When, if ever, is it a good idea for governments and central banks to set interest rates at ultra-low or negative levels?

 

Ultra-low interest policies have been a feature of global monetary management since 2008 in most countries (and were tried in Japan before that.) They exist in the context of the near-collapse of the global economy and of national and international banking, credit, and derivative markets in 2008, though they also reflect a perceived lack of inflation risk. The idea behind ultra-low interest rates, or negative real or nominal rates, was, firstly, to prevent a credit crunch.

Credit crunches happen when banks have lent out a great deal of money and cannot fund a large volume of withdrawals. This causes banks to reduce refinancing and new lending, which puts individuals and businesses in a position where they cannot stay in the market and pay their bills and debts, thus creating a spiral of economic decline. In addition, banks might in such circumstances start asking for their loans and credit payments back early, worsening things still further.

Many modern banks also are principally mortgage lenders. If they have equity in housing as a lender, but then a credit crunch means that people cannot take out new mortgages or pay existing ones, banks lose share value. They lose profits. The demand for housing collapses, worsening the process. Ultimately, savers might queue to close accounts and withdraw money, at the same time as borrowers face restrictions and banks face crisis. This is how depressions start.

There is very little resilience in the modern economy, which across the developed world is based on various forms of sophisticated individual and corporate debt. Low central bank interest rates allow for liquidity on the part of banks which borrow from the centre, create a sense of security and stability for those banks (and some pension and hedge funds) and therefore keep the system going. One problem is that there is still a great deal of risk in the economy, since structural unemployment, a lack of ownership, property, transferable skills, or savings amongst the population, and economies used to high consumer spending and rents, still exists.

This means that the ‘excess’ liquidity caused by low or negative rates, which discourage saving, turns into ‘safe’ lending to those who already have money or property, which then worsens the gap between rich and poor and makes the poor and small businesses more dependent on credit and borrowing. It discourages saving too, and encourages spending, which can create inflation, but which also deprives businesses and entrepreneurs of incentives to invest. Those who have money then tend to invest it in ‘bubbles’ or, if they are public limited companies, to inflate the apparent value of their shares by buying them back themselves. Eventually, an inflationary scenario develops in which expectations change, people respond to the threat of inflation by buying up stores of value (like gold, silver, and bitcoin) and the velocity of money increases. Velocity of money means the desire to get rid of cash and to replace it with something which delivers a greater return than saving, and explains why, after a big reduction in interest rates and an expansion of cash, construction costs are soaring in the USA and house demand is rising massively in the UK.

Trying to force economic growth and development with an emergency policy which should have been time-limited is like becoming addicted to medical steroids or medical opioids. It is a currency debasement which has always led to inflationary surges. Great Inflations, even hyperinflations, are not always bad things in the abstract; they ‘reboot’ societies, remind people of the importance of saving, crash economies that do not make things that people want, and demolish dangerous financial practices for several decades. They also rebalance inequality, and some societies have benefitted from them in the long run (Weimar Germany escaped many of the burdens of the Treaty of Versailles, the inequalities of the French Ancien Regime were assaulted, the eastern European market democracies gained a balanced set of prices which actually worked in 1991, and Venezuela is being discouraged from economic lunacy, for instance). In the short run, however, they are terrible, and require sympathetic and internationally organised coordinated rescues or protection for those citizens, particularly the most dependent or vulnerable, who are affected by them.