Are low interest rates really the answer?

Posted on April 23, 2013 in Debates – business/economy – As growth slumps, debt builds, people on fixed incomes suffer and investors take on risks, some wonder why cheap money isn’t working.
Apr 12 2013. By: David Olive

Could it be that the cure-all policy of sustained low interest rates deployed worldwide to lift us from the Great Recession has failed? The thought is almost unimaginable, since today’s historically low rates have been so widely embraced. Indeed, the one conspicuous holdout among central banks — a lengthy reluctance of the European Central Bank (ECB) to ease rates — is roundly blamed for worsening Europe’s current debt crisis.

Yes, there is a certain groupthink among central bankers, no less than makers of lookalike vehicles and fans of Justin Bieber.

There’s no reason to anticipate a volte face among central bankers in abandoning the cheap-money panacea they adopted at the outset of the Great Recession. If anything, in its next policy meeting on Wednesday, the Bank of Canada will join the U.S. Federal Reserve Board, the Bank of Japan and the Bank of England in their recent re-commitments to keeping rates at record lows. The BoC might confirm the consensus of economists, who believe the bank won’t feel the Canadian economy has regained enough strength to enable it to begin raising rates again until 2015. Indeed, the U.S. Fed has clung to ultra-low rates for a dozen years, initially to soften the blow of an anticipated recession following the 9/11 attacks.

But the sages finally are asking the unthinkable, based on the irrefutable track record of the longstanding cheap money practice: Namely, why hasn’t it worked?

With hindsight, the initially promising economic recovery in the immediate aftermath of the 2008-09 credit crash can be attributed mostly to deficit-financed government stimulus by the major economies, not to cheap money. Stimulus put money in people’s pockets, through job creation and continued social-welfare supports. By contrast, uncertainties since the Great Recession have kept many fretful individuals and businesses from borrowing, no matter how cheaply loans are priced.

And it has been the premature scrapping of this fiscal stimulus even as cheap money policy has remained untouched that has curtailed the initially strong recoveries in economies hardest hit by the Great Recession. We see this most powerfully in Europe, whose embrace of austerity — spending cutbacks and layoffs that are the opposite of stimulus — has inflicted a double-digit recession on Britons and devastated Southern European economies. The jobless rate in Spain, among the biggest of Eurozone economies, has climbed above 25 per cent and to about 50 per cent among Spaniards 18 to 24 years of age. These are Great Depression jobless levels.

To the extent that the United States, still the most powerful driver of the world economy, has been able to show any growth since a Republican Congress killed President Barack Obama’s successful stimulus agenda, that growth derived largely from the U.S. Fed engaging in several rounds of so-called “quantitative easing.” That’s the Fed’s sudden, huge appetite for U.S. debt, a backdoor stimulus measure intended to keep Washington solvent. A U.S. recovery, such as it’s been, hasn’t come from the Fed’s cheap money practices. And even with “QE,” U.S. growth is anaemic. More recently, the slowdown has hit Canada, where GDP growth began slumping in this year’s first quarter.

What this suggests, in a nutshell, is that the Keynesian “pump priming” of deficit-financed government spending in North America, Europe and Japan to shift economies into higher gear worked. And conversely, central bank monetary policy of re-jigging interest rates has been of only modest help, or downright dangerous.

We have to face the fact that the era of easy money has been accompanied by bubbles in commodities (everything from spiralling fuel costs to repeated developing-world food shortages), then housing, and now stocks. At their current highs, the S&P 500 and the Dow Jones are hardly reflective of real-world economic conditions, and are poised for a tumble. In short, sustained cheap money — and our latest experience with it was intended to be short-lived — distorts economic decision making.

The deep-discount mortgage financing unleashed by the U.S. Fed in the early 2000s merely replaced the calamitous panic-buying of stocks in the dot-com era with the ultimately catastrophic panic buying of America’s epic residential real estate bubble of 2002-‘06.

Canadians and Americans also seized on cheap money as a means of making ends meet. Just as Athens, finding Greece’s cradle-to-grave social safety programs increasingly unaffordable, turned to heavy external borrowing, a North American middle class enduring a 30-year pay freeze was compelled to finance everyday expenses with credit.

Yes, there was excess personal spending, notably in the Vancouver and Toronto housing markets. But for most over-indebted Canadians in an era of spiralling fuel, tuition and other costs, and only stagnant income with which to cope, maxing out on credit cards and the credit lines that banks were eager to offer became an irresistible means of funding everyday needs like new clothes that kids had outgrown.

If low interest rates are such a balm, one has to ask why Japanese GDP has stagnated during the past two decades of near-zero Japanese borrowing costs. Persistent low interest rates have also exacted an obvious toll on the fixed-income population. And that’s not just seniors. Investors have practically been forced to buy over-valued stocks and dicey Cypriot bonds offering double-digit yields, when safe interest-income investments are a losing bet after inflation.

That has pushed a generation of investors into riskier investments, including over-priced property and Facebook and Apple stock, which trade at outrageous price-to-earnings multiples. “Frothiness is back as investors search for higher returns, whether in junk bonds, African government debt or the new ‘structured credit’ products dreamt up by the same investment banks that sliced up mortgages in the bubble years,” notes The Economist in a recent editorial on the flaws of the cheap-money orthodoxy.

Cheap money is supposed to spur business investment, and historically it has. But global business uncertainty is such that companies that do borrow have been using the funds to buy back their own stock, pay higher dividends, roll over existing debt at more favourable terms, or build up a cash cushion against a feared encore of the credit crunch. They’ve used the funds from corporate bond sales for everything but boosting budgets for R&D and new-product development, plant expansion, and job creation. In the U.S. alone, publicly traded companies are hoarding $1.8 trillion in idle cash.

There’s no question we’ve not been well served by this unusually long era of low interest rates. Look around at the weak economic growth and chronic high unemployment in most of the world’s major economies that have lived by the mantra of cheap money, and the argument for low rates lacks, well, currency.

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