Low interest rates in the US and Greece are not a sign of recovery, but a warning of permanent stagnation, creating the potential for future financial instability
By Jeremy Warner: It is now nearly seven years since the start of the financial crisis, yet despite growing evidence in America and Britain of a return to relative normality, something remains profoundly broken at the heart of the world economy. One manifestation of this – much discussed among the officials, finance ministers and central bankers gathered in Washington this week for the spring meeting of the International Monetary Fund – is the persistence of unnaturally low interest rates.
Sometimes, economic developments creep up on you almost unawares – and then, all of a sudden, they are the established reality. One such phenomenon is now almost universal: even in Spain, long-term rates have fallen to the point where they are almost as low as in the US – a dramatic turnaround given that as recently as two years ago, yields on Spanish government bonds were off the scale over fears of a sovereign debt default. Even Greece, so bad a basket case that most of its sovereign debt had to be written off, has this week been able to tap the markets for new money at rates of close to 5 per cent. Two years ago, Greek bonds were yielding six times that.
Optimists hail this change as evidence that Europe is finally out of the woods. To some degree this is true. A series of 11th-hour interventions by the European Central Bank (ECB) – at just the point that it looked as if it was all over for the beleaguered euro – have succeeded in calming the crisis. But it is also indicative of a much more worrying possibility: the emergence of a permanently low-growth, low-inflation, or even deflationary world.
At the start of the crisis, abnormally low interest rates were considered a temporary, but necessary, aberration that would disappear as soon as advanced economies got back on their feet. The general assumption was that over time, both short- and long-term interest rates would drift back to pre-crisis levels.
At the start of the crisis, abnormally low interest rates were considered a temporary, but necessary, aberration that would disappear as soon as advanced economies got back on their feet. The general assumption was that over time, both short- and long-term interest rates would drift back to pre-crisis levels.
This can no longer be taken for granted. A return to the good old days is looking ever more questionable. What economists call the natural, or “equilibrium”, rate of interest may have settled at a permanently lower level, with dramatic long-term implications for investment flows, savings and asset prices.
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Very low interest rates are, in essence, the natural corollary of a stagnating economy. And that, at root, is what the newly deflated Spanish bond yield is telling us. This is not, as the government in Madrid would like to believe, a sign of a resurgent economy, but rather of an economy that is likely to remain stuck with unemployment at near-record highs for years to come. Indeed, the markets assume the situation is so bad that the ECB will eventually have to abandon its scruples and start engaging in quantitative easing, forcing interest rates lower still.
Low rates are also a reflection of what market veterans call “searching for yield” – a trend much in evidence before the crisis, and one of its main underlying causes. If rates of return on conventional assets are poor to non-existent, investors will chase higher-risk investments, which in theory offer better value. Eventually, these yields too will get compressed, as more money pours in. In such circumstances, even Greek sovereign debt becomes attractive.
When real interest rates are very low, investors will inevitably chase their way up this “yield curve”, thereby creating new asset bubbles and the potential for future financial instability. This is precisely what is concerning those in Washington. In its latest Global Financial Stability Report, the IMF warns about such dangers, citing the return in the US of record levels of junk-debt issuance, and of so-called “covenant-lite” lending, where normal credit safeguards are waived.
Money has rarely been as abundant and cheap, but there is nowhere productive for it to go. So instead it gets invested in junk, risky emerging market assets, or in another bubble in the UK housing market. Central bank money-printing has made matters worse. While early fears that quantitative easing would drive up price inflation have proved wide of the mark – it has, for instance, self-evidently done nothing for wages – it has certainly supported asset prices, as reflected in the UK’s current explosive house prices.
Today, George Osborne – flush with pride at Britain boasting the best rate of growth in the G7 – will give a speech to the American Enterprise Institute. Only a year ago, he was accused by the IMF’s chief economist, Olivier Blanchard, of “playing with fire” by pursuing austerity in the face of a stagnant economy, so he is entitled to a little self-congratulation. He’s proved the “deficit deniers” wrong; and now that they’ve switched tack to complain instead of “secular stagnation” – a permanently low state of growth – he’s determined to prove them wrong again.
Yet the Chancellor must avoid any temptation to crow. Austerity, such as it is, has not prevented the UK economy from growing anew, but whether the sort of growth the Chancellor and the Bank of England have engineered is sustainable remains very much open to question. If it is only a resurgent housing market that is firing up the UK economy anew, then he has plenty to worry about.
And here’s where it gets confusing. For although the IMF is warning of the dangers of a renewed search for yield, it still thinks the world economy too weak to withstand a return to higher interest rates. On the one hand, the IMF advocates the maintenance – and in Europe even extension – of “unconventional monetary policies” to prop up demand. On the other, it warns of the renewed financial instabilities these policies will eventually create.
