Cheap Money’s Toxic Legacy

The September edition of the Master Investor magazine was largely dedicated to an examination of how likely interest rates were to rise, and what would be the consequences of a rate hike for your portfolio. I argued in my contribution that waiting for interest rates to rise was like Waiting for Godot. We might wait and wait, and then wonder what we had been waiting for.

Back in the summer, some commentators were expecting a rate increase “at the turn of the year”. On 05 November, at the Bank of England’s periodic Inflation Report press conference, Governor Mark Carney suggested that the “turn of the year” in question was the end of 2016 stroke beginning of 2017. His reticence was grounded in the fact that global growth had slowed and inflationary pressures had diminished with it. Mr Carney opined that inflation is likely to remain “lower for longer”. What he did not say was that the risk of significant deflation has also increased.

Even if rates go up by (shall we say) fifty basis points to one percent in early 2017, the current super-low interest rate of 0.5% will have persisted for getting on for one hundred months. That will have been by far the longest period of constantly low interest rates since the foundation of the Bank of England in 1694. After the Wall Street Crash of 1929 and the Great Depression which ensued, Bank Rate (as Minimum Lending Rate was then called) was held at two percent from 1932 to 1939. During WWII, rates edged up, but were then held at two percent again from 1945 to 1951.

So we are living through not just a historically unprecedented low rate of interest, but one which will have been sustained for a record period. This exceptionally low rate, let us recall, was designed to stave off financial collapse after the most significant banking crisis of (possibly) the last 200 years. So it does seem odd that several years into the economic recovery (precisely when it began is arguable) the MLR is still at 0.5%, even if quantitative easing has been attenuated in the UK and the USA.

My point here is this: This weird state of affairs is having a corrosive effect on our economy and our long-term prospects in ways that are not always obvious.

Firstly, in a world where central banks have abandoned the notion that a natural interest rate is one which brings savings and investments into equilibrium, stock prices have been artificially stimulated. My colleague, Felipe R. Costa explored this in a piece published on this site on 13 November (Which Theory Supports Central Banks?). As Felipe explains, when central banks print money, that money flows disproportionately to non-GDP assets.

Another way of looking at this is to revisit the old chestnut of financial theory that the value of a stock is little more than the present value of all future cash flows (dividends and the final cash sale price) to be derived from that asset. Discount that series of cash flows at a lower rate and the present value increases, regardless of the prospects for that stock. In this model, any increase in interest rates, when that occurs, all things being equal, will have a negative impact on stock prices.

Now if assets have been valued at an artificial discount rate, they are overvalued. Sooner or later, the little boy will tell the emperor that he has no clothes. By the way, if you try to adjust the stock markets to take out the effects of cheap money, it would surely seem that the London market has gone nowhere in the first fifteen years of the 21^st century. Why rates of return in the equity markets may be falling long-term is something I’d like to examine another time.

Second, UK house prices have continued to rise faster than wages which means that first-time buyers will find it increasingly difficult to get on the housing ladder. Some argue that there will come a point where the first-timers drop out all together and the entire market judders to a halt. In the meantime, there is something of a bonanza underway. In the first week of November Halifax announced that UK house prices had risen by nearly ten percent over the last year, although Nationwide put the figure at just four percent. Either way, with wages growing at around three percent and consumer price inflation hovering around zero, house prices are galloping ahead.

Third, there is almost no incentive for people to save money. Not only is thrift old-fashioned; it doesn’t even pay. In fact, rates for savers are still falling. I have lost count of the number of times my bank has written to me over the last two years to advise that the rate on my ISA has been reduced. And when you take out the basic rate 20% tax on interest accrued outside an ISA, returns to savers are pitiful. Young people, who arguably will need to save more than their parents to fund their retirements, have got the message that saving is a mug’s game. As for the elderly, those provident types who sought to top up their retirement incomes with the interest on their nest eggs have been cruelly disappointed.

In the relentless search for yield, sober minded types who might once have left their savings in the bank are getting into all kinds of unsuitable gimcrack schemes: diamonds, carbon credits, fantasy real estate… The swindlers are having a field day.

Just consider also that, in the Keynesian model, savings equals investment. So lower savings means lower investment – and that in turn means lower long-term growth.

Fourth, super-low rates have kept marginal businesses afloat which under normal conditions would have gone to the wall. You might think that is a good outcome, but long-term it means that capital is tied up in under-performing businesses when it could have been allocated to more productive activities. In economic parlance, that is sub-optimal.

Fifth, the longer that rates remain at artificially low levels, the more businesses will assume that they will persist indefinitely. That means that their investment decisions could be increasingly skewed to inferior projects. (The effect of discounting, once again.) When rates do rise, the results could well be catastrophic.

Sixth, the central banks themselves now risk losing credibility. The more that they ruminate and delay, the less confidence the markets will have in their leadership. Mr Carney started out as a central banking mega-star; now there is tittering in parts of the audience.

Those self-help books tell us that putting off difficult decisions in our personal lives usually makes life more difficult in the end. Central bankers take heed. The longer Alice in Wonderland economics persists, the more difficult it will be to get back to normality.