The Genesis of Low Rates
The low rates enjoyed by the global economy, for more than thirteen years since 2008, were pushed on by central banks in response to a financial crisis (GFC 2008). Advocacy for central bank interventions during times of crisis was present even in the 18th and 19th centuries. Edward Chancellor notes Walter Bagehot as one of its earliest proponents in his book’ The Price of Time’.
However, Bagehot’s suggestion of central banks’ extending credit during times of crisis came with three caveats: 1) high-quality assets should back the emergency credit, 2) such credits must be made at high interest rates, and 3) the policy should be a short-term measure because allowing it to continue for long would bring ill-effects on the economy. Unfortunately, today’s central bankers seamlessly ignored these caveats during their intervention during the 2008 crisis.
They extended credit at low interest rates. They bought mortgage-backed securities – the same securities from which the crisis originated – on a large scale, during and after the crisis. Also, they allowed the easy money policy to go on for too long – thirteen years is a very, very long time.
As the deviation of central bank interventions from the prudential path during and after the crisis was extensive, so will the distortion they might have fostered. One major reason for the deviation was that the beliefs of modern central bankers at the helm for the past two decades were significantly shaped by the experiences during the ‘Great Depression’ of the 1930s.
Those beliefs strongly influenced the monetary policy interventions they took during the 2008 crisis. They believed that the failure of central bankers of the 1930s to act extensively in the economy through monetary interventions during the Great Depression was largely responsible for exacerbating and prolonging the crisis. Guided by this belief, modern central bankers interfered extensively during the 2008 crisis.
They acted with the best of intentions: they didn’t want a repeat of the great depression. And, in some way, they succeeded at it: the economy rebounded within one or two years. But despite the recovery, they hesitated to pull the plug on low rates and asset purchases. They justified their reluctance to withdraw easy money with the argument that ‘we don’t want to derail the nascent recovery.’ Additionally, they argued that since inflation remained subdued, there is no need to hurry towards a more normal monetary condition now.
Though the central bankers who guided the economy before, during, and after the crisis might be experts in monetary policy, experts too can be fallible. It is a likely possibility that modern central bankers might have navigated the economy through and post the crisis less optimally (I’m being polite; erroneous would be a more appropriate word). This might have birthed economic distortions and financial imbalances. Since we are now in a more normal monetary condition after the steep rate hikes of 2022-2023, the reckoning for the economic distortions and financial imbalances isn’t too distant.
Flawed Monetary Interventions
I surmise there to be two reasons why central bankers’ monetary interventions consequent to the 2008 crisis and afterwards were less than optimal. The first is that they learned the wrong lessons from the depression, and the other is the central bank’s mandate: price stability and inflation targeting.
Today’s central bankers believe that the Great Depression would never have been so severe and prolonged had the central bankers at the time taken more aggressive actions. They believe deflation exacerbated the economic difficulties then, and hence, maintaining price stability is imperative for financial stability and sustainable economic growth.
The actions of modern central bankers, since 2008, were significantly driven by three lessons they learned from the depression era: 1) expansive, aggressive monetary interventions are essential during a financial crisis; 2) price stability is so essential that it should be achieved at all costs; and 3) deflation could be disastrous for the economy, so prevent it in all ways possible.
However, there is no substantive evidence supportive of these beliefs, argues Chancellor in ‘The Price of Time’. Surprisingly, there is enough to prove the contrary. There is conclusive evidence that monetary actions were responsible for many of the credit booms and speculative manias of the past three centuries. Moreover, there is no evidence of price stability ensuring financial and economic stability. Rather, Chancellor states that “much of the previous periods of stability have ended unhappily.”
By lowering the interest rate, central banks discouraged savings and investments, leading to poor economic output growth. Low interest rates foster credit boom, asset price inflation, and speculative manias. Chancellor suggests that credit growth, asset price inflation, and capital inflow are more reliable harbingers of a crisis – not price stability.
