How rock-bottom interest rates are doing more harm than good - THE TELEGRAPH
The line was delivered with the kind of menacing sneer debaters reserve for a knock-out rhetorical blow.
During their heated exchanges on managing the economy in their television debate on Monday, July 25, the former Chancellor Rishi Sunak looked across at his opponent to become Prime Minister, Liz Truss, and demanded to know whether she was aware of what mortgage rates are in the United States.
“C’mon, what are they,” he heckled while Truss remained stony-faced. If she were to admit that rates had almost doubled over the last six months, which as it happens they have, he clearly felt it would be fatal to her economic plans. The economy could not possibly be entrusted to someone that reckless.
But hold on. Is that really true? We have lived in a world of near-zero interest rates for 14 years now. We have become so used to them, we hardly even discuss them anymore. And yet, it now appears they are finally coming to an end as central banks around the world start to grapple with soaring inflation.
In the US, the Federal Reserve this week increased rates by 0.75 percentage points, its fourth consecutive rise, and its benchmark lending rate is now at 2.5pc.
The Bank of England is steadily raising rates and will no doubt do so again in August. Even the European Central Bank (ECB) has finally, although belatedly, joined the party, with a 0.5 percentage points increase, its first increase after a decade with rates that were actually negative. Perhaps, as Sunak clearly believes, that will be a catastrophe for the global economy, plunging households and companies into bankruptcy, and we must do everything possible to keep cheap money flowing forever.
And yet, it is also possible that zero rates were always an illusion, and one that ended up doing more harm than good. Ultra cheap money created a bitter generational divide as soaring house prices made it impossible for younger people to get on the property ladder; it created legions of zombie companies that were kept barely alive on easy credit; it encouraged feckless spending by governments that thought the bills would never fall due; it created an explosion of debt and fuelled asset-price bubbles; and it destroyed the incentive to save.
True, free money might have helped rescue the economy in the wake of the financial crisis of 2008 and 2009. But one day interest rates will have to get back to normal – and now is the moment.
“By any historical measure, interest rates have been exceptionally low for the last 14 years,” says Nicholas Crafts, emeritus professor at Warwick University and an expert in British economic history. “Even in the [worldwide depression of the] 1930s they did not go below 2pc, and even that was only for a few years. And yet, over that time, growth and productivity and investment have also been very weak.”
The zero-rate era has lasted far longer than anyone originally thought possible. Rewind to 2008, with banks around the world crashing, and with the financial system in turmoil, and central banks around the world slashed rates to 300-year lows. From 5pc before the crisis, by March 2009 the Bank of England had taken rates all the way down to just 0.5pc, the lowest level since it was founded in 1694, in an effort to boost the economy.
At the same time, it launched the first round of what was then a new-fangled strategy called “quantitative easing”, a polite term for what used to be known as printing money. It was sold as a short-term crisis measure to prevent a re-run of the Great Depression.
Once everything was back to normal, interest rates would be raised again. But the return to normal never arrived. Instead, rates remained close to zero for the next decade, and were then cut again, all the way down to 0.1pc in the UK, to cope with the Covid-19 pandemic. In some countries, such as Sweden and Switzerland, and the eurozone, rates even went below zero.
In a through-the-looking-glass financial twist, you actually had to pay the bank to look after your money for you. Nothing like that had ever happened in financial history before.
No one denies the strategy helped the global economy recover from the crash of 2008. After a steep initial fall in output, most developed countries bounced back fairly quickly. The trouble was, as the years went by, financial and asset markets became more and more distorted. Like opioids, zero rates may have been effective in an emergency – but they quickly became addictive and potentially fatal as well.
Take housing, to start with. As mortgage rates fell, debt loads became easier and easier to service for anyone who already owned a property, sending prices soaring upwards, and locking a whole generation out of the market. From £157,000 in 2009, by last year the price of the average British house had risen to £273,000 even though real wages were broadly stagnant in real terms over those years.
