Monetary Policies

DANIEL LACALLE is chief economist at hedge fund Tressis and author of “Freedom or Equality,” “Escape from the Central Bank Trap,” and “Life in the Financial Markets.” Daniel Lacalle

Why Artificially Low Rates Are Bad

Bubbles and excess debt won’t form if rates float freely

The disastrous era of negative rates may be ending, but it isn’t over. Imposing negative nominal and real rates is a colossal error that has only encouraged excessive indebtedness and the zombification of the economy. However, nominal rates may be rising but real rates remain deeply negative. In other words, rates are still exceptionally low for the level of inflation we have.

The excuse for implementing negative rates is based on a fallacy: that central banks lower rates because markets demand it and policymakers only respond to that demand; they don’t impose it. If that were the case, why not let the rates fluctuate freely if the result is going to be the same? Because it’s a false premise.

Imposing artificially low rates is the ultimate form of interventionism. Depressing the price of risk is a subsidy to reckless behavior and excessive debt.

The reader may think I’m crazy because hiking rates makes mortgages more expensive and families suffer. However, you should also ask yourself why house prices rise to unaffordable levels. Because cheap borrowing drives higher indebtedness and makes asset prices significantly above affordability levels.

First, prudent saving and investment are penalized and excessive debt and risk-taking are promoted. Think for a moment about what kind of business it is that’s viable with negative rates but not with rates at 0.5 percent: a time bomb.

It’s no accident that zombie companies have soared in an environment of falling interest rates. A zombie company is one that can’t pay interest on debt with operating profits, has a negative return on assets, or has a negative net investment. According to a study by the Bank for International Settlements, the percentage of zombie companies has risen to all-time highs in the period of low rates.

In the case of governments, negative rates have been a dangerous tool. They’ve made it comfortable to take on vast amounts of debt and make deficits skyrocket.

But negative real and nominal rates disguise risk, giving a false sense of solvency and security that quickly dissipates with a slight change in the economic cycle. These extremely low rates generate greater problems as risk accumulates above what central banks and supervisors estimate, starting with governments themselves.

Negative rates have fuelled the public debt bubble that will end with higher taxes, higher inflation, lower growth, or all of them together.

Of course, the other effect of this economic aberration is high inflation—the tax on the poor. For years, it has generated enormous inflation in assets by encouraging risk-taking, from the real estate sector to the multiples of industrial assets or infrastructure. Borrowing was unusually cheap, and when credit soars, it flows toward high-risk assets and, of course, the creation of bubbles.

It’s surprising. The entire economic consensus recognizes that the rate cuts of the early 2000s led to the bubbles that cemented the excess of risk prior to the 2008 crisis. However, that same consensus applauds the madness of negative rates because there’s a perverse incentive in statism when the bubble is sovereign debt.

Following the high inflation in assets, high inflation of consumer prices has arrived, a double negative effect for savers and real wages.

The European Central Bank has raised rates—to zero! The biggest increase in 22 years and the first time without negative rates for eight years. With inflation in the eurozone at 8.6 percent, it’s clearly an insufficient and timid rise.

When you worry about the cost of a new mortgage going up, think that house prices have skyrocketed well above what we consider affordable precisely because of negative rates.

Bubbles and credit excesses always occur after a planned incentive such as artificially lowering interest rates and injecting liquidity above the real demand for currency.

If rates fluctuated freely, the creation of bubbles and excesses of debt would be almost impossible because the risk would be reflected in the cost of money.

The best way to prevent financial bubbles and crises isn’t to encourage excess risk and debt by artificially lowering rates.

Rates don’t have to be hiked or cut by a central planner. They need to float freely. Anything else creates more imbalances than the alleged benefits they promote.

The entire economic consensus recognizes that the rate cuts of the early 2000s led to the bubbles that cemented the excess of risk prior to the 2008 crisis.