Importantly, none of the modern central bankers of the past two decades had experienced the Great Depression directly. All they know about it is from the study of history. Histories are always written from different perspectives, and generally, over time, only a few of them attain prominence. The prominent narrative doesn’t necessarily have to be the most inclusive and accurate one. So, it is probable that today’s central bankers learned about depression from a limited or faulty perspective. The essentiality of price stability, which today’s central bankers hold on to tenaciously, might have been arrived at through such a limited (or flawed) understanding of history, or without considering diverse historical perspectives.
The principal mandate of today’s central banks is price stability. They have fervently adhered to this monetary dogma for the past two decades. But instead of bringing the intended results, the policies adopted to achieve those mandates have created more economic distortions and financial imbalances.
One major risk flagged by central bankers in support of their easy money policy is the danger of deflation. They strongly believe that it was deflation that worsened and prolonged the economic hardships of the great depression. But this seems to be an overstatement.
All deflations aren’t bad – there are both good and bad deflations. The deflation brought about by the productivity growth should be considered good. Meanwhile, debt deflation is a bad kind of deflation. It occurs when people who have run up large debt during the boom years decide, after the boom has imploded, to repair their balance sheet by paying off their debt. One way to discourage them from their intentions is by lowering interest rates further. And that is exactly what central banks have done over the past two decades: incentivize spending and discourage debt contraction by the incessant lowering of interest rates and, simultaneously, expand the supply of money and credit.
Not Solved, Just Postponed, Thus Exacerbated
The monetary regulators never solved the economic problems that their easy money intended to do. It is ridiculous that regulators adopted a policy of easy money to mitigate a crisis whose origins could be traced back to easy money policies of earlier times. It’s like trying to put out fire using fire.
Modern central bankers have always blamed economic troubles on ‘real’ economic factors and considered monetary actions as solutions to those troubles. However, there are extensive studies that prove the role of monetary actions as the causation for much of the recent economic distress, panics, and crises.
The easy money policy never solved our economic problems, it just postponed it. ‘Easy money bought us time, but time was wasted’, says Edward Chancellor in ‘The Price of Time.’ But, thanks to the easy money policy, as the eventual mitigation keeps getting postponed, the distortions and imbalances it fostered grew. This means that the pain from the eventual mitigation would be severe too.
Due to massive central bank interventions, market interest rates deviated much from the natural rate of interest – the rate of interest at which the economy functions at its most optimal level without causing a rise in inflation. When such deviations occur, capital misallocation ensues. But as inflation remained benign, central bankers concluded that the economy was in a better condition. But it wasn’t.
Despite the near-zero interest rates and massive printing of money, the global economy grew at its slowest pace post the 2008 crisis. Instead of mitigating, the easy money policy allowed weaknesses in the system to persist and expand, and in the process sapped the economic vitality essential for sustainable economic growth. A debt mountain accumulated, less efficient firms were allowed to continue, banks carried bad loans on their balance sheet rather than recognizing them, and over-speculation drove asset prices precariously high.
Investing Habits Fostered by Easy Money
Chasing High Yields
When interest rates are low, investors’ income from safer investments such as government securities and bank deposits is too low. If those low rates are a recent phenomenon – i.e., interest rates have declined to lows in recent years – then investors are receiving an income lower than they are normally accustomed to. Under such conditions, the general tendency among investors is to recompensate the lost income by embracing more risk.
When there is such a willingness among investors to embrace more risk for extra return, there always arises someone on the other side (supply side) ready to fulfil those demands. Under such conditions – fostered by low rates – new banks and financial institutions emerge that promise better returns once offered by safer investments – sometimes more than that.
In their thirst for high yields in a low-rates world, investors invest in firms that offer higher yields than traditional sources. But when they do so, they never enquire how these firms provide them with the promised returns. Desperate for high yields, investors are credulous to the ‘high yield’ firms’ promises.
