The Downside of Easy Money

A recent paper by William White, Chairman of the Economic Development and Review Committee at the OECD, looks at the balance between the desirable short-term effects and undesirable long-term effects of central bank easy money policies.  Here we go.

As we all know, central banks in both advanced and emerging market economies have lowered interest rates to the zero lower bound (ZLB).  On top of that, they have taken other actions which have caused their balance sheets to swell to unprecedented levels, loading up with increasingly risky assets.  By doing this, advanced economies have pushed their exchange rates down against the currencies of the emerging markets.  Central banks of emerging market countries have resisted these moves and have increased their reserves of foreign exchange to record levels (i.e. by buying advanced market currencies, they push the price of the currency back up when compared to their own), swelling their own balance sheets to record levels.  When looked at through historical lenses, all of these central bank machinations are unprecedented even during the Great Depression; going back to 1954, short and long term rates have never reached such low levels for so long as shown here:

During the Great Recession, the world's major central banks implemented measures to restore stability. Even after it appeared that the world economic situation was stabilizing after the implosion of Lehman Brothers in the fall of 2008, central banks kept easing largely because it was believed that the duration of the Great Depression was lengthened because there had been insufficient easing.  As well, the governments of advanced nations were reluctant to use more fiscal stimulus because of growing concern about sovereign debt levels.  This left central bank policies as the "only game in town", meaning that interest rates were the only measure that could stimulate aggregate demand by stimulating the use of credit.

Why are these low interest rates so dangerous?   Let's look at several problems that are cropping up:

1.)  Bond Bubble:  Many economists believe that these rates could be creating another asset bubble that will eventually burst in a most painful manner, this time, in the world's bond markets.  Long term rates in countries that appear to be most creditworthy could still rise due to fears among the holders of sovereign debt (counterparty fears) since the required change in government spending habits to reach fiscal balance are practically impossible.

2.) Consumer Lack of Confidence:  Lower interest rates are used to push consumers to spend now rather than save for later since there is no reward for saving.  Unfortunately, as interest rates have dropped to unprecedented levels, consumers "smell" desperation on the part of central bankers and this can (and perhaps has) depressed consumer confidence and their willingness to spend.  Since the Great Recession, it appears that the public has lost confidence in the ability of central banks in advanced economies to implement policies that will fix joblessness, housing price declines and, in some countries, control inflation. 

3.) Low Return on Savings:  Lower rates are a two-edged sword.  On one hand, borrowers see their disposable income increase as interest rates drop.  On the other hand, older people living off the returns from their accumulated assets see their investment returns plunge, necessitating cutbacks in consumption.  When the older savers cut back spending more than the increase in spending by those who borrow, overall household consumption levels fall and GDP grows at a lower rate.

4.) Boom and Bust Cycle Enhancement:  Since the middle 1980s, central banks have been successively more aggressive at both pre-empting downturns (i.e. after the 1987 stock market crash) or responding to downturns (i.e. 1991, 2001 and 2008).  Each of these actions set the stage for the next "boom and bust cycle" which was fuelled by easier credit and expanding debt.  Here is a paragraph from the article:

"From the perspective of this hypothesis, monetary easing after the 1987 stock market crash contributed to the world wide property boom of the late 1980’s. After it crashed in turn, the subsequent easing of policy in the AME’s (Advanced Market Economies) led to massive capital inflows into SEA contributing to the subsequent Asian crisis in 1997. This crisis was used as justification for a failure to raise policy rates, in the United States at least, which set the scene for the excessive leverage employed by LTCM and its subsequent demise in 1998. The lowering of policy rates in response, even though the unemployment rate in the AME’s seemed unusually low, led to the stock market bubble that burst in 2000. Again, vigorous monetary easing resulted, as described above, which led to a worldwide housing boom. This boom peaked in 2007 in a number of AME’s, seriously damaging their banking systems as well. However, in other AME’s, the house price boom continues along with still rising and often record household debt ratios. This latter phenomena, as well as other signs of rising inflation and other credit driven imbalances in EME’s, reflects the easy monetary policies followed worldwide in the aftermath of the crisis."

Apparently, central bankers are slow to learn from their past mistakes.

5.) Government Debt:  Lower short-term rates are impacting the structure of government debt as governments rely on shorter and shorter financing.  This leaves them very vulnerable to interest rate risks when rates begin to rise.  As well, very low rates impose a false sense of confidence in the sustainability of government fiscal strength.  Low rates mislead governments into thinking that they have no need to impose austerity measures until sometime far in the future.

