By Dr Constantinos Alexiou, Professor of Macroeconomics and Policy
Ever since the early 1980s interest rates have been dwindling dramatically. ‘Pushing on the string’ policies have been implemented internationally hence contributing not only to the boom that followed the post-inflationary crisis (1967-1982) but also to the dot-com in 1999/2000 and the real estate bubbles in 2006/2007 respectively.
In the years that followed, the low interest rate policy prescription continued more actively, culminating in further injection of money, the so-called Quantitative Easing (QE) which was introduced first in Japan and then in the US and the EU. The resulting zero-low-bound (ZLB) interest rate environment that dominated the period 2009-2018 galvanized the stock market considerably.
In the EU, March 2015 heralded the commencement of QE whilst in the USA the FED decided to reverse the policy by announcing QE tapering to indicate the end of the Great Depression. Today, interest rates could get even more negative as central bank's proclivity to move to more active QE suggests that the novel negative interest rate environment is conducive to economic growth.
Contrary to conventional wisdom, easy money, zero or negative interest rates are far from boosting investment activity and hence economic growth. Traditional monetary policies have failed to deliver, and central banks are running out of ideas. Investors are unwilling to respond to the emerging ZLB environment, and the bond yields have turned negative for the first time, potentially indicating a brewing recession.
Theoretically speaking higher interest rates have a positive effect on average profitability whereas very low interest rates give a new lease of life to businesses - which under different circumstances would fail – as well as promote speculative activity. The sheer reality of dwindling profitability and increased savings in some advanced economies has led their respective monetary authorities to resort to unconventional monetary policies in an attempt to generate economic growth.
After many years of ZLB interest rates and now negative rates, advanced economies are finding it rather hard to generate decent economic growth. The premise that financial markets can positively affect the real economy through negative interest rates appears to dominate conventional wisdom. There is ample evidence however to suggest that such a notion might be inherently flawed as the causality in all likelihood runs from the real economy to the financial sector - in which case a weak financial sector is to a great extent the result of a shrinking real economy and not the other way around. Moreover, the low or negative interest rate environment is thought to also act as an inhibitor to what Schumpeter called ‘gale of creative destruction’ in so far as the maintenance of obsolete capital contributes further to dwindling profitability and investment activity.
Currently, we live in a ‘fictitious world’ of negative interest rates, where borrowers get monetary rewards for borrowing and lenders pay to make available excess funds they possess. In Germany for instance government bonds have negative interest rates, i.e. paying the German government – the borrower in this case - to buy them, whereas in Denmark, mortgage lenders are paying you to take out a mortgage. As investment in risk free assets i.e. government bonds, increases considerably, the yield on the ten-year bond is bound to fall below that of the two-year or in some case even the three-month bond. This is the point where the yield curve becomes inverted. Past experiences suggest that such occurrences act as precursors to economic recessions. Will history repeat itself? It is yours to discover!
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