The downside of persistently low interest rates isn’t obvious at first blush. Reduced borrowing costs for individuals and businesses alike clearly make it easier to purchase new equipment, buy a home or take out a consumer loan.
But if we want to shine a critical light on the effects of low interest rates (even as they increase spending capacity), we have to move gradually up the scale from common sense to counterintuitive reasoning.
Let’s start with common sense.
Low interest rates reflect a certain recognition that things aren’t going so well. After all, if central banks keep their policy rates at rock-bottom levels, it’s certainly because they feel that investment and consumer spending need a helping hand.
Moreover, the level of long-term rates – more than that of short-term rates – results from the natural equilibrium of supply and demand among market participants (unless central bankers step in as they did during the “asset purchase programme” years).
So if long-term rates stay extremely low, it’s presumably because there aren’t enough long-range investment projects to push up the associated financing costs.
A final explanation is that, with short-term rates unlikely to rise at a time of weak economic growth and negligible inflation, there’s no point in borrowing long-term – except at very low rates.
Right or wrong, such bearish sentiment works, at least to a certain extent, like a self-fulfilling prophecy.
This is particularly true in Europe, where economic activity is more directly dependent on bank lending, whereas US companies (mid- and large-cap) can turn more readily to capital markets for funding.
The fact is that low interest rates hurt the earnings capacity of European banks in three ways.
First, they make margins on loans highly visible, and thus harder to ‘sell’ to clients.
Second, a large part of a commercial bank’s activity involves borrowing short-term and then lending long-term at higher rates, thus earning a profit on ‘maturity transformation’. So that when long-term rates are no higher than short-term rates (or even lower), maturity transformation ceases to be profitable. That is the main problem with flat yield curves.
Third and last, the European Central Bank’s policies have driven short-term yields so low that they are now negative in several countries. In addition to being an unorthodox concept, negative interest rates mean that the cash held by banks costs them money instead of yielding a profit. Needless to say, the idea of charging retail customers for their deposits wouldn’t go over very well.
So extremely low interest rates are bad news for banks, which in turn is bad news for economic growth. The upshot is a vicious cycle that pulls interest rates further and further down.
Why? Because the self-fulfilling-prophecy aspect of low rates and flat or even inverted yield curves gets ratcheted up a notch.
Conscious of the feedback loop between low rates and a feeble economy, market participants begin to price in a downward spiral in interest rates. Low interest rates thus go from being a cure for weak economic growth to being a harbinger of it. We have come full circle: we’re on our way to the next recession.
From a macroeconomic standpoint, the reason why virtually free money is harmful is that extremely low interest rates allow companies to engage in relatively unprofitable investments – thereby encouraging the misallocation of capital, which creates very little wealth. In seeking to provide cheap credit, central banks have in fact blighted economies’ medium-term growth potential – and with it employment.
How do you explain this paradox?
In times of economic or financial crisis, an easy money policy makes sense, because it offers a powerful way to fend off the threat of a liquidity crunch that would cause the whole financial system to seize up, with disastrous consequences for the broader economy.
The trouble starts when free money becomes the new normal, with no underlying crisis conditions to warrant it. At that point, the nefarious side effects have taken hold, and it’s extremely hard to shake them off – unless you lift the curtain on all the distortions to financial asset prices and capital allocation that have built up over the years.
Above all in Europe, it is precisely this dark side of central-bank power that is revealed by today’s excessively low interest rates.
Didier Saint-Georges is a member of Carmignac’s investment committee. The views expressed above are his own and should not be taken as investment advice.