Interest rates aren’t a policy tool for central banks, but rather an important pricing mechanism. Yet since the 1080s central bankers have been doing it all wrong, creating crisis after crisis, writes Max Rangeley
It is never a good sign when bond yields take up an outsized proportion of the news agenda. But in the last three months, they have risen by over 100 basis points and occupied a decent chunk of our collective concerns. This is a strong indicator of risk that has built up in the system, but it is important to understand that, first, much of this is the consequence of years of central bank policies and irresponsible government spending and, second, this build up of risk has been a phenomenon that goes well beyond just the UK.
Earlier this month, I spoke at the European Parliament on the unfolding economic situation around the world. The fragility in the banking system over the last few weeks has caught many policy-makers by surprise, yet much of what is happening is entirely predictable. In 2018 and 2019 I gave a series of speeches in the European Parliament detailing the consequences of zero percent interest rates—the unparalleled growth in debt and build up of risk in the global financial system that was developing.
For the last forty years, through much of the developed world, each recession has been responded to by central banks setting lower and lower interest rates, thereby creating larger and larger debt bubbles. This is a phenomenon that has taken place across almost all of the developed world. For instance in America—which as the holder (at least for the time being) of the world’s reserve currency has special importance—when the bubbles in property and other asset classes burst in the late 1980s, the response from Alan Greenspan was to set interest rates at 3 per cent, the lowest for a generation, and then follow up with several iterations of the so-called “Greenspan Put,” thereby creating the Dot Com Bubble.
When the Dot Com Bubble burst in 2000, the response from the Federal Reserve was even lower interest rates, of 1 per cent, which then created an even larger bubble—the Housing Bubble. When this burst in 2008, the response was the lowest interest rates in history, 0 per cent, with some central banks even setting negative interest rates, for more than a decade. The main consequence of this, far from bringing back prosperity, has been to generate an even larger global debt bubble.
In 2007, global aggregate debt—the total of household, government and corporate debt—was $157tn, already the largest debt bubble in history by some margin. Following the era of zero percent interest rates, this rose to almost $300tn, practically doubling the size of the bubble since the 2008 financial crisis.
The consequences of artificially low interest rates, however, go well beyond just debt levels. With each phase of central banks’ increasingly “stimulatory” policy from the 1980s onwards, the number of zombie companies has increased concomitantly as more of the resources of the economy are diverted to those firms which produce little value but can survive indefinitely on artificially cheap credit.
Last year, the British pension fund system came close to serious difficulties due to so-called Liability Driven Investments, but these are just the tip of the iceberg with respect to the risk build up in global bond portfolios. As years of artificially low interest rates incentivised risk and distorted the underlying pricing mechanism of credit, the lowest-quality bonds came to constitute increasing amounts of bond portfolios in pension funds and elsewhere.
In fact, with each phase of the growth of the global debt bubble from the 1980s onwards bond quality has fallen as issuing more debt became the solution to every problem—thereby making the economy more reliant on artificially low interest rates.
The question then remains—how do we extricate ourselves from this quagmire of debt? At least part of the answer will be to take heed of twentieth century economist Friedrich von Hayek, who wrote of the importance of interest rates as a crucial pricing mechanism for the economy. When central banks set interest rates artificially low to “stimulate” the economy, the reality is that they distort the economy, leading to both debt bubbles and distortions to the underlying capital structure of the economy; the economic growth is illusory and fleeting.
Unlike previous business cycles from the last hundred years, we now have to unwind an entire generation of ever-larger distortions. Now that this iteration of the generational debt bubble is beginning to burst, it is an opportunity to re-examine the role of interest rates in the economy and view them as an important and systemic pricing mechanism rather than a “policy tool” for central bankers.