Across the UK, the average deposit needed to buy your first home rose above £50,000 by last year and above £70,000 in London. Without help from their parents, those were unimaginable sums for most under-30s, even if they were in well-paid jobs.
Not very surprisingly, the rate of home ownership, which had been rising through all the post-war period, and accelerated in the era of Mrs Thatcher’s home-owning democracy, went into reverse. From 73pc when rates went to zero, it dropped all the way down to 65pc. Even more alarmingly, ownership levels plunged among younger people. The Office for National Statistics found recently that a third of 25 to 44-year-olds are now renting from private landlords compared with fewer than one in ten 20 years earlier.
Sure, perhaps the millennials were spending too much on their smashed avocado brunches and chai lattes to save up for that deposit. And, sure, we don’t build enough homes. But there was no getting away from the real problem. Artificially low interest rates inflated a property bubble that rewarded the old who already owned their houses and punished anyone younger who had not yet got their first foot on the ladder.
Next, take a look at what happened to the corporate sector. Normally when there is a crash, as in 2008, lots of firms go bust. It is tough on staff and suppliers, and even tougher on the shareholders, but it is part of a process during which the commercial ecosystem renews itself, clears out the deadwood, and comes back healthier than before.
A few major retailers disappeared over a decade ago – the much-missed Woolworths, for example – but most businesses have simply staggered on. They are known as zombies: companies that just about bring in enough money to cover the interest bills (not especially hard when you are only paying half a percent), but are incapable of growth and have little left over for investment.
How many zombies are out there? According to the think tank Onward, one in five British companies now rank among the living dead. Put them all together, and they are tying up huge amounts of capital, land and labour, resources that could all be put to work more productively among faster growing businesses.
True, our departure from the European Union has hardly helped. But investment rates in the UK have been dismal since rates were slashed to zero, as they have been across most of the developed world. A coincidence? To some degree. But there can be little question that keeping money artificially cheap has meant the economy is cluttered up with too many poorly performing companies.
In the meantime, governments have borrowed more and more. In the UK, the debt to GDP ratio stood at less than 50pc before the crash. It carried on rising even during the supposed “austerity” of the Cameron-Osborne era, and then shot up again during the pandemic. By last year that had almost doubled to 94pc, its highest level since the 1960s when we were still paying for the cost of the Second World War.
It is even worse elsewhere. In the US, the debt ratio went from 65pc to 135pc over the same period. If it is measured on a global scale, including government, corporate and global debt, the amount the world owes has never been higher. By last year, according to IMF calculations, total global debt had hit $226 trillion, or 256pc of global output, more than 50 percentage points higher than it was before rates were slashed to almost nothing. And heck, why not? With money so cheap, it made sense to borrow as much of it as you could.
If that money had been used by companies to invest in new factories, warehouses or products that would be fine. And yet there was very little evidence of that. Instead, much of it was used by a rapacious private equity industry that took over companies such as the supermarket chain Morrisons, and venture capital firms puffing up technology businesses to absurd valuations based on little more than some slick PowerPoint presentations and smart-looking apps.
None of that added very much to the productive potential of the economy, nor did it do anything to lift growth. Instead, assets were shuffled from place to place, making the fund managers rich, but leaving the companies they owned withered and emasculated. Typically, the private equity funds starve the companies they buy of investment, load them up with debt, and squeeze every last penny out of them to fuel short-term profits.
At the same time, the power of central banks has grown and grown. From faceless technocrats charged with nothing more than keeping inflation under control and stabilising the financial system, they have acquired rock-star status as they have flooded the world with money.
In this country, Mark Carney, the little-missed predecessor to Andrew Bailey, seemed to spend most of his time lecturing anyone who could stay awake about sustainability, diversity and climate change. In the eurozone, Christine Lagarde, the impeccably politically correct president of the ECB, seems to spend more time worrying about global warming than how to rescue Italy from permanent recession.