Unfortunately, no meaningful way of squaring the circle is offered. Instead, the IMF puts its faith in the ability of central banks and regulators to micro-manage the expansion of credit through the use of “macro-prudential” tools. In Britain, this would involve the Bank of England taking the steam out of the housing market not by raising interest rates, which it is assumed would only destroy jobs, but by tightening up on mortgage lending conditions, so that funding for property purchases becomes scarcer and more costly than in other areas of the economy.
I very much doubt this is going to work. When the crisis first hit, the Bank of Spain claimed to have everything under control, on account of its unique system of macro-prudential capital control. In the event, this proved about as useful as an umbrella in a hurricane. Regulators flatter themselves in thinking that they can outwit markets.
In any case, the IMF’s latest World Economic Outlook comes to the conclusion that real long-term interest rates are never going to return to pre-crisis normality – or not within any foreseeable time horizon. They may rise a bit, but they won’t go back to the sort of levels we were used to.
If this is right, it points to a deeply depressing future for advanced economies, one of permanently low investment in productive activity and repeated bouts of financial instability. If the Chancellor wants to prove the IMF wrong all over again, he needs to be much more ambitious with supply side measures that genuinely improve Britain’s productive potential. In seeking only to return the economy to the way it was, he’s been far too timid.
Low rates are also a reflection of what market veterans call “searching for yield” – a trend much in evidence before the crisis, and one of its main underlying causes. If rates of return on conventional assets are poor to non-existent, investors will chase higher-risk investments, which in theory offer better value. Eventually, these yields too will get compressed, as more money pours in. In such circumstances, even Greek sovereign debt becomes attractive.
When real interest rates are very low, investors will inevitably chase their way up this “yield curve”, thereby creating new asset bubbles and the potential for future financial instability. This is precisely what is concerning those in Washington. In its latest Global Financial Stability Report, the IMF warns about such dangers, citing the return in the US of record levels of junk-debt issuance, and of so-called “covenant-lite” lending, where normal credit safeguards are waived.
Money has rarely been as abundant and cheap, but there is nowhere productive for it to go. So instead it gets invested in junk, risky emerging market assets, or in another bubble in the UK housing market. Central bank money-printing has made matters worse. While early fears that quantitative easing would drive up price inflation have proved wide of the mark – it has, for instance, self-evidently done nothing for wages – it has certainly supported asset prices, as reflected in the UK’s current explosive house prices.
Today, George Osborne – flush with pride at Britain boasting the best rate of growth in the G7 – will give a speech to the American Enterprise Institute. Only a year ago, he was accused by the IMF’s chief economist, Olivier Blanchard, of “playing with fire” by pursuing austerity in the face of a stagnant economy, so he is entitled to a little self-congratulation. He’s proved the “deficit deniers” wrong; and now that they’ve switched tack to complain instead of “secular stagnation” – a permanently low state of growth – he’s determined to prove them wrong again.
Yet the Chancellor must avoid any temptation to crow. Austerity, such as it is, has not prevented the UK economy from growing anew, but whether the sort of growth the Chancellor and the Bank of England have engineered is sustainable remains very much open to question. If it is only a resurgent housing market that is firing up the UK economy anew, then he has plenty to worry about.
And here’s where it gets confusing. For although the IMF is warning of the dangers of a renewed search for yield, it still thinks the world economy too weak to withstand a return to higher interest rates. On the one hand, the IMF advocates the maintenance – and in Europe even extension – of “unconventional monetary policies” to prop up demand. On the other, it warns of the renewed financial instabilities these policies will eventually create.
Unfortunately, no meaningful way of squaring the circle is offered. Instead, the IMF puts its faith in the ability of central banks and regulators to micro-manage the expansion of credit through the use of “macro-prudential” tools. In Britain, this would involve the Bank of England taking the steam out of the housing market not by raising interest rates, which it is assumed would only destroy jobs, but by tightening up on mortgage lending conditions, so that funding for property purchases becomes scarcer and more costly than in other areas of the economy.
I very much doubt this is going to work. When the crisis first hit, the Bank of Spain claimed to have everything under control, on account of its unique system of macro-prudential capital control. In the event, this proved about as useful as an umbrella in a hurricane. Regulators flatter themselves in thinking that they can outwit markets.
In any case, the IMF’s latest World Economic Outlook comes to the conclusion that real long-term interest rates are never going to return to pre-crisis normality – or not within any foreseeable time horizon. They may rise a bit, but they won’t go back to the sort of levels we were used to.
If this is right, it points to a deeply depressing future for advanced economies, one of permanently low investment in productive activity and repeated bouts of financial instability. If the Chancellor wants to prove the IMF wrong all over again, he needs to be much more ambitious with supply side measures that genuinely improve Britain’s productive potential. In seeking only to return the economy to the way it was, he’s been far too timid.
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