However, to provide higher returns than conventional banks or institutions, these new firms should also lend at higher rates than the conventional ones. But why would a borrower borrow money from these emergent firms when conventional (or established) banks could lend them at lower rates? The only plausible explanation is that ‘only those borrowers who need money but don’t meet the credit standards of conventional firms would avail credit from the emergent firms at high lending rates.’
Investors/depositors chasing high yields in a low-rate world should know that high yields are enabled by embracing high risks and, for their safety, it is essential that they be aware of these risks.
The low creditworthy borrowers, shunned by conventional financial institutions but embraced by the emergent firms, might have availed credit with the best intentions. They might be able to meet their debt obligations – but only when the times are easy. But easy times don’t last forever. When the easy times come to an end, which it eventually does, in time, a few of the borrowers will fail to meet their debt obligations.
Once the borrower defaults, the emergent firms that lent them money get into trouble. Gradually, these lenders will then fail to meet their obligation to depositors. The financial system runs on trust and once it is lost, the system is ripe for distress or panic.
Depositors panic when they become aware of troubles at firms where they have trusted their money. Their panic exacerbates the distress at the emergent firms with fearful depositors rushing to withdraw their money before they are all gone. The respective emergent firm because of its already precarious position fails to fulfil such sudden deposit withdrawals.
Eventually, the firm fails and depositors in their quest for high yields lose both the expected high yields and their hard-earned money. The mistrust and panic slowly creep into other similar firms. They too get into trouble due to sudden deposit withdrawals from panicked emotionally engulfed depositors, despite following good lending practices and having a good credit profile.
On paying close attention, one can surmise that it was the low interest rates from which all these troubles emanated. Investors lost money while chasing high yields by taking undue risks. It was the low rates in the first place that drove them to chase high yields.
Over-Speculation
Another way investors chase high returns in a low rates world is by indulging in stock speculation. We should ‘invest’ in stocks not ‘speculate’ is an oft-repeated advice in the stock market – so often that it has become more of a cliché now. However, there is a high degree of ambiguity on what constitutes ‘speculation’ and ‘investing.’
For our discussion, let us define ‘speculation’ as buying and selling stocks within a very short period to profit from anticipated changes in stock prices. Or, in other words, chasing quick profits from some soon anticipated price changes. Meanwhile, investing is buying stocks to hold them for longer to profit from the firm’s increased earnings and profitability going forward.
While speculating, only a stock’s price change is considered, while its fundamentals and valuation are neglected or sidelined. Meanwhile, while investing, the stock’s fundamentals and valuation are given more significance; although considered, the stock’s price is less relevant here.
Interest rates and stock prices are inversely correlated. This is because a stock’s present value is its future cash flows discounted to the present. As the interest rate (discount rate) decreases, the present value (discounted future cash flow) rises. Stock prices rise to reflect the new (higher) present value. Therefore, stocks ought to rise during periods when interest rates are declining.
Investors searching for better yields outside of their traditional sources (due to their low yields) will surely be impressed by the superior returns from stocks during periods of declining interest rates. These mesmerized investors, on finding stocks gaining 20 – 40 per cent yearly, particularly at a time of low rates, will naturally flock to stocks hoping to achieve those higher returns for themselves.
However, such investor-flocking becomes self-fulfilling because as more investors enter the market, more money is entering the market, driving prices higher. Again, these price rises attract furthermore investors into the market, causing furthermore price rises. A little into these good times, investors start thinking that stock prices have been gaining 20 – 30 per cent yearly for some time. Credit is plenty and cheap. So why not borrow at low rates and invest in stocks, which are gaining 20 – 30 per cent per year and, thus pocket the difference?
Now people start investing using borrowed money hoping to pay for it from the speculative gains. Initially, only a few embrace borrowing to speculate, but once others see the early embracers succeeding at it, more follow the path, first gradually, then en masse.