The power of the financial markets has also rocketed, with the rise of ever flimsier so-called assets. When rates were slashed to zero, the first Bitcoin had yet to be released (it made its debut on January 9, 2009, in case anyone is wondering). You could pick one up for a tenth of a cent. In 2021, one was worth more than $60,000.
There are dozens of other cryptocurrencies that have been launched since then, from Litecoin to Ethereum, to the basically satirical Dogecoin, launched first as a parody of the whole craze, but which then became an asset in its own right. And why not? When real money has gone bonkers, and is being given away for nothing, why not create completely imaginary currencies?
There may be some solid arguments for purely electronic currencies, but it is hardly a surprise that their rise coincided with the zero interest rate era, nor is it terribly surprising that, as rates start to return to normal, their prices are collapsing again. Crypto might have been the most extreme example, but there was also the craze for NFTs, digital artworks and collectibles, and extreme valuations for any kind of technology stock.
Wall Street’s Nasdaq index, home to most of the major tech businesses, grew eight-fold over the zero-rate era as all the cheap money flooded into fashionable assets. Sure, some of those were genuinely brilliant companies, such as Amazon or Apple, but many more were hyped-up apps making huge losses and with little to recommend them. It was all part of the era of financial froth.
Indeed, many of the architects of the policy of near-zero rates appear to regret the monster they unleashed back in 2008 and 2009.
“This ratcheting up of central-bank balance sheets and government balance sheets, I think, is a real problem for the future,” said the former Bank Governor Lord Mervyn King in a lecture last year, a startling admission for a man who presided over the first dramatic cuts in rates. In its wake, “zombie companies” were being supported by low borrowing costs and needed to be “allowed to fail” to help a more efficient allocation of resources as the economy adapted to a post-pandemic world.
“People have failed to recognise that the problem is one that can’t just be solved by even lower interest rates or even more fiscal stimulus,” he argued. Likewise, Ben Bernanke, the Fed chairman who cut American rates to close to zero, said as early as 2015 that he never expected them to stay so low for so long.
Of course, as interest rates start to finally rise again there may well be a rough couple of years ahead. It could well trigger a house price crash, or at least a correction, spelling political death for whichever party is unlucky enough to be in power when it happens (however, it is worth remembering that 83pc of UK mortgages are now on fixed rates, although admittedly a lot of them are quite short-term, so it may not be as dramatic as sometimes feared).
A fair number of those zombie companies may well go bust when the cost of the bank loans starts to rise again, and corporate debt is typically a lot more short-term so that impact will be very sudden.
The huge increases in government debt will start to get a lot more expensive to service; we saw a £10bn rise in the UK’s Government’s interest bill last month and that will get a lot worse in the year ahead. Even more seriously, it may trigger a financial crash as banks and hedge funds lose access to cheap money.
“The key is finding a balance between addressing inflation and triggering a dangerous liquidity crisis,” says Dr Riu Xie of the University of Bath, who has just published a report on the issue. “The risk is that ever-tighter monetary policy and interest rate hikes taken in very large steps will increase funding costs for financial institutions, and generate a liquidity crisis, which will increase the risk of global recession.”
Very true. No one would argue that steadily raising interest rates will be an easy path. And we may never get back to the 7pc to 10pc levels that anyone who bought their first property in the 1980s or 1990s will painfully remember.
Prof Crafts argues that interest rates may be permanently lower than in the past, but, and this is the important caveat, not close to zero.
And yet, looking back on the last 14 years, this was surely an experiment that failed, not just in this country but around the world. Shutting a generation out of the property market, creating a legion of zombie companies, inflating asset bubbles, and creating a debt-fuelled economy kept afloat on a tidal wave of cheap and printed money was hardly a great achievement. Nor has it done much for growth, equality, opportunity, or investment.
Rishi Sunak may think that rising interest rates are too terrifying to even contemplate. And yet he is surely wrong about that, as about so much else.