Misallocated capital

One of the most amazing features of our economy nowadays is that interest rates, adjusted for inflation, are negative, and there is every reason to believe that they will remain so for quite some time.

The same thing happened after the end of the Second World War, and then again in the 1970s. However, in those eras inflation was much higher than it is today.

The reported inflation rate is now falling, primarily because of the low commodity prices. Yet, except for nations such as Greece and perhaps Switzerland, almost no one expects the outright deflation, which could justify the currently low interest rates.

Later, inflation is certain, so our short-term rates, adjusted for prices, will provide a negative return.

The major central banks are targeting inflation at about 2 per cent. It should be noted that in the 1970s inflation was not expected, but investors currently are aware that they will be losing money in real terms.

The level of interest rates now is the price which balances the desire for saving with the demand for investment. It is obvious then that investors are extremely cautious and businesses are unwilling under present circumstances to invest in new projects.

Certainly it is clear that the objective of government policies is to discourage saving-hoarding capital and stimulate consumer demand along with more business spending to reduce unemployment.

The central banks attempt to affect interest rates by setting the base rates at which they will supply liquidity, that is, funds to banks. In order to accomplish this they have been using so-called quantitative easing – the printing of new money to buy bonds with the objective of pushing down longer-term yields.

There is a correlation of real interest rates and economic growth. When the economy is flourishing, there will be many profitable opportunities. Businesses then will be borrowing and speculators will be tempted to acquire money to invest in property development or the stock market.

There is a great danger in this. The fall in financing rates may tempt borrowers to ignore ordinary caution and invest funds in risky ventures that would not even be considered if interest rates were at normal levels.

Also, banks may be inclined to disregard the ability of borrowers to carry the loans. Moreover, pension funds likely would take chances with speculative vehicles in order to compensate for sub-par rates of return.

Hence, over-leveraging misallocates capital, creating asset bubbles and inflating commodity prices. The situation will be made worse once inflation and commodity prices inevitably climb again.

Clearly, artificially low interest rates will entail great dangers.



Bruce Whitestone