Making Sense of Bottomless Interest Rates

A friend of mine, knowing I had some background in economics, asked me whether I could write something to make sense of today’s extremely low interest rates. He finds it puzz­ling. I did too. So, I decided to try to make sense of it all. Partly, it is a race to the bottom, I concluded. Partly it is the studied and persistent application of an economic theory in the face of clear evidence that it isn’t working. Finally, it is the product of having dug a hole so deep that it is impossible to climb out.

Those setting interest rates on the world stage cannot afford to be laggards when it comes to lowering them. Fashion provides an analogy. Think of the business risks for fashion houses of lengthening skirts when shorter skirts are all the rage. The momentum is on the side of making them shorter still. But there is a natural limit. Such a limit was reached, if my memory serves, at the close of the 1960s or early 1970s when skirts, having nowhere else to go, became longer. You would think that lowering interest rates would also have a natural limit. And there is one. Not many people would agree to hold bank deposits on which negative interest applied. At some early point they would choose to hold cash instead. The powers that be are alive to this rational human reaction.

This essay appeared in a recent Quadrant.
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The European Commission recently flirted with the idea of imposing limits on the value of cash payments; though, thankfully, for now, it has put aside legislative action. Meanwhile, researchers at the International Monetary Fund (Agarwal and Kimball, “Breaking Through the Zero Lower Bound,” October 23, 2015) applied their minds to devising a mechanism which would allow negative interest rates by discounting the value of cash payments as against electronic transfers of bank deposits. Effectively, this would penalise customers when paying bills in the form of cash. Hopefully, this research will remain in the back room.

We shall have to see where this all goes. But whichever way it goes, it is difficult, at this stage, to see what will trigger a rebound of interest rates into more normal territory. And why is that? Because extremely low interest rates, contrary to conventional wisdom, tend to prevent the kind of robust economic recovery that would lead central banks, and financial markets generally, to adjust rates upwards. It has produced a kind of madness. Central banks lower interest rates to get economies moving. It doesn’t work. Hoping to get a different result, central banks again lower interest rates, and even into negative territory.

In order to flesh out the story, I will set the scene prosaically with recent decisions of four prominent central banks. Bear with me.

The Bank of England (BoE) kept its Bank Rate (the base rate used by banks to determine their lending and deposit rates) steady at 0.75 per cent on September 18. This compares with an average of about 5.5 per cent in 2007. And, roughly speaking, this historical comparison applies across all jurisdictions. I have gone to the BoE first because it sets out the (Keynesian) economic case for low interest rates in plain terms, as follows:

The Bank of England … sets monetary policy to meet the 2% inflation target, and in a way that helps to sustain growth and employment … A low Bank of England rate encourages people to borrow money because it’s less expensive for them to repay. The less you spend repaying debts, the more money you can spend elsewhere. More spending makes for a more buoyant economy.

The Reserve Bank of Australia lowered the cash rate (the rate at which banks lend to each other overnight) from 1 per cent to 0.75 per cent on October 1. The economics is a little less plain but what isn’t is the expressed need to follow global trends. The relevant part of the press release announcing the decision is as follows:

The Board took the decision to lower interest rates further today to support employment and income growth and to provide greater confidence that inflation will be consistent with the medium-term target [2 to 3 per cent]. The economy still has spare capacity and lower interest rates will help make inroads into that. The Board also took account of the forces leading to the trend to lower interest rates globally and the effects this trend is having on the Australian economy and inflation outcomes.

The US Federal Reserve lowered the federal funds rate (equivalent to the RBA’s cash rate) on September 18 by 0.25 per cent, to a range of 1.75 to 2 per cent. The relevant part of the Fed’s press statement is as follows:

Weakness in global growth and trade policy uncertainty have weighed on the economy and pose ongoing risks. These factors, in conjunction with muted inflation pressures, have led us to shift our views about appropriate monetary policy over time … Of course, this is the role of monetary policy—to adjust interest rates to maintain a strong labor market and keep inflation near our 2 per cent objective.

The European Central Bank (ECB) lowered the rate banks receive for overnight funds deposited with the ECB by 10 basis points to minus (yes, minus) 0.5 per cent on September 12. The relevant part of the announcement is as follows:

The Governing Council now expects the key ECB interest rates to remain at their present or lower levels until it has seen the inflation outlook robustly converge to a level sufficiently close to, but below, 2% within its projection horizon, and such convergence has been consistently reflected in underlying inflation dynamics.

You will notice that each central bank is aiming to lift inflation to around 2 per cent. This is a proxy. The goal is not per se to lift inflation but to increase economic growth and lower unemployment. The thinking is that low inflation has its counterpart in sluggish growth. Otherwise labour market pressure would lift wages and in turn prices.

