This Is How Low Interest Rates Destroy the Economy

November 8 2016

Of course, you will read about everywhere how low interest rates hurt savers and pensioners. But this obvious and visible consequence is not the real bottleneck. Interest rates are the most important prices in a market economy. Interest rates coordinate production over time. The artificially low interest rates of today will lead to erroneous investment decisions, which will avenge themselves in only one possible way: a depression with a capital D.

How Do Entrepreneurs, Firms and Capitalists Decide Where to Invest?

The problem is that many people have no clue as to why companies invest money in project A instead of project B. To understand how artificially low interest rates will destroy the economy, we first must understand how and why businesses make certain investments.

A financial valuation precedes every investment decision. Every financial valuation consists of two components:

  • (Future) cash flows
  • A discount rate, i.e., an interest rate

(Future) Cash Flows

A company, entrepreneur or investor tries to estimate the future cash flows a given investment will generate in net terms.

Let’s take a food truck to illustrate how this works. A food truck requires some upfront investments: the truck, an improvised kitchen, some materials and ingredients. These costs represent negative cash flows. The owner of the food truck must take some money out of his pockets to cover the costs.

But this food truck is soon able to generate revenues. The earnings from the sales of, let’s say, hamburgers, assuming a positive margin, represent positive cash flows. This is money flowing into the pocket of the food truck owner.

If we net out all the negative and positive cash flows, we will see that someone who invests in a food truck will perhaps bear a net negative cash flow in the first year, but would anticipate positive cash flows rather soon. The period of production of hamburgers is short; the initial capital investment is low. Money can be made pretty soon.

Interest Rate

Yet, receiving $1000 in two years’ time is not the same as having $1000 right now. “Time is money,” the old cliché goes, and the interest rate is the price of time. In other words, we want to know how much that $1000 we expect to earn in year 1, year 2, year 3, year 4 and year 5 is worth today. And, therefore, we use an interest rate to get to the present value of these future cash flows. We use an interest rate, or a discount rate, to bring future cash flows to the present.

In other words, interest rates determine how much future cash flows are worth now. Low interest rates? Future cash flows are worth more today. High interest rates? Future cash flows are worth less today.

The Problem

Investors, firms and entrepreneurs invest in those production projects which they think will be most profitable. The thing is: projects with a (relatively) long period of production that require lots of capital are more profitable when interest rates are low: the present value of the future cash flows that these investments promise is after all higher.

The present value of the future cash flows of our food truck example will improve somewhat with a lower interest rate.

But other investments are more complex than an investment in a food truck. There are millions of investment possibilities, each with its own duration (the period before the investment starts to bear fruit) and capital requirements (the initial and future capital expenditures).

The longer the duration of an investment, and the more capital the investment requires, the bigger the effect of changes in interest rates on the present value of the future cash flows of this investment.

Interest rates are decisive.

Low interest rates thus lead to more investment in more capital intensive, more long-term projects. The lower interest rates, the more these kinds of investments are favored.

An Illusion

These low interest rates create an illusion. Interest rates arise, without intervention, because people have different subjective time preferences. Some demand present goods to a greater degree than others. These time preferences do not change. While interest rates under normal circumstances inform entrepreneurs, firms and capitalists as to what durations their investments should have, they are now being misled by the absurd monetary policy of central banks.

The artificially low interest rates give investments an aura of profitability while it is merely a temporary illusion fed by the ECB. In other words, we must prepare for an economic disaster. Entrepreneurs, companies and investors are being misled.

These investments will, however, not end well. They are based on projections of future demand that are based only on the financial veil of the ECB. These investments will only result in bankruptcies and liquidations.

Unfortunately, these investments are on the books of financial intermediaries. The ECB is planting the seeds of the future destruction of its own banking system.

The Absurdity of the Attempts to Explain Low Interest Rates in Other Ways

Since some economists have no knowledge of capital theory, they try to defend their failing models by reaching for the most absurd explanations possible of the recently low or zero interest rates. Instead of blaming central banks, they base their explanations on a so-called “savings glut.” Former CPB-director Coen Teulings, for instance, refers to “birth control” and the diminishing population growth, while on the other side we have the baby boom generation that arose out of a birth wave after the Second World War.

