For years, central bankers in the developed world have been trying to battle poor economic growth and weak demand with ultra-low, and even negative, interest rates. It’s not working. More than 17 years after Japan cut interest rates to zero, and eight years after the financial crisis prompted central banks in the US and Europe to slash their policy rates to record lows, growth has stubbornly refused to recover to pre-crisis levels and deflation remains an ever-present threat. The response among central bankers has been to cut further, defying all historical precedent to push interest rates into negative territory.
The eurozone, Denmark, Sweden, Switzerland and Japan all now have interest rates prefixed with a minus sign, while US$11 trillion of government bonds now trade at yields of less than zero. Yet even these desperation measures – intended to encourage a pick-up in spending and investment – have failed. According to the latest forecasts published by the International Monetary Fund last Tuesday, the world’s advanced economies will grow by just 1.6 per cent this year, down from an average growth rate over the 10 years preceding the 2008 financial crisis of 2.8 per cent. Meanwhile consumer inflation has collapsed to 0.8 per cent, from an average of 2 per cent before the crisis.
The time has come for policymakers to ask themselves some searching questions. What if the conventional economic wisdom is completely and utterly wrong? What if low interest rates are not the cure for weak growth? What if, instead, low interest rate are actually the cause of the developed world’s chronic economic malaise?
This is not as batty as it sounds. To see why, consider the behaviour of entrepreneurs, who in any advanced economy are by far the most important source of sustainable long term growth. We all know how entrepreneurs respond if interest rates are too high. If the cost of capital is higher than the return they can expect to earn by making new investments in their businesses, then entrepreneurs will simply stop investing, and growth will grind to a halt.
But what if interest rates are too low? Conventional wisdom holds that the more you cut interest rates, the more entrepreneurs will be encouraged to borrow to invest in new productive capacity, and the faster growth will accelerate. The trouble with this view is that investing in new projects is risky. For every investment that makes or exceeds its expected return on capital, there are probably five or six that fall short. As a result, if interest rates are very low or negative, it makes more sense for the owners of capital to leverage up and invest in existing assets like property or financial instruments than to risk their money on uncertain new ventures. The expected returns may not be as exciting, but leverage can juice them up, and the pay-off is more reliable.
But investing in existing assets doesn’t add to the productive capacity of the economy. So if interest rates are too low, leverage expands and financial assets surge in price, but investment in productive new business projects dwindles and economic growth evaporates.
There is evidence this is exactly what is happening. Ahead of its annual meeting this weekend, the IMF warned that private sector debt has climbed to a record US$100 trillion. At the same time the price of financial assets has soared, with the US stock market setting a new all-time high in August. Yet according to the IMF, in the advanced economies gross fixed capital formation, the broadest measure of investment in new stuff, has slumped to just 1.4 per cent, down from 3.1 per cent before the financial crisis – and economic growth has shrunk accordingly.
In a healthy economy, interest rates should be set high enough to discourage the growth of excessive leverage and rampant financial engineering, but not so high as to deter entrepreneurs from investing capital in productive new business projects. Determining where this sweet spot for interest rates lies is tricky. Adjusted for inflation, it’s probably a shade below the real trend rate of economic growth. In nominal terms that suggests benchmark interest rates in the developed world should currently be somewhere in the vicinity of 2 to 3 per cent.
One thing is certain, though: interest rates should not be at zero – or negative. But don’t expect central bankers to raise rates to their optimum level any time soon. If they did, they would immediately precipitate a devastating financial crisis as all the excessive leverage built up over the years when interest rates were too low would be forced to unwind. Instead expect policymakers to stick to their low rate orthodoxy in an evermore desperate attempt to conjure up growth and inflation – an attempt that is destined to fail, because low interest rates aren’t the cure for the developed world’s economic sickness, they are its cause.
Tom Holland is a former SCMP staffer who has been writing about Asian affairs for more than 20 years