6.) Income Inequality:  It is possible that ultra-low interest rates are in some way responsible for growing income inequality around the world.  On a corporate level, rising profits have largely been driven by the financial sector; this sector systematically exploits their knowledge of the system to increase gains from both fees and market movements.  Those individuals who are wealthy enough to have savings, invest on a leveraged basis, making profits as asset prices rise during a boom.  During a bust, these individuals may lose a small part of their accumulated wealth but it is those of the middle classes that see their accumulated assets transferred to the wealthy.  Members of the lower classes see their access to credit disappear along with their jobs as an economic bust takes hold during a downturn.

7.) Financial Sector Viability:  Low interest rates have threatened the viability of some parts of the financial sector.  Low rates have made money market mutual funds a "mug's game" as asset returns are often not sufficient to cover operating costs.  Insurance companies have seen declines in returns on their portfolios which has led to the lowering of dividends, raising of premiums and reduced payouts to the insured.

From this posting and William White's analysis, I hope that you can see that central bank ultra-low interest rate policies have a limited ability to stimulate "strong, sustainable and balanced growth" in the economy.  Low interest rate policies have a wide range of undesirable effects that show quite clearly that "...aggressive monetary easing in economic downturns is not "a free lunch..." no matter what Mr. Bernanke would have us believe.

The Painful Impact of Ultra-Low Interest Rates

We are all quite aware that we are living in an ultra-low interest rate environment thanks, in large part, to the creative efforts of the world's central bankers.  This environment was created in response to the near collapse of the world's economy during the Great Recession and has been carried forward into the third year of the so-called "recovery" as a desperate means of stimulating a rather sick world economy back to health.  Thus far, the response of the world's economy to all of this cheap credit has been a resounding and reverberating "Meh".

Just so we can get a sense of how low interest rates really are compared to historic norms, here is a graph showing the benchmark interest rate for the United States since 1972:

Here is a graph showing the benchmark interest rate for the United Kingdom since 1972:

And, finally, here is a graph showing the benchmark interest rate for Canada since 1990:

While the central bankers of the so-called "developed nations" ponder why the world's economy seems so unresponsive to all of their machinations, there may be an explanation.  While this particular posting pertains to details about the issue in one nation, the same cause-effect relationship applies to all nations that are currently experiencing near-zero interest rates.

UHY Hacker Young, a United Kingdom-based accounting firm, has released a study showing that low interest rates are responsible, in part, for damaging the economy.  UHY estimates that the combination of high inflation (a United Kingdom Retail Price Index (inflation rate) of 3.5 percent) in combination with near-zero interest rates on savings and current accounts has resulted a decline in the value of the nation's savings.  UHY estimates that U.K. savers are losing nearly £18 billion per year as inflation erodes the value of their savings, even on higher interest savings accounts and longer-term locked-in investments.  While I realize that this data is specific to the United Kingdom, the same issue faces savers in Canada, the United States and other nations where interest rates are at or near historic lows.

The Bank of England reveals that over £115 billion is currently deposited in U.K. bank accounts that are yielding zero percent interest.  To put this number into perspective, these savings work out to just over 7.5 percent of the United Kingdom's GDP for 2011.  Since smaller investors experienced frightful capital losses during the stock market collapse of 2008 - 2009, many retirees, in particular, are cautious about seeking the higher returns that could be available by investing in equities.  Many would prefer to see their real net worth drop as inflation slowly eats away at their nest egg rather than to suffer from the sudden shock of a cliff-like decline in the stock market.  Despite historically low returns on savings, the United Kingdom household savings ratio was 7.7 percent in the fourth quarter of 2011 and 7.4 percent for all of 2011, up from 7.2 percent in 2010.

With no return on relatively risk-free savings, savers are much more likely to spend less.  Since much of the developed world's economies relies on consumer spending for continued growth, cutbacks in household spending on all of those wonderful toys and other non-essential items will be curtailed, ultimately having an impact on economic growth around the world.  This is a prime example of the law of unintended consequences; central bank actions may actually be hurting the economy rather than helping it.  

Thanks to QE, banks around the developed world are getting away with paying savers very little or nothing for their savings, generally offering rates that are well below the rate of inflation.  This means that your savings today are worth less in the future as inflation quickly eats up any investment income.  On the upside for the ruling class, extremely low interest rates mean that governments around the world can continue to spend far more than what they are bringing in because the interest owing on their debt is not punitive....at least, not yet.