The Paradox of Low Interest Rates
Cheap credit is hindering deleveraging, along with economic growth
At the low-point of the Great Recession, in March 2009, when $30 trillions of global wealth vanished inexplicably, central bankers of the world converged on a clear prescription: “deleverage, you must!” was the unarguable path to alleviate the unprecedented levels of debt carried by rich countries.
The deleveraging imperative, or the necessity to shed some weight from the financially overburdened nations, became the new mantra. Central bankers, starting with the Fed and later accompanied by the ECB and others, thought they had figured it out: by dropping interest rates as low as possible they would facilitate debt reduction or rescheduling and, also, prevent an economic contraction, in the hope that conventional growth would ensue. They also taught inflation wasn’t a threat, but rather deflation was.
The Bank of International Settlements (B.I.S) , which acts as the central bankers’ bank worldwide, was so concerned about the level of public and private debt accumulating in the developed world that in 2011 it undertook some pointed research in that direction. Their research suggested that a total-debt-to-GDP ratio of about 260% would seriously hamper economic growth. Furthermore they went on to document that for the 18 OECD economies, the well-off nations of the world, that ratio stood at 169% in 1980 (ex-financial sector debt), significantly below the 306% “growth-killer” attained in 2010. “Deleverage, or else”, couldn’t have been clearer, especially for countries like Greece, Italy and Portugal whose debt outdistanced economic growth over a long 30 year stretch.
Moreover, in 2009, the distribution of the excessive debt itself varied from country to country, much like excess weight that accumulates in different parts of the human body. Certain countries like Italy and Spain had their business sector overextended with debt, Japan and Greece were top-heavy with accumulated government deficits, while the US, UK and Netherlands stood out with overstretched households and overexposed banks.
The European sovereign debt crises that followed in the next few years confirmed once more that government debt reduction was the hardest type of deleveraging there was. Without tax increases, assisted by other relevant reforms, this one was hard to shrink.
Ironically, the B.I.S study had excluded the impact of financial sector leverage – the primary culprit of the Great Recession on both sides of the Atlantic – from their analysis. In other words their model was a best-case scenario which assumed that all financial institutions that destabilized the global system would all deleverage in a hurry for their own sake.
So, where does the world stand now with the deleveraging imperative? The answer is unquestionably worse off. According to the International Center for Monetary and Banking Studies based in Geneva, world’s total debt-to-GDP (ex-financials) has climbed about by as much after the Great Recession than it did in the 7 years preceding it, straight up -- without even a brief pause! Moreover, emerging markets have also been joining the chorus, with China in the front row, for credit growth surging well above economic output growth.
Well, what about banks and other financial institutions? It doesn’t look good there either: with the notable exception of the US, most of the big banks in the EU remain “too big to bail”, while Chinese banks are working overtime to increase business and consumer loans. For cynics, the global economic crisis is seemingly morphing into a global leverage crisis.
Yet, America stands out slightly ahead in global deleveraging, with a measurable reduction in the debts of its Financial and Household sectors. However, that was accomplished at two costs: incremental public debt in excess of $5 trillion by 2014 – representing an insidious liability transfer from the private sector to an ill-prepared and unsuspecting government – combined with the burden on its central bank, the Fed, which ended-up with $4 trillion of bonds as the collateral risk associated with the still inconclusive QE programs.
Alas, it seems that the valuable lessons from Japan’s 20 year-long struggle to overcome stagnation with cheap and abundant credit are not being heard: QE and ZIRP just buy time to get debts and deficits in order, but they do not eliminate them. The latter requires true economic value creation and not just monetary policy tricks. One paradox of cheap credit is that, in perverse contrast with expectations, it did not induce aggregate debt reduction but its continued accumulation in just about every country in the world.
What about the goal of stimulating economic growth? You wish. After almost seven years, and despite exceptional measures with record-low interest rates augmented with QE monetary experiments by many central banks, it is still unclear that the path to sustainable growth for the rich countries of the world has been found. Furthermore, the sovereign debt of a few rich countries still contain significant risks, signaling more disruptions ahead.
The outlook for growth isn’t much promising in the US either: not only is there no magical turnaround, but excessively low-cost credit has already demonstrated to widen income distribution disparities to undesirable levels, weakening thereby broader consumer spending on which the recovery so desperately depends. And therein lies the second part of the paradox: negligible interest rates seem to hamper economic growth, instead of promoting it.
By now it is clear that, on the back of a failed deleveraging process everywhere, repressing savers with negligible interests while inviting financial asset-based inflation – primarily record equity values, levitated by investors’ thirst for higher yield at the hidden cost of heightened risks – have proven unlikely to generate nationally constructive business investments, increased consumer spending or improved confidence about the future anywhere – all essential ingredients to sustainable economic growth.
When will the rich countries of the world, starting with the US, realize that the prosperity of nations depends more on smart policy choices than experiments with monetarism?
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