It is the time when the financial media reviews the business experiences of the last decade to determine whether we are all better off today than a decade ago.
Many will argue, for instance, that ultra-liberal monetary policy by central banks has saved the global economy from a much deeper and longer recession. Others believe that low-interest rates boosted economic growth during the early stages of the economic recovery, but contrary to the mainstream economic theory of the European Central Bank, holding rates too low for too long can actually hurt growth.
Businesses have become addicted to low-interest rates. Financial markets react in panic when central bankers indicate a mild inclination to start increasing interest rates. Economic growth, especially in Europe, continues to be sluggish. So keeping interest rates at their present historically low levels is certainly not encouraging strong economic growth.
Mainstream economists and central bankers will argue that low-interest rates stimulate economic growth by boosting investment and consumption. But is this what is happening today? Low-interest rates in Europe are doing little to boost investment and are actually reducing consumer spending in most countries by more than the mild stimulus to investment.
It is the right time to start normalising interest rates to restore the link between risk and reward
Investment decisions are less dependent on the level of interest rates than many central bankers may think. If their econometric models are built on assumptions of significantly increased investment tied to lower interest rates, these models may be flawed. If one were to ask a business leader whether he or she ever gave the green lights to an investment project based mainly on the level of interest rates, the answer would likely be negative.
Low-interest rates admittedly help house building projects. But even here there are caveats that one needs to take in consideration. Bank lending standards are becoming more stringent in most EU countries at the same time that house prices are rocketing as a result of a shortage of construction workers and stricter planning regulations. Record low mortgage rates have so far failed to spark a strong recovery in European housing.
European banks are also being hurt by the low-interest rate regime of the ECB. When the ECB cut interest rates again last September, it increased pressures on banks’ profit margins. This pressure happened at a time when banks are struggling to bring down their very high costs partly as a result of tightening banking regulation and partly because of increased investment in technology to acquire digital platforms to compete with fintech start-ups. Moody’s rating agency cites lower interest rates as one of the factors behind its decision to change its outlook for global banks from stable to negative.
Apart from the effect on banks, low-interest rates hurt consumer spending. Economic theory on the impact of interest rates on saving is often ambiguous. Higher rates usually give people the incentive to save more, but lower interest rates could force people also to save more to fund their retirement adequately. Interest rates have been low for so long that may now believe that this is a permeant phenomenon. They will, therefore, be inclined to save more not to jeopardise their retirement pot.
Those who are better off usually have substantial financial assets in the form of equities and bonds. These assets, as US President Donald Trump keeps tweeting, have performed very well in the last few years. But pensioners are more likely to have their savings in the form of government bonds and bank accounts that are now paying miserly interest rates. It will not be surprising if many retired people will reduce the level of consumer spending to make both ends meet. Some will even eat into their capital.
Of course, there will be some in the baby boomer generation who see their holdings of stocks and bonds and their house prices increasing. This appreciation is no more than an illusion of wealth as younger people find it that much more difficult to own these assets as their prices become unaffordable.
Most European countries, including Malta, have a severe demographic problem. By reducing the spending power of the majority of older people as a result of falling returns on savings caused by low-interest rates, we could soon be facing serious social problems.
It is the right time to start normalising interest rates to restore the link between risk and reward. Markets will continue to groan when central bankers mention the prospect of reversing the low-interest rate strategy. But structural reforms have a better chance of restoring steady growth.