Keeping interest rates at historically low levels is not working. We know that because the trend on the whole has been to push them lower and lower and to signal a preparedness to do more of the same, including bouts of quantitative easing (buying up bonds in the marketplace). Mind you, it’s worth pointing out, for reasons associated with Donald Trump’s deregulatory and taxation policies, that the US economy is well out-performing its competitors. Still, Trump wants more; hence his unrelenting pressure on the Fed to match other central banks.

Matching is the key. Countries with higher interest rates tend to attract financial capital unless, of course, they are dodgy failing states with plummeting currencies. There is no point in earning 30 per cent interest in Venezuela when the bolivar is crashing. But, other things being equal, the higher are interest rates, the more capital flows in, the higher the exchange goes and, perforce, the less competitive becomes domestic industry. The result can be higher unemployment and lower inflation.

It is untenable for one country to stand out from the crowd. Hence the race to the bottom which I referred to above. Trump sees this clearly. He knows that his policies have more than offset the competitive disadvantage of having higher interest rates, at least for the time being. But why accept the handicap, he no doubt thinks.

One thing is clear: the economic and financial crisis of 2008 to 2010 set the stage for low interest rates. Brought in universally to stimulate economies, they didn’t stimulate economies nearly enough. As I will argue, it is by no means clear that lower and yet lower interest rates ever could. But, as they didn’t, they have been brought down close to zero and beyond out of sheer Micawber-like hope that the past is no guide to the future. And, also, out of fear of breaking ranks. So, we’re stuck with them. Pensioners getting next to nothing on their bank deposits are collateral damage. Nothing personal, as the crooks say in the movies before disposing of their adversaries.

Unfortunately, there is an evident lack of sophistication when it comes to understanding the effect of low interest rates on economic growth. Keynes is not to blame for all economic ills but he plays a part in most. He set the rate of interest against the expected return from an amalgam of all business capital investments. It is a conceptual macroeconomic perspective which hides the differentiated and nuanced actual microeconomic world of individual decision-makers.

Take any business investment. A lower rate of interest will make it more attractive. That is true. Ergo, a lower rate of interest will produce more investment, more employment and more growth. That is not true. It is a non sequitur. Though Nobel Prize-winner Paul Krugman (New York Times, March 14, 2015) doesn’t think it is:

Of course we want to understand things as well as we can, but is it unreasonable to assume that lower interest rates mean higher demand under pretty much any detailed story. A foolish insistence on micro-foundations at all times and no matter the issue is the hobgoblin of little minds.

I will explain why my mind, according to Krugman, is on the smaller side.

As with any price, the rate of interest rations demand. In the case of the rate of interest, it acts to filter out those investments which have an expected return insufficient to cover borrowing costs. It follows, as the former BoE governor Mervyn King argues in The End of Alchemy, that untowardly low interest rates can “encourage bad investments”—investments, in other words, which ordinarily would be filtered out in normal times. While the term “bad investments” unduly narrows the scope of the problem, it does point to the heart of the matter.

Capitalism is not a neat system. It is a dynamic system filled with false steps, ups and downs. It is a living system (see my article “Prospects for Economic Growth in a Finite World,” Quadrant, December 2014) whose growth depends on doing tomorrow what cannot be done today. Standing still is not an option, which is the reason why those who would like growth to stop, say, in the interests of the environment, are deluded and misinformed. Precisely because capitalism is a living system, growth can go on and on, without limit, and must. And I don’t mean the kind of growth which comes from simply importing more people (to which Australia’s federal treasury seems attached), I mean growth which lifts everybody’s standard of living. What drives that kind of growth is the question.

What doesn’t drive it are bad investments. More expansively, what doesn’t drive it are run-of-the-mill investments. These are investments in residential buildings or in factory expansions or in anything which either makes nothing (like a house) or which uses tried-and-true existing technology. Growth is driven by businesses and entrepreneurs doing new things. By definition, this brings great risk along with the potential of great reward.

Now set interest rates at extremely low levels and take two projects. One is safe, offering a sure and certain return in single digits. The other is highly risky, offering a potential return in tens of digits. I suggest that the available savings will tend to be drawn disproportionately to the safe investment. Why take a risk if a perfectly acceptable riskless return can be earned? That would not nearly be the case if borrowing costs cut significantly into the returns available from the safe investment. Low interest rates steer the economy away from adventure towards the humdrum. The result is anaemic growth. And it becomes a fool’s errand to lower rates still further to stimulate growth.

Incidentally, if a business-driven tendency towards lower-value investments in the current climate were not enough, the Governor of the Reserve Bank speaking on 29 October (Sir Leslie Melville Lecture) actually encouraged businesses to take advantage of low interest rates by lowering their hurdle rate of return on new projects. There it is. We are in the hands of those whose appreciation of economics is of Keynesian provenance.

Mark Carney, the current governor of the BoE, sought to explain low interest rates in a speech at John Moores University in Liverpool on December 5, 2016. “The unprecedented desire for safety has helped drive down the equilibrium interest rate [that] central banks must deliver,” he said. That might still be true as a hangover from the economic and financial crisis but the question is whether central banks are helping or hindering by giving in so assiduously to the desire for safety.

