cent inflation target) is debatable in its own right. Both the Fed and the ECB have targeted consumer price inflation below or near 2 per cent in the medium term. And both argue that inflation (the devaluation of money) is now ‘too low.’
The two central banks are very well aware that in both of their economies core inflation – which excludes volatile food prices and drastically sinking energy prices, especially crude oil – has held fairly stable at about 1 per cent. A deflationary cycle is simply not on the cards.
Policy makers also know that cheap money can cause dramatic problems, as it did before 2007. Too much money chasing too few serious investment options can lead to asset price inflation, as well as boom and bust cycles that shrink the economy.
Only on the third goal, relieving fiscal pressure on member states, can the ECB claim to have had some effect – at a huge cost. While the ECB did manage to buy time for struggling finance ministers to get their accounts in order, the politicians have mostly failed to take advantage of the opportunity.
The Italian government, for example, sold more than 7 billion euros of two-year government bonds at negative interest rates this year. This comes at a time when Italy is lagging behind the rest of the EU in terms of economic growth, domestic investment is at record lows, and the government’s debt-to-GDP ratio is topped only by Greece’s.
Economists cannot agree on a single explanation for the unusual phenomenon of zero or even negative nominal interest rates. Much of the debate centres around the ‘natural rate of interest.’ Simply put, this is the rate at which supply (savings) and demand (investment) are balanced, permitting the economy to operate at its full potential without inflationary or deflationary pressures.
A long-term decline in productivity and population growth, along with increasing risk aversion and uncertainty, might explain why savings have increased and demand for loans has decreased in recent decades. This trend brought down the ‘natural rate of interest’ from an estimated 3.5 per cent in 1990 to about 2 per cent in 2007, before it dropped to zero or below after the 2008 financial crisis.
Many economists and ECB officials share the view that economic fundamentals, not monetary policy, are responsible for record low long-term interest rates. However, other economists, inspired by the ‘Austrian School’ of economic theory, argue that central banks exert a key influence on long-term rates.
Incentive to speculate
In this view, by lending below the ‘natural’ rate, banks can easily trigger overinvestment, causing the boom and bust cycles that have put economies in their current straits. Central banks play a crucial role in this process. There has been a consistent asymmetry in central banks’ policies since the early 1980s, when short-term interest rates in the US, Japan and Germany were all close to 12 per cent.
In times of economic or financial crises, central banks tend to lower interest rates drastically. Afterwards, they shy away from raising borrowing costs to pre-crisis levels. This behaviour pattern is taken as implicit insurance for speculators in asset markets: booms will not be stopped, and the pain of busts will be soothed by cheap money. Bad assets will simply be bought up by central banks.
This assurance enhances the incentive to speculate rather than invest in the economy. As interest rates near zero or turn negative, they no longer serve as a risk premium or a mechanism separating good long-term investment ideas from bad ones. In the end, monetary policy creates asset price bubbles and prevents the creative destruction of bad investments.
As could first be seen in Japan, and now also in the eurozone, essentially insolvent ‘zombie banks,’ ‘zombie companies’ and ‘zombie states’ can only survive with increasingly frequent injections of new, cheap credit. The main suppliers of such injections are the central banks.
Two side effects of this brave new world of ‘costless credit’ have already become apparent. Firstly, further asset price bubbles and bad investments add more zombie-like banks and businesses to the list of those depending on cheap credit injections. Secondly, necessary political reforms are put off as governments are allowed to borrow at low cost or even paid to do so by desperate investors. In essence, eurozone states have also become junkies who need the ECB to do ‘whatever it takes’ to provide them with the next fix.
With this latter risk comes another, related negative effect: the creeping expropriation of the middle classes, who have a preference for risk-averse savings. Usually, the richer portions of society benefit the most from booms fuelled by cheap credit. It is their risk that central banks have proved to be most willing to cushion in the event of crisis. In turn, ‘normal’ and ‘low-risk’ investments in savings accounts, government bonds and pension funds – the staples of middle class investing – no longer provide positive returns, especially on an after-tax, inflation-adjusted basis.