What’s in an interest rate? – Part II

Last week we discussed what exactly interest rates are in the article What’s in an Interest Rate?

This week, we take a deeper look at the general interest rate policy trend of central banks worldwide, and what it means for the world.

ZIRP

“ZIRP” may sound like a phrase from the local dialect of Area 51, but it’s actually an acronym for something far more insidious – Zero Interest Rate Policy.

Under ZIRP a central bank maintains a zero (or close-to-zero) interest rate policy, artificially setting short-term interest rates at these levels.

Initially, ZIRP was introduced by central banks after the Great Financial Crisis of 2008 to counter the price deflation that immediately followed the crisis. Ostensibly zero interest rates are to stimulate the economy into an economic recovery.

A decade later, it is abundantly clear that this thinking has all but recovered the economy as the world teeters on the brink of yet another recession.

Interest Rate meddling

The problem with central banks artificially intervening in the natural functioning of the market economy to set interest rates below the natural market rate is that it simply destroys the mechanism by which savings are recycled into capital for production.

When interest rates are not tampered with, they serve as an important tool in accumulation of real savings and the facilitation of its flow toward productive capacity and wealth-generating infrastructure.

Under interest rate suppression, savers are discouraged from saving. Instead of storing the hard-earned fruits of their labour in the form of bank deposits, which in turn can be made available for entrepreneurs to invest in productive capacity, savers are forced to speculate to achieve a return.

Negative Interest Rates

The most recent development on the front of extraordinary monetary policy is the concept of negative interest rates.

Europe and Asia are both awash in $13 trillion worth of negative-yielding sovereign and corporate bonds, and by the dovish actions of the US Fed, we can predict that the US is in close pursuit.

Again, the ostensible goal of these policies is to stimulate spending in the economy for recovery. But negative interest rates turns everything we know about economics upside down.

Consider this – a negative natural rate of interest would mean that, given the choice between R100 today and R50 tomorrow, you would prefer the R50 tomorrow. That is a complete absurdity and does not conform to reality. 

This distortion of economic reality results in the taking on of debt becoming a profitable business, especially to the state or special interest groups who have primary access to the cheap credit.

The Product of Interest Rate Shenanigans

All of these weird and wonderful policies rely on the absurdity that an economy grows by borrowing and spending instead of saving and producing.

But, let’s look at the practical consequences.

In the short term, whether it’s ZIRP or negative interest rates, the process toward lower interest rates drives asset price inflation. Shares, bonds, property and all financial assets become more expensive (this is because the present value of assets are determined by the asset’s discounted future cash flows – lower discount rates mean higher present values).

In aggregate, a speculative bubble grows.

This perceived artificial economic boom obscures the fact that the economy is actually living off its subsistence, as savings are eroded by a disincentive to save and capital driven toward speculation and consumption instead.

Gradually, as the foundation erodes, economic growth starts to dwindle and production starts to fall; real returns diminish; a wave of bankruptcies and job cuts starts to roll; asset prices start to collapse; income distribution starts to divide societies; and, as some point, the bubble bursts.

Unless we’re no longer living in a world of scarcity – one where goods and services can be printed out of thin air – the likely outcome of the above is widespread economic impoverishment and political chaos.

Any of this sound familiar?

Maybe central banks are taking advice from Area 51 after all.

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