Commentary on Political Economy

Tuesday 9 February 2021

Cheap money addiction will be hard to shake

What could be wrong with cheap money? A great deal when central banks do not know when to stop.

Satyajit DasContributor

Central banks globally aren’t thinking about thinking of normalising interest rates. With the price of money near its zero bound, authorities are increasing its supply through multiple rounds of quantitative easing.

Cutting interest rates is now standard operating procedure for financial collapse, economic crises, pandemics and, one suspects, even for an alien invasion. While undoubtedly useful, excessive reliance on this policy lever is dangerous. Central banks should heed Winston Churchill’s admonition to occasionally look at the results no matter how beautiful the strategy.

US Federal Reserve chairman Jerome Powell. The Fed Open Markets Committee has opened a money tap it can’t shut.  The New York Times

First, the effect on real economic activity may be limited and uncertain. Low rates do not necessarily increase the supply of credit because of banks’ risk aversion and unwillingness or inability to pass on rate cuts fully. Business and individual demand for credit is based on needs and borrowing capacity. In the absence of income certainty, investment and consumption decisions are not driven solely by the cost of debt.

Low rates and the resultant reduced cost of capital encourages substitution of labour with automated production techniques. There may also be a shift from bonds into equities in search of income. Investors force companies to increase dividends and undertake share buybacks. To meet these pressures, companies must boost cash flow and earnings by shedding workers and reducing investment. The process increases share prices and shareholder returns but is bad for the overall economy. Given that 60 per cent to 70 per cent of activity in developed economies is driven by consumption, reduced employment and wages is unhelpful.

Lower interest levels may perversely encourage greater saving, including for retirement, to provide for future needs, also reducing consumption and demand.

Mispricing of risk

Low interest rates frequently target currency devaluation to increase a nation’s export competitiveness. This may not work where, as now, most countries have similar policies. Since the Reserve Bank’s last rate cut, the Australian dollar has risen by more than 10 per cent against the US dollar and by a smaller amount on a trade-weighted basis. Smaller countries are at a disadvantage in currency wars, battling nuclear-armed opponents with imported Swiss Army knives.

Second, low interest rates encourage mispricing of risk, creating asset bubbles and ultimately financial instability. It drives a “dash for trash” as investors switch to high-dividend-paying shares, low-grade debt and risky-structured products to replace lost income. Low rates favour borrowing, encouraging businesses to substitute debt for equity, increasing leverage.

Given the reliance on this regime for over a decade, current settings may be difficult to change.

Low rates feed asset price inflation, as future cash flows are discounted at ever lower rates and the search for diminishing income squeezes risk premiums. Overvaluation reduces future returns and also heightens risk. Minimal opportunity costs allow investors, speculating on price increases, to purchase non-productive investments, reducing the flow of capital and economic activity.

It distorts financial activity. This is the “bad news is good news” syndrome as poor economic performance drives price rises anticipating additional monetary accommodation.

Long-term reliance on low rates encourages zombie economies. Weak businesses survive, directing cash flow to service the minimal interest payments on loans that cannot be repaid but that banks will not write off. With capital tied up, banks reduce lending to productive enterprises, especially small and medium-sized ones, which account for a large portion of economic activity and employment. Firms do not dispose of or restructure underperforming investments, reducing long-term productivity and returns.

Third, it is easy to cut rates and print money but the true test is the ability to withdraw temporary support. Given the reliance on this regime for more than a decade, current settings may be difficult to change. High and ever-increasing debt levels encouraged by low rates are unsustainable when they increase. Financial instability engendered by the US Federal Reserve’s attempts to normalise rates in 2013 – “taper tantrum” – and in December 2018 highlight the dangers of reversing these policies.

The true reasons for low rates are different. Monetary policy has supported asset prices through successive shocks to protect the financial system by preserving the values of loan collateral. Low interest rates subsidise financial institutions, allowing them to borrow cheaply and then invest in higher-yielding safe assets such as governments bonds. Low rates and QE help finance governments, with central banks now purchasing a substantial proportion of new issues to support government spending.

Monetary actions substitute for governments equivocal about using fiscal policy and implementing structural reforms. They are not designed to deal with an economic slowdown because of a public health issue and prophylactic actions, especially lockdowns and movement restrictions, to control infections. Current policies represent short-term relief purchased at great cost by policymakers to cover up fundamentally unsound economic structures, chronic stagnation and societal pressures, particularly persistent inequality.

The world is addicted to ever lower interest rates and QE. Protestations that these are merely short-term, emergency measures have the conviction of an addict’s insistence that he can give up any time, as long as it’s next week.

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Satyajit Das is a former banker. His latest book, released next month, is 'A Banquet of Consequences – Reloaded: How we got into this mess we’re in and why we need to act now’. 

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