After all, the capital market, Coen Teulings explains, is a market just like any other market where supply and demand meet.

That nowadays a very important share of that “supply” originates from the unlimited wallet of the central bank, is conveniently ignored by Teulings.

In the meanwhile, the central bank owns 50 times more assets than the biggest hedge fund in the world. And whereas from 2006 to 2016 savings have increased a “mere” 80 billion euro in the Netherlands, the European Central Bank (ECB) pumps the same amount in capital markets in just one single month with only its QE-program. So much for “supply and demand.”

But “interest rates have been coming down all the way since the 80s.” That can never be the result of the monetary policy of the past five years, Teulings argues.

First, those are a lot of assumptions in one single statement. In the 1980s, interest rates rose to record highs. In 1980, interest rates on the Dutch 10-year government bond reached a high of 15%. A historically abnormal height and for good reason: inflation got out of control. In 2000, two decades after inflation retreated, interest rates on 10-year government bonds within the Eurozone were at about 5%. A historically normal height.

So, yes: interest rates went down from 1980 to 2000, but that was merely a normalization of nominal rates after a turbulent period of high inflation. However, what happened after that period has everything to do with central banks. Interest rates were lowered before the change of the millennium, because of (highly exaggerated) fears of Y2K. After Y2K, interest rates were manipulated downward even further as a reaction to the 2001-recession (and the bursting of the dotcom bubble) and the terrorist attacks in New York. The eventual result was the biggest recession since the Great Depression of the 30s, with this time more of the same: after the recession of 2008, interest rates were even further lowered to practically zero.

The explanation of Coen Teulings, blaming demographic factors for low or zero interest rates, is absurd and hopely not serious.

Do not be fooled, dear reader. There is one culprit and one culprit only: the central bank.

What Is About to Happen

The reason that interest rates are low is simple: central bank intervention. This intervention occurs on two levels:

  • Indirectly: the banking system takes bigger interest rate risks because it can get all the liquidity it possibly needs practically for free at the central bank (in economic jargon: the banking system is engaging on a larger scale in maturity mismatching. In other words, banks finance themselves on the liabilities side with increasingly shorter maturities, while investing on the asset side in increasingly longer maturities. One of the consequences is that long-term interest rates have come down.
  • Directly: the central bank is expanding its asset purchases and, moreover, assets with longer durations and maturities than before. Interest rates go down, but the effect is especially notable on long-term interest rates.

Precisely that long-term interest rates, that is the most manipulated rate in our times, is crucial in the investment decisions of entrepreneurs, companies and capitalists.

What we see now is, however, unprecedented.

Since the crisis of 2008, the assets of small banks have increasingly longer maturities. For instance, in 2007 only 16% of their assets were invested in assets with a maturity over 5 years. Nowadays, that percentage is 31%. More importantly, since the crisis of 2008, big banks are financing themselves increasingly with short-term credit (your own bank deposit is an example of such a short-term credit; you can, after all, demand repayment at any time). Whereas in 2001 33% of all bank liabilities were financed with maturities shorter than 3 months, in 2007 this increased to 44% and today it went up to more than 55%. 55% of all bank liabilities have maturities shorter than 3 months, compared to 33% in 2001.

In other words, we have never experienced maturity mismatching to such an extreme extent in the banking system.

And because we know that artificial low interest rates fool entrepreneurs, firms and capitalists into making the wrong investments (that is, investments in more capital-intensive projects with longer durations), we also know that a banking crisis awaits us of unprecedented scale. The fact that low interest rates encourage bad investments, while banks never took as much interest rate risk as today, is a guaranteed recipe for disaster.

The consequences will be disastrous. Currency ECB monetary policy will lead us to the brink of a complete destruction of our economy. The fact that savers are suffering from low yields is in that perspective only a small, additional harm.

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