The Federal Reserve recently lowered its benchmark interest rate. Meanwhile yields on 10 and 30 year U.S. Treasuries are at or near record lows, as are rates around the world. And according to recent news articles, nearly 25% of government bonds worldwide have negative yields, some $15 trillion worth. Moreover, the likelihood of negative rates in the United States seems greater with each passing day, especially given the political pressure being applied by those in power.
I’ve written elsewhere about the immense dangers of easy money and modern central banking policy. However, given today’s downward trend of interest rates, a decade after the 2009 financial crises, I wanted to write a short post summarizing the major downsides of prolonged and artificially low interest rates. To keep this discussion at a breezy pace, I am not going into the wonkish mechanics of monetary policy nor will I burden you (or me) with any more numbers or statistics. I will simply attempt to make the case that the side effects of low rates are vastly underappreciated, and highly damaging
However, before we start discussing these downsides, indulge me for a very quick and high level primer on the theoretical rationale for low rates.
The rationale for low rates
Economists and central bankers are trained to believe the following: when the economy is experiencing negative or slow growth, and when unemployment is unacceptably high, it is the central bank’s duty to lower interest rates. Why, you ask? Because companies are more likely to invest in building a new factory or opening a new store when the funds needed to do so are cheaper. And building and operating a new factory or a new store requires additional employees. Thus by making the funds necessary for investment less expensive, central banks expect the unemployment rate to decline. Factories get built that otherwise would not have been built. Stores are opened that otherwise would not have opened. Employees are hired that otherwise would not have been hired.
In a similar way, low interest rates encourage consumers to spend more money. Like businesses, they too have an easier time borrowing to finance such purchases as houses and automobiles. In addition, low interest rates act to discourage saving since the amount earned on savings (the interest income) is reduced. In both instances, increased consumer spending acts to decrease unemployment as additional workers are needed to provide the incremental goods and services being purchased.
The simple rationale for low interest rates that I just described relies on several key assumptions. The most important is that the money that companies borrow because of low interest rates winds up being invested in job-creating ways. The second is that the money is invested in job-creating ways in the domestic economy, and not overseas. The third assumption is that interest rates can only remain low whilst unemployment is high. Once everyone who wants a job has a job (known as “full-employment” or the “natural rate” of employment), cheap money no longer works to goose hiring and economic growth. Instead, low interest rates cause prices to rise (inflation) as companies have to raise wages to hire not the unemployed, but those employed by competitors. The last major assumption is that monetary policy is a short-term solution to a temporary (not a long-term or structural) problem of high unemployment.
Unfortunately, all four of these key assumptions are false, undermining the theoretical rationale for low interest rates. The vast majority of the money invested because of low interest rates has been invested in unproductive and job-destroying ways, as we shall shortly see. Second, much of what has been invested in job-creating ways has gone overseas as U.S. companies accelerate the trend of outsourcing and offshoring. Third, the official unemployment rate in the U.S. is at record lows (currently 3.7%), far lower than what economists used to consider full employment even during high growth eras. Lastly, we’re now going on a decade of historically low interest rates (never before seen in thousands of years of recorded history) with no end in site. Clearly not a temporary solution to a temporary problem.
In short, low interest policy doesn’t do what economic theory says it is supposed to do. But who cares right? No harm, no foul? Wrong. The problem with low interest rates is not that they don’t work. The problem is that the side effects are enormous. Let’s now move on from the discussion of theory to the very practical. What are those terrible side effects? What are the most significant downsides of perpetually low interest rates?
The missing inflation
One of the things most confounding to central bankers and mainstream economists is the lack of inflation given a decade of extraordinarily low interest rates. Recall that economic theory says that once employment is full, further monetary stimulus should cause a rise in inflation. And yet the key rates of inflation such as the consumer price index (CPI) have rarely exceeded the 2% target set by central bankers. Central bankers have hence concluded that full employment must not be yet met, and further stimulus is both necessary and good.
A while ago, I wrote a lengthy post explaining the conundrum of the missing inflation which I of course encourage you to read. For our purposes here, however, we need to concern ourselves with only one aspect of that explanation. Inflation is hiding in plain sight and it is having a terrible effect on consumers and the overall economy. Why economists are blind to this is one of the unsolved mysteries of the universe.
The missing inflation can be put into three categories. The first is non-tradable goods and services or more simply stuff that can’t be made in China and other low-cost producing countries. Prime examples of that stuff? Real estate, education and healthcare. Over the prior several decades of easy monetary policy, and certainly over the past 10 years, the inflation rate on these three giant categories of consumer spending has vastly exceeded the rate of the CPI. And while this inflation hurts nearly everyone, it especially impacts younger workers who face the trifecta of enormous students loans, unaffordable health insurance and sky-high home prices. We will come back to this point later when we talk about weakening demographic trends.
