This week I want to take a look at just how much damage keeping interest rates at 0% may have done to our economy.
Later in the week, I’ll look at everyone’s favourite topic – the housing market.
But today, let’s have a look at how 0% rates could have distorted the investment behaviour of companies and individuals – and how the longer we stay at zero, the worse it gets…
Zombie companies and Russian-roulette playing investors
As Kristin Forbes pointed out in her recent speech marking her departure from the Bank of England, one worry about low interest rates is that they may create behavioural distortions that in turn damage the economy.
Firstly, low rates may force worried individuals to save harder for retirement. Did you know that in 2009, a mere seven years ago, a pension pot of £500,000 would have bought a 65-year old man an annuity income of roughly £35,000 a year (though with no inflation protection)? Today, it would buy him about £25,000 a year.
As a saver, that’s terrifying. If you want to get the same income that you could have bought in 2009, you’re going to need a much, much bigger pension pot on retirement. (And yes, while we’re all very happy about the new pension freedom rules that mean you don’t have to buy an annuity, the same basic problem still exists.)
So what can you do about it? Potential future returns today look a lot lower than they did in 2009, because markets are a lot more overvalued than they were back then. So there’s no reason to expect your pension pot to grow faster today than it would have back then.
That leaves only three options. The first is to save harder. As Forbes notes, when faced with this sort of hostile savings environment and the desire to “ensure a certain income stream”, a worried saver might “increase savings and reduce spending – thereby slowing overall GDP growth”.
The second option – for those who can’t increase their savings – is to take careless risks in the hope of growing your pot faster. Let’s say you cannot see a scenario in which you will be able to save enough for a comfortable retirement, regardless of how hard you save. What do you do?
The famous Daniel Kahneman and Amos Tversky “loss aversion” experiment presents investors with two choices. Choice A is a certain loss of $7,500. Choice B is a 75% chance of losing $10,000 and a 25% chance of losing nothing. Statistically speaking, neither option is better. But most people prefer option B – they’d rather risk losing a bit more money in return for a shot at losing nothing.
Say we swap Choice A for a 100% chance of “an uncomfortable retirement” and Choice B for a 75% chance of “a slightly more uncomfortable retirement” and a 25% chance of “enjoying a bitcoin-and-FX-speculation-fuelled windfall that delivers an acceptable retirement” (25%). Put it that way, and you can see why zero rates might inspire more speculative behaviour among ordinary investors.
It’s no coincidence that the rise of Mrs Watanabe – the name given to the phenomenon of Japanese housewives turning to currency speculation to supplement (or devastate) the household’s savings – began during the 1990s, when Japanese interest rates collapsed.
And you do have to wonder if something like bitcoin could ever have achieved its current success in a higher interest-rate environment.
Finally, you could just abandon the idea of ever having enough saved up for tomorrow, and blow the lot today, in the hope of throwing yourself on the mercy of the state in your old age. As implied by the current record-low savings ratio, a sizeable portion of the population might just have gone for this option.
The point is, none of this – desperate saving, unhinged risk-taking, or hysterical consumption – represents a healthy approach to investment.
And unfortunately, these arguments apply to companies too. As Forbes notes, firms with exploding pension deficits “could cut back investment… in order to replenish pensions – further slowing overall GDP growth”. In other words, everyone’s productive resources get diverted to fruitless efforts at running to stand still.
Meanwhile, low rates “can reduce the ‘churn’ in an economy” – the pace at which new, more efficient companies replace older, indebted, less efficient ones.
In other words, low rates short-circuit the process of creative destruction, by allowing “zombie” companies to trudge on and crowd out youthful challengers. In turn, that holds back productivity growth.
That’s certainly something we’ve seen – productivity in the UK has been particularly bad since the financial crisis. It’s only just recovered to the levels seen before the crisis, and it’s probably the biggest economic concern we have right now.
This looks just like an economy in secular stagnation
All of this might not matter in the early stages. When rates first fall, the boost to activity outweighs the drag from these side-effects.
But leave rates at zero for a long time, and this behaviour starts to get ingrained. Eventually, you’re doing more harm than good.
If you leave your population in a demoralised state of financial “learned helplessness” – too mentally paralysed to invest and save sensibly – then it’s no wonder that productivity suffers.
Similarly, creative destruction between companies might not be much fun for those who are creatively destroyed. But it means more competition in the economy, and in turn that means more efficiency, and in turn that means higher wages and a better standard of living for everyone as a whole.
An economy without creative destruction is an economy in limbo. In fact, an economy without creative destruction looks an awful lot like an economy in “secular stagnation”.
This is the buzz phrase used by economists (most prominently, ex-US Treasury Secretary Larry Summers) who think that we’re now in a state of semi-permanent depression, which should be combated by permanently low interest rates and a massive fiscal stimulus.
They’d argue that interest rates are low because the economy is weak. And that might have been true in the early days of the crisis. However, I’m starting to think that the causality increasingly runs the other way.
Raising rates from here would be painful. But keeping them at zero only builds up the distortions. Unfortunately, as we noted in yesterday’s Money Morning, it’s only when the distortions get too big and damaging to ignore that central banks will feel forced to act. And by then, there will be no good choices left.