What happens when interest rates are kept too low for too long? It might sound like an academic question. But when the correct answer is “the 2008 global financial crisis,” you should sit up and listen more closely. Especially given where interest rates are now – the most out of whack in investing memory.
The Bank of England’s rates are going nowhere fast despite savings deposits returning close to zero while inflation is above 5% and mortgages are available at half that. This is a bizarre combination.
In the euro area, it’s much the same, but the central bank is refusing to budge on interest rates at all.
And in the United States, they’re panicking over the prospect of tight monetary policy which nevertheless gets nowhere near reining in inflation.
But all this inflation and interest rate talk is just one side of the story – the financial and monetary side, you might say.
Today, I want to talk about the real economy. What happens to the real economy when interest rates are kept too low for too long?
To answer this question, you need to understand that there are limited real resources in the real world. Space, people and physical resources like metal and oil being the most obvious constraints.
This stands in stark contrast to the monetary system, which can be manipulated by governments in spectacular fashion, well beyond the limits of rationality or reality.
Infinite amounts of money can be printed, interest rates can go below zero and an infinite amount of debt can be soaked up by central banks. Governments can knock zeros off of bank notes and bank accounts, or declare an entirely new currency into existence.
But, let’s get back to reality. The constraint of scarcity, as economists call it, means that the key economic question is how best to allocate resources to best meet our needs. Who should make what, where, how, using what, in other words.
A key part of this is the capital structure. Should farmers grow a mix of crops and livestock, or specialise in one of them? Should the nation specialise and trade? Should a car company try and build a car by itself, or outsource design, assembly and the bits in between? What combination of people and machines should be used to do the work? Where should the factories be located? How big should they be? How many types of car should be made? Should our milk be used to make butter or cheese, or just sold as milk? Should a bakery make bread, or our supermarket, or should we make it ourselves at home?
How prosperous we become, and how high our living standards are, depends on how well we answer these questions. And the shape of our living standards also depends on how we answer these questions. I don’t think Japanese people would want to live like the English, nor vice versa…
In our economy today, who makes these decisions? Who decides what it is produced where, how and by whom?
Well, in a socialist or communist economy, the government makes the decisions. You go where you’re told, do what you’re told, in the way you’re told, using what’s provided, and in the end you get what you’re given.
But in a capitalist one, individuals making individual decisions about their own individual lives is how these decisions get made.
You can see why economists favour government planning, right? Capitalism sounds like total chaos.
The thing is, because the value of something is in the eye of the beholder, capitalism is the best way to make economic decisions. Governments simply do not know what their people want well enough to get allocation decisions right.
Despite realising this applies to most parts of our economy to some extent, especially after the failures of Communism, we still got stuck with a particular form of central planning. Namely, central banks.
Which brings us back to our story about low interest rates.
Capital allocation decisions are the sorts of decisions that macro-economists, like central bankers, who focus on aggregates like GDP, don’t think about. And so, they miss the effect which interest rates have on the real economy. The misallocations of capital which low interest rates cause.
Conveniently, a band of economists who are referred to as “the Austrian School of Economics” answered this question many decades ago.
Inconveniently, nobody in governments or central banks pays attention to them any more.
In short, according to the Austrians, artificially low interest rates encourage overinvestment in capital. That is a fancy way of saying a bigger factory, more machinery and a more complex form of production.
When interest rates are low because of high savings rates, such investment is a good thing. That’s because savings signal an increase in future consumption, which can be met in the future by the higher production which higher investment in productive capacity allowed.
But when interest rates are artificially lowered by central banks by means of creating money, as opposed to real savings, this fools the economy into thinking that there will be more consumption in the future. But, because printed money is not the same as true savings, when the future consumption fails to arrive, the investments prove to be a mistake. You get bankruptcies and a recession.
This is how central bank manipulation of interest rates causes the business cycle, as opposed to mitigating it as the news readers would have you believe.