The second category of the kind of inflation not found in the CPI is financial asset inflation (which also includes real estate). The damage of asset inflation is at least threefold. First, it all but guarantees lower returns going forward, in essence taking consumption, income and wealth that should be in the future, and should belong to today’s younger generations and shifting it forward to today’s older, wealthy generation. This is a generational transfer of wealth that is both unfair and exacerbates income inequality. Second, as we will discuss in further detail, asset inflation affects income inequality even further as the wealthy who hold financial assets see their wealth climb even higher. Third, asset inflation increases instability in the financial system and with it, the inevitable risk of future financial crises and meltdowns.
The third type of inflation that is missing from the CPI is something that typically keeps economists at central banks awake at night. This is the classic wage/price spiral, a cycle of continuously rising wages and rising prices that feed on each other. The difference, however, is that the inflationary wage/price spiral occurring today is not happening to the average consumer represented by the CPI. Instead, this inflation is happening to the highly skilled and to the wealthy.
Evidence for such a wage/price spiral can be clearly seen when examining the salaries of technologists in San Francisco or those of financiers in New York, and the things they buy. We’ve experienced a continuous cycle in such cities of rising income, rising real estate prices and rising restaurant and luxury hotel prices. You can also see the dramatic inflation in the skyrocketing prices of scarce and luxurious collectables favored by the wealthy and ultra-wealthy such as modern art, fine wine and professional sports teams. The higher the prices or the more stratified the goods, the higher the rate of inflation. Not only does this trend exacerbate income inequality, as we will discuss later, but it causes vast distortions to the economy as an inordinate amount of economic resources are utilized producing luxury goods and services for the few, rather than middle class goods and services for the many.
The mortgaging of the consumer
We’re already discussed the idea that one of the primary goals of easy monetary policy is for consumers to spend more and save less. And not just spend more and save less out of income, but to incur debt to spend more. The impact of both the disincentives to save and the low income earned on the little money that is saved, is an overly indebted consumer class with no rainy day funds, no retirement savings, no equity in their homes and one completely dependent on government funds for retirement. Add to the mix insolvent pensions (discussed next), soon-to-be insolvent social security, rising healthcare costs (discussed previously) and bad demographics (discussed later), and you’re left with a ticking time bomb for the consumer middle class.
The implosion of pensions
While interest rates have caused a slowly ticking bomb for consumers, the clock on pension implosion runs much faster. Pensions have to invest workers contributions in order to meet projected retirement payouts in the future. Similarly, insurance companies have to invest insurance premiums to meet their forecasted insurance payouts. Pensions along with insurance companies represent by far, the largest pools of savings in the economy.
Historically these types of institutional investors invested prudently in relatively safe assets such as government bonds. But as you of course know, returns on relatively safe assets such as government bonds are paltry given the workings of central bankers. The only way for pensions and insurers to even attempt to achieve the returns required to meet future liabilities is to take on more and more risk.
The obvious problem of taking on more risk is that it is, well, riskier. Pensions have increased their holdings of stocks in lieu of government bonds, of high yield debt in lieu of highly rated debt, and especially of so-called alternative assets such as private equity and hedge funds. When the next financial downturn hits (and in the life of a pension or insurance policy, it certainly will), riskier assets will prove a disastrous investment.
To add insult to injury, many of these pensions, specifically those of state and local governments are already woefully underfunded, and people are generally living longer. Together, you have all the makings of a crises that can only result in either drastic cuts to basic government services, drastic cuts to retirement income, or more likely, both. This inevitable outcome will not be pretty.
Insolvent pensions are actually the smaller of the two evils of too much investment in risky assets. The less obvious but more damaging result is that investors such as pensions are subsidizing investments that are directly detrimental to jobs, to the middle class and to the long-term health of the economy. Specifically, they are subsidizing financial engineering, M&A and unproductive technology companies. These are the subjects of the next three sections.
The job destruction of financial engineering
As I mentioned earlier, due to low interest rates, institutional investors have been forced to put money into riskier stocks and highly leveraged or high yield debt. If that money was in turn invested by companies in new factories and stores we would likely conclude that monetary policy is working. But it’s not, and it isn’t. Most of the money is going instead to what we can loosely categorize as financial engineering: stock buybacks, mergers and acquisitions, hedge funds and private equity.
The economic problem with investing in such financial maneuvers, is that such financial maneuvers nearly always result in fewer jobs, not more. Funds used to buyback stock could have been used for investment in new products or new services, in capital expenditures, in R&D. Acquisitions nearly always result in job cuts in the name of synergy and often in increased outsourcing and offshoring. Hedge funds, always short-term oriented, and especially the activist variety, put immense pressure on companies to downsize, to under-invest and to return money to shareholders, money that otherwise could have been invested productively. Private equity forms do the same to their portfolio companies, and with the greatly increased risk of value and job destroying bankruptcies.