By now stock prices might have risen to levels that cannot be justified by their fundamentals. But despite that, prices keep rising because more money is flowing into the market.
This can’t go on forever. Some developments will close or tighten the tap of money flow to the market, causing prices to stop rising. Then, speculators who were speculating on borrowed money and expected to meet their borrowing obligations through stock profits will find it hard to meet their borrowing obligations.
As stocks have stopped rising, they will be forced to sell stocks to meet their obligations. This causes prices to fall. Once prices start falling, lenders become concerned about their borrower’s ability to meet their borrowing obligations, and thus tighten their credit tap. This exacerbates the distress and prices fall steeply.
This is what happens when people over-speculate: speculative frenzy causes a steep rise in stock prices, which is soon followed by a much steeper fall in prices; in the end, most investors end with losses, some even in debt.
Rising stock prices also bring about a slackness in the behaviour of firms. It causes them to be more optimistic; so optimistic that they now hold unrealistic expectations about their future, consequent to which they over-invest. Too much money flows into unproductive endeavours. This causes serious distortions in the financial markets and the economy through overcapacity and poor return on capital.
Once the easy money policy comes to an end, these distortions will be corrected. Money will leave the unproductive to the productive. Those who had bet too much on the unproductive side will suffer as the froth accumulated during the speculative phase starts deflating.
As we saw earlier, stock prices and interest rates are inversely correlated. The end of the easy money policy means interest rates rise to more normal levels. As interest rates rise, the present value of future cash flows declines. Stock prices should decline to reflect this new reality.
Although the most common, stocks aren’t the only object of speculation during periods of speculative manias fostered by low rates. Historically, speculation in objects as absurd as tulip bulbs has occurred. However, besides stocks, other common objects of speculation include real estate and precious metals like gold and silver.
The Way Forward
We are no longer in an easy-money policy environment. A steep spike in inflation, during 2021-2022, forced central banks to raise interest rates at the steepest pace in forty years. Now interest rates in most of the major economies stay above their long-term average.
Although interest rate hikes were effective in anchoring inflation, the threat of inflation remains. Moreover, much forth has accumulated in the economy due to the capital misallocation enabled by the easy money policy. These include a mountain of bad debt, high asset prices, and the existence of many weaker firms in several industries that easy money allowed to continue despite their inherent inefficiency.
It was low rates that allowed banks to carry bad loans on their books without recognizing them. Now with higher rates, they would be forced to recognize bad loans and start the long-warranted balance sheet cleansing.
With rates higher, investors can now expect meaningful returns from their traditional investment avenues of bonds and bank deposits. This will trigger a gradual capital outflow from riskier assets such as stocks towards fixed income. This will cause stock prices to correct the froth in valuation accumulated over a long period of low rates. Stock price movements will now be dictated more by their fundamentals, rather than capital flows.
There will be an increase in the number of bankruptcies going forward. Many weaker firms that survived under an easy money policy despite being inefficient and incompetent will fail to survive under a more normal monetary condition.
All these developments are surely going to be painful. But they are essential to bring back the economic vibrancy we lost during the long period of easy money. In short, short-term pain leads to positive long-term consequences.
As for the central bankers, as always, they will try to lower rates at the slightest whim of economic distress. However, with the threat of inflation now being real, and having already experienced it recently, central bankers’ enthusiasm for rate cuts wouldn’t be as intense as before. Inflation will act as a leash on central bankers’ affinity for lower rates.
Interest rates were near zero at the end of World War II. However, for the next thirty years or so, interest rates rose gradually to a peak of 16 – 18 per cent by the early 1980s. A common theme of this period of rising interest rates was high uncertainty which caused high volatility in economic growth, interest rates, inflation, and asset prices. But it was also a period of high productivity growth, inclusive economic growth, and general prosperity.
I surmise we are to witness such a similar theme play out in our economy going forward. If so, I believe, the most vital skill for navigating such economic conditions is the ability to embrace and deal with uncertainty effectively.
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