If they are hindering, as I hypothesise, then we are stuck. Central banks believe that low interest rates work to underpin economic activity, and they do to a limited extent but, at the same time, they keep economies in second gear. While economies remain in second gear, central banks are reluctant to raise rates. And compounding the problem is that no single central bank can afford to break ranks. Game, set and match. There seems no way out. True, this is a hypothesis. It cannot be proved. Nothing much can be proved in economics. Capitalist economies are too complex and fluid. Nevertheless, in my view, it offers a plausible explanation where none other exists.

It needs to be understood that we are only ever at the margin when considering economic activity. Whatever the state of play, the bulk of activity goes on day after day. The margin is all that matters. An economy growing at 3 per cent per annum is a full third larger in ten years than one that is standing still. Safe investments keep economies moribund. Policies that reward safe investments are complicit.

An ancillary factor might also be in play to keep economies subdued when interest rates are extremely low. In the classical economics world of John Stuart Mill and others, savings provide the wherewithal to fuel investment. Think of wanting to build a boat on a desert island. You first need to save some coconuts to tide you over while you’re building. And, by the way, nothing about complex modern economies makes this less true.

Low interest rates are assumed to reduce the availability of savings. People are more likely to save if there are greater rewards for doing so. If this is the case a shortage of savings might be holding back investment. Research is mixed. You can find papers that report finding a significant positive relationship between the rate of interest and the rate of saving and others that don’t. On balance it seems reasonable, at the least, to assume that low interest rates do not encourage saving and therefore that this too could be adding to the dilemma faced by central banks.

Is there a solution? Is there light at the end of the tunnel? Is it possible that we will see interest rates return to more normal levels in, say, three, four or five years?

One solution would be for central banks of industrial countries to agree collegiately to begin gradually raising interest rates, in lockstep, to more normal levels. And, while doing that, to bear the economic pain that this would cause. Asset prices driven up by low interest rates—property and shares in particular—would plummet and unemployment would almost certainly rise before it fell. And the chances of central banks so acting? Put it at zero. The only other glimmer of light on the horizon that I can see comes from transforming technological change.

Think of the development of the motor vehicle at the beginning of the twentieth century for an example. Almost within the blink of an eye, the horse and buggy gave way to the internal combustion engine. Within a few years, streets filled with horses became streets filled with cars. This was a transforming technological change.

Supposedly, the third or fourth (it depends on who you read) industrial revolution is already under way. It is often described as the digital revolution, comprising artificial intelligence, robotics, the internet of things, autonomous vehicles, 3-D printing, nanotechnology, quantum computing and the like. Some think it will bring breakthroughs at a pace without historical precedent. I simply don’t know. But, if it lives up to the hype, it could possibly precipitate growth that would let central bankers off the hook by getting inflation beyond that magical 2 per cent level that so occupies their minds. However, to be taken into account is an artificial deadweight holding economies back. That deadweight is climate change or, more to the point, what is being done about it.

Technological change works to transform economies by making new things and by making existing things much cheaper. Businesses and entrepreneurs pile in to take advantage of profitable opportunities. Profit drives the process of converting technology into employment and the production of goods and services. Making power more expensive and less reliable puts an obstacle in the way of profit; how much of an obstacle it is hard to say. Then there is also the large-scale development of electric vehicles and batteries. It is one thing if these developments were an expression of market forces. But they are not. They would not exist without government subsidies and penalties. They drag resources and, note, savings away from where they would be applied much more productively and profitably.

Climate change may be harming pensioners more than simply through increased power prices. It may well be contributing to keeping economic activity subdued and therefore to keeping interest rates low. It is not such a long bow.

What will I tell my friend? In a nutshell, that interest rates are abnormally low because we live in abnormal times. Central bankers have collectively dug a hole for themselves and show all signs of wanting to dig deeper. As it is, low interest rates are effectively preventing resources from being used adventurously and thus economies are performing poorly. And because economies are performing poorly central bankers won’t risk increasing interest rates.

Central bankers have made an enormous mistake. But perhaps that was an inevitable outcome of wrong-headed economics meeting dire economic circumstances. Not that this will be acknowledged. Luminaries at the Economist (October 11) sum up the Keynesian party line: “The ECB’s critics tend to miss the underlying cause of low interest rates: weak demand across most of the rich world.” Economists wouldn’t talk like that if they understood how economies actually work. However, even if central bankers had a road-to-Damascus experience, it is too late now for anything to be done which is not going to result in considerable and prolonged economic pain. As the Irishman said when asked for directions. “Well, sir, if I wanted to go there, I wouldn’t start from here.”

Peter Smith is the author of Bad Economics: Pestilent Economists, Profligate Governments, Debt, Dependency and Despair (Connor Court).