The creation of M&A fueled monopolies
As we’ve already discussed, low interest rates leads naturally to inflated equity prices, riskier investments and increased financial activity such as mergers and acquisitions (M&A). We’ve also mentioned how M&A leads to the destruction of jobs. However, there is an even worse impact of the M&A activity in the cheap money era. It has led to unprecedented and massive consolidation in nearly all industries, and the creation of monopolies.
Highly consolidated industries and monopolies always result in some combination of higher prices, less innovation, worse service and (obviously) fewer choices. Facing little competition, monopolies tend to under-invest in product development, in customer service, and in basic R&D, and over-invent in political lobbying in order to maintain their market position and keep out new entrants. Moreover, size begets political power and political power begets size as monopolies lobby for regulation, tax advantages and subsidies. Lastly, industry consolidation is perpetuated as monopolies have the subsidized funds to acquire any and all companies they view as potential competition. While this has happened in virtually all industries, as I stated above, nowhere has this been more prominent than in technology.
Contrary to what is believed in conservative and libertarian circles, it is monopoly, not government that is the true enemy of the free market and the true enemy of freedom.
The parasite of subsidized technology
I’ve talked about how much of what has been invested in the era of low interest rates has gone to financial engineering such as M&A rather than used by companies to build or expand their businesses. It is certainly unfair and untrue to state that there has been no real investment in businesses. This is especially true in the technology sector. However, even more so than in finance, the investment in technology has been generally unproductive, job destroying, and altogether calamitous for the economy.
The parasitic nature of technology, specifically the internet is a topic I wrote about in depth here. We have been trained by both economists and the media to think of technological advancement as a positive for the economy and for the world. In a world of normal interest rates that might have been true. But in today’s world, the impact is decidedly negative. I’ll go as far as to say that the internet might just be the worst thing to ever happen to human beings.
Let’s take the behemoth Amazon, my favorite internet punching bag. Amazon has, in fact, created hundreds of thousands of new jobs. The problem, however, is that Amazon’s retail operations (the vast majority of its revenue) has come at the expense of traditional retailers. For every job Amazon has created, several more have been destroyed, with an outsized negative impact on small, local retailers and local commercial real estate. Job destruction of this nature is pervasive throughout the tech industry, and given its disruption of traditional industries, pervasive throughout the economy.
Naturally, there are those who say that the Internet represents creative destruction at its finest. That such job destruction is both productive for the economy, and inevitable. Such people are mistaken. The vast majority of tech companies, Amazon included, either lose enormous sums of money with unsustainable business models, or at best, earn far lower margins than the traditional companies they have disrupted (margins that would be totally unacceptable in investors in a world of normal interest rates). Uber, Netflix, Twitter, Tesla, WeWork are just a few more examples of highly disruptive technology companies that have lost, or continue to lose billions. These companies are completely subsidized by the unceasing flow of cheap money.
As destructive as the technology industry has been to jobs, we are unfortunately just scratching the surface of the damage these companies have done to society as a whole. By making information free, by violating copyright, by failing to police their content as a traditional publisher would, by abusing their monopolistic and political power, technology companies have among other things, incited hatred and terrorism, undermined elections, destroyed privacy, decimated journalism, undermined truth and fact, increased loneliness, reduced a sense community, cut attention spans, killed intelligent thought and debate, popularized and brought into power fringe politicians and caused irreparable damage to democracy and freedom.
Every day another article or academic study appears in one form of media or another about the damage that technology companies and the internet have caused. A consensus seems to be building that both the underlying cause and the solution to society’s internet problem are anti-trust laws. That lax anti-trust enforcement allowed these tech companies to become so powerful and that only strict enforcement can now restrict that power. This consensus is wrong. The real culprit is the subsidy of easy money. These companies would never have become as powerful without the perpetual low interest rates. And the only way to reduce their power is to take away that subsidy.
The cancer of income inequality and the demise of democracies
As I’ve written about in great depth and in summary form, the central banking policy of low interest rates is the single most important cause of the drastic increase in income inequality of recent decades. To best understand this trend, it helps to separate income inequality into two types: the decline of the middle class and the rise of the super wealthy.
The story of middle class decline is as follows. The entrance of China and other low wage manufacturing countries to the global economy caused wage pressure in high wage countries such as the United States. Regulations, unions and legacy pension costs together wouldn’t allow wages to fall to remain competitive. Instead factories, businesses and entire industries went bankrupt and closed. Laid-off workers were forced to take jobs in much lower wage service jobs, as second-class citizen contractors lacking benefits, or more recently, in the gig economy.
