Interest rates

Ultra low interest rate: implications and consequences (spoiler: not good)


Lawrence Summers attends the annual meeting of the World Economic Forum (WEF) in Davos, Switzerland, Jan. 18, 2017.
(Ruben Sprich / Reuters)

In a way, I don’t think Larry Summers expects the 20s to roar very hard.

Bloomberg:

Former US Treasury Secretary Larry Summers said global financial markets appeared to anticipate slow growth and low real interest rates for the next few years, which would undermine the ability of central banks to guide economies.

“What the markets seem to be valuing is a return to secular stagnation or Japanization,” Summers said at a lecture at the London School of Economics on Wednesday.

Calculating what the markets are valuing at any given time is not a precise science (# understatement), especially at a time when Fed policies are also skewing the price of money (interest rates). Nonetheless, Summers’ commentary suggests that the extent of this distortion should not be overstated. Businesses don’t seem in a rush to put money to work, and (to oversimplify) that means the money would be “cheap” anyway.

Bloomberg:

The remarks are based on [Summers’s] since 2013 that one of the main problems of industrialized countries is excess savings and lack of investment.

At least part of the reason for this lack of investment – as I have discussed here and here – is, I guess, that the financial crisis (and memories of the financial crisis) have “marked” the directions of a way that led them to reassess their perceptions of risk. If “the impossible” had happened, it could happen again. This meant that the potential return that managers should expect before embarking on a new project should be higher than it would have been before. The ‘impossible’ has, of course, now returned, this time in the form of COVID, and it’s also likely to leave scars – something that, as I also mentioned earlier, those responsible for the original work on the scars had contemplated.

To quote (again) Julian Kozlowski of the St. Louis Fed:

Perception can be anything: people observe new events and use those experiences to inform their expectations. For example, if you haven’t seen a lot of pandemics, you think pandemics are rare. However, when you see a pandemic, you come to believe that pandemics are not as rare as you once thought. . .

Consciously or not, we all use past events to inform our beliefs, as econometrics do. Rare events are those for which we have little data. In turn, the scarcity of data makes new rare events particularly informative, so rare events trigger larger belief revisions. Additionally, since it will take many more observations of non-rare events to convince someone that a rare event is truly unlikely, these changes in expectations are particularly persistent.

Somehow, I suspect that the obvious reluctance of some in government to ease COVID-related restrictions will only make these scars worse.

Whatever the causes of this decline in investment demand, Summers (Bloomberg reports) believes that it will limit the ability of policymakers to use rising interest rates as a means of stabilizing the economy (an increase in the price of ‘a good for which demand is low will not be very useful). Summers says the task will fall to the government, the report said, a worrying prospect at a time when the administration’s plans – from higher taxes to increasingly onerous regulations – appear designed to discourage investment. The idea that, by default, this could be used to strengthen the case for increased state investment is no cause for celebration.

To add to the gloom, Summers is (rightly) worried about how ultra-low interest rates are boosting one type of investment: the bad investment.

Bloomberg:

Summers also warned that low borrowing costs would increase the risk of another financial crisis.

“Extremely low interest rates pave the way for leverage and the perpetuation of zombie companies and the perpetuation of financial bubbles,” said Summers, who is also a paid contributor to Bloomberg. “We see a lot of evidence of speculative risk. Extremely low and negative real interest rates are problematic.

Indeed, they are.