But there are many other effects of artificially low interest rates. The most intuitive is housing bubbles and banking crises.
Just as price controls on energy led to a series of energy company bankruptcies in the UK’s energy sector, so too can interest rate policy from the central bank lead to banks going bust. It leads to excesses in lending, and then lending contractions.
This is basic supply and demand economics. If you introduce a price control, you get surpluses and shortages. Which, in the world of debt and lending, show up as loan booms and bank busts.
As for housing bubbles, it’s even simpler. The key factor influencing demand for housing is loan affordability. And the central bank-controlled interest rate is the key factor influencing loan affordability.
Right now, this manipulation has reached the most extraordinary mismatch. Lloyds is offering the cheapest ever 10-year fixed mortgage at a rate of 1.66% while inflation is above 5%. This is, simply, nuts. Inflation is paying off your mortgage three times over!
Of course, it’s just an extreme example, but it does reflect the madness in the mortgage market in the UK, the United States, Europe and elsewhere.
But, not so fast…
Remember the key lesson of economics is scarcity. Governments can muck about with money, inflation and interest rates. But they cannot suspend reality.
The result is surging house prices.
Some of this inflated demand ends up triggering a building boom. That was exactly what we saw in Ireland and Spain leading up to 2008, when entire housing estates were exposed as malinvestments – and precisely what the Austrian school predicts as the consequence of low interest rates.
But the key is rising prices because physical reality cannot be suspended, only the monetary.
UK house prices posted their strongest start to the year since 2005, with an annualised growth rate above 11% in January.
Do you remember what came after 2005?
Let me give you one more consequence of excessively low interest rates. They keep zombie companies alive. Zombies are companies that cannot afford to pay their debt, but they can find lenders to keep rolling over their loans.
Now, a crisis in which zombie companies go bust is a scary one. But consider the alternative.
These firms are using up resources to produce and provide things which do not earn a profit for the company. And profit is a signal that what is being produced is worth more than what was used up to produce it.
Profit signals that value was created, in other words. If you’re making a loss, it’s a sign you’re wasting resources that could better be used elsewhere.
This is why socialism failed – the planners were unable to figure out whether economic activity served its purpose of creating value for consumers. They didn’t know whether to make butter or cheese with the resources because there is no way of knowing in an economy without prices, profit and loss.
Failure in a capitalist system is so important because it allows resources to be reassigned from activities which use up resources but destroy value, to those which create value. And the profit motive is the regulating mechanism to ensure we are always striving to get the biggest benefit from the resources we use up.
When artificially low interest rates are stopping zombie companies from going bust, they create waste. And it might seem like a huge amount of corporate failures would be terrible. And it would be, in the short term.
But in the long term, it is precisely this reallocation of resources which makes our living standards improve. Otherwise we’d still be using blacksmiths to shoe horses, Kodak film to process photos and coal to power our electric cars…
Instead, we recognised that the resources being used in those economic activities were being wasted and should be used in different ways. Well, we’ve recognised it for most things…
Where could all this lead us?
The ultimate expression of monetary meddling crashing into real economy constraints is stagflation. Rising prices and a moribund economy is something that makes things people don’t want…or at prices they don’t want.
Then central bankers face a choice. They can raise interest rates, which destroys the zombified economy. Or they can allow inflation to run hot and keep the stagflation going.
Historically speaking, they tend to accidentally trigger debt crises with interest rate hikes every few years. Right up until even governments are impossibly overindebted themselves. Then they begin to choose the latter and don’t even try to rein in inflation for fear of sending their employers bust.
The big question is whether we’ve reached that point. Will central bankers trigger a debt crisis or allow stagflation?
There is of course a pair of investments that benefit from either outcome. The first is gold because it is both an inanimate object and therefore not subject to the machinations of monetary maniacs (in the long run), and because it is a monetary metal that societies fall back on when their government run money fails.
And the second is gold’s younger and more exciting cousin.
Nick Hubble
Editor, Fortune & Freedom