Meanwhile, while prices of goods from China (and elsewhere) did decline, the overall price level did not. Why not? Because the central bank kept their foot on the monetary gas pedal. Partially because of their illogical fear of deflation, partially due to their naive desire to eradicate the business cycle and partially because of a series of Wall Street bailouts. The money had to go somewhere.
As we discussed earlier, what prices went up the most? Real estate, healthcare and education. These all became unaffordable to the middle class. Further, low interest rates allowed more borrowing in order to fund those purchases of Chinese goods, and outsourcing and offshoring were expanded due to M&A transactions and hedge fund short-termism. All of these factors acted to accelerate the globalization trend farther, and with far more impact on U.S. jobs than it otherwise would have had there been normal or market interest rates. In short, declining wages, fewer jobs, rising prices, and over-indebtedness created middle class despair.
The second, and even worse type of income inequality that the entire world has experienced is the the wealth accumulation by the rich and the super rich. Here the blame lies even more so at the door to the Federal Reserve and the world’s other central banks. The low interest rates that have caused the subsidies to financial engineering such as M&A, and to growth and risky investments such as technology have caused the income and wealth of public company CEOs, tech entrepreneurs, venture capitalists, hedge funders, investment bankers, private equity partners, and many others to skyrocket. With risk and correspondingly growth subsidized, all of the economy became a “winner take all” game. And of course the inflation in financial asset prices due to low interest rates perpetuates the growth of inequality.
Combine these two trends of a sputtering middle class and the wealthy getting wealthier and more politically powerful and you sow the seeds of populism, socialism, unrest and ultimately revolution.
The strangulation of economic growth
Central bankers, politicians and nearly all voters focus only on short-term results. This is one of the inherent problems of democracy. In this last main section, I want to talk about long-term economic growth. In many ways, this serves as a summary of everything we’ve covered before. We’ve discussed how low interest rates have shifted spending forward by decades which will result in lower economic activity in the future. We’ve talked about how pensions won’t have the money to pay retirees. We’ve also mentioned how asset inflation sets the stage for future financial crises. But those are not the only, or even the worse impacts on tomorrow’s economy.
Over the long-term, economic growth is essentially a function of two basic factors: productivity growth and population growth. Low interest rates kill both. As we’ve discussed a number of times, subsidizing risk has led to under-investments in basic R&D and long-term product development. It has led to stagnating monopolies and unproductive technologies.
But perhaps most importantly, it has led to under-investment in employees and their skills. With layoffs and downsizing always around the corner, lifetime employment dead, independent contractors and gig workers flourishing, employers no longer invest in their employees, and employees no longer invest in their employers. Productivity is a difficult concept and misunderstood by many. While technological breakthroughs like the cotton gin, electricity, the automobile or the computer get the headlines, they are rarely what drives productivity growth. What more typically drives productivity growth are the small, incremental improvements made by long-term employees increasing their skills and knowledge, and invested in their jobs and careers. Without such long-term employees, these kind of productivity improvements wither away.
The second variable of long-term economic growth is population growth, which is itself a function of two factors, child birth and immigration. And yet again, monetary policy has negatively impacted both. Young people crushed by student loans, sky-high real estate prices, unaffordable healthcare and poor job prospects delay getting married and having kids. Or worse, fail to do so entirely. At the same time, middle class despair together with technology-fueled misinformation and nativist sentiment supports populist-style leaders and erodes support for immigration.
Taken together, population growth is stifled. This is exactly the situation of Japan where three decades of suppressed interest rates have caused a demographic implosion, in essence, a dying country. The United States and Western Europe are following in Japan’s ever diminishing footsteps.
Conclusion
Well meaning but unwise central bankers have backed themselves into a corner as the world has become addicted to cheap money. Unaware of the consequences, blind to reality, slave to erroneous theory, and bullied by political pressure, economists in power have suppressed interest rates, causing immeasurable economic distortions and societal damage.
Continue current policy and yes, you likely delay the inevitable restructuring of the worldwide economy. In the meantime, the middle class continues to be crushed, income inequality keeps rising, productivity stagnates, monopolies flourish, demographics worsen, political power consolidates, truth and fact lose significance, populist and socialist leaders surge, democracy and freedom crumbles.
But assuming we survive all these things – and we may not – sooner or later we will experience a crises that no central bank can print their way out of. One that dwarfs the financial meltdown of 2009. When, I don’t know. Perhaps months from now, perhaps years, perhaps decades. But for sure it will come.
Normalize interest rates now and the value of financial assets will plummet. Wall Street and Silicon Valley will crater. Unemployment will rise. The global economy will likely go into a depression. But the world that will emerge, and it will emerge, will be more productive, more equal, more fair and more free.
Making the right choice isn’t easy. It may be politically impossible. But the first step must be education. Until central bankers, politicians, the media and voters awaken to the reality that the downsides of low interest rates far, far outweigh the upsides, the U.S. and the world will continue forward, on its disastrous course.