“Our country continues to face a difficult and challenging time….People have lost loved ones. Many millions have lost their jobs. There is great uncertainty about the future. At the Federal Reserve, we are strongly committed to using our tools to do whatever we can, for as long as it takes…to ensure that the recovery will be as strong as possible, and to limit lasting damage to the economy” –Jerome Powell, Chairman of the Federal Reserve, June 10, 2020
America is hurting. From a pandemic to a recession and mass unemployment to social unrest over the sadly still-present systemic racism in our institutions, our country’s future feels extraordinarily uncertain. Jerome Powell speaks to this above, and he is leading the Federal Reserve in taking an active role to try and mitigate the uncertainty. Perhaps the most important way in which the Fed is trying to mitigate uncertainty is through committing to near-zero interest rates for the foreseeable future. In his speech last week, Powell noted that there is no time horizon in which the Fed sees itself moving rates higher than zero and forecast 2022 as the earliest possible date for a rate hike. If the Federal Reserve persists with zero (or negative) interest rates for the foreseeable future, the American economy will be condemned to stagnation—like Europe and Japan before it—as capital flows away from productive investment and toward ever increasing debt payments.
| Why would the Fed take this path? In short, this is the crisis playbook. The Fed appears to believe that zero or negative interest rates will stimulate the economy by encouraging consumers to spend now—as opposed to saving—and that increased spending will spark an economic recovery from the recession we find ourselves in. For this to work, the Fed is putting its faith in the textbook, straight-line relationship between interest rates and savings holding despite mounting evidence against it.
Long periods of zero and negative interest rates have been tried before—notably in Europe and Japan—and the results have been not just disappointing, but devastating. The evidence suggests that instead of ensuring a strong recovery and limiting lasting economic damage, zero or negative interest rates almost surely lead to a slow recovery and inflict significant long-term economic damage. |
Lower yields force households to save more - Click to enlarge |
| In Japan, the Bank of Japan moved to zero interest rates in the late 1990s and has barely budged since. |
Japan Interest Rates, 1980-2020 - Click to enlarge |
| Japan has not, however, had the strong, growing economy that this was intended to foster. Instead, it has experienced persistently low rates of growth on a declining trend, only touching the previously common 2 percent growth threshold twice in the nearly three decades since it brought rates down to near zero. |
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| The Japanese stock market hasn’t recovered either. Since interest rates hit the floor, its market has been range bound at a level below where it was prior to dropping interest rates.
The use of zero interest rates may have been necessary as a crisis-fighting tool when first introduced, but the persistent use of zero interest rates for the decades following have not led to any form of meaningful or sustainable growth—either in the real economy or in financial assets. Japan could be an anomaly, however, or other factors could be at play. It has an aging population, relies on manufacturing in an age increasingly dominated by services and technology, and has little to no natural resources to speak of, all of which may have weighed on growth. Let’s look at Europe as a second case study. |
Japanese stock market, 1972-2020 . |
| In Europe, we see the same exact story playing out as in Japan. Zero and negative interest rates were instituted later in Europe than in Japan—the European Central Bank did not dramatically lower interest rates until Europe was in the midst of the financial crisis of 2008, and it did not go to zero until the euro crisis in the early parts of last decade. |
European Interest Rates, 2000-2020 - Click to enlarge |
| There are no plans to increase rates in the eurozone, and many countries (including fiscally strong countries such as Germany) have even issued debt with negative interest rates over the last few years. This has had a similar effect on growth to what we saw in Japan. |
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| Growth in the eurozone has been on a consistent negative trend for decades, and the last decade of low interest rates has been especially difficult. European stock markets, which roughly reflect the underlying economic fundamentals, have fared similarly—the last fifteen years have seen modest asset price appreciation in many parts of the eurozone. |
Stoxx Europe 600, 2004-2020 - Click to enlarge |
| The common thread between Europe and Japan is a longstanding policy of zero interest rates that has effectively ground their economies to a halt by crippling the banking sector. We can see this in part by looking at the profitability of the banks via a proxy—their share prices—during this time frame. A sample of the largest European banks over the last two decades paints a bleak picture for Europe’s banks.
Note: This chart contains data that was manually adjusted to account for differences in calendar days for which historical stock prices were available for each company.
As the chart shows, the European banking sector never recovered from the financial crisis, and has become less profitable today than it was two decades ago. Zero interest rates have constrained their ability to be profitable, along with increased regulation. Low interest rates make it difficult for banks to be profitable, as they typically earn a profit by borrowing at a low rate (such as that offered by a central bank), and lending at a higher rate. The difference reflects the risk the bank takes on as the lender in the transaction. Low rates, however, are associated with lower spreads than high rates, as money is in general cheaper and move available to borrowers when rates are low. As cheap money abounds, this constrains profits, because, as with any cheap good, competition increases and profit margins are slim. |
European Banking Stocks, 2000-2020 - Click to enlarge |
| The ability of the banks to generate profit isn’t just a problem for the banks. It’s a problem for the economy, because banks are a central engine behind economic growth. The less profitable the banks are, the less credit they are able to extend to you to start a business or buy a house. It is this ability to create and lend money to businesses and individuals that contributes significantly to economic growth by expanding investment in productive assets and increasing consumption. Further, economic expansion leads to lower unemployment, higher incomes, and a better standard of living. In short, weak banks are able to lend less, and leave the economy as a whole worse off. There isn’t an alternative to banks as the engine for economic growth. There are no battery-powered economies. Without the banks to grease the wheels of the economy, the whole system grinds to a halt, leading to increased unemployment and reduced incomes. This is what happened in 2008—the banks collapsed and dragged the economy down with them. This time, central bank policy has made it so the banks can’t stand up, and the economies of the eurozone and Japan have paid the price.
The situation is a little different in the United States. We have had rates near zero as well, but we also climbed back up above two percent last decade. |
Federal Reserve, 1996-2020 - Click to enlarge |
| Our economy has seen a slowdown in growth—particularly in the last five years—but our stock market had a record-setting decade.
While the growth story over the last decade is better than Europe’s or Japan’s, our recovery after 2008 has not seen meaningful and sustained increases in wages, and it has seen a steep drop-off in the labor force participation rate despite a generally low level of unemployment, suggesting an incomplete or weak recovery. |
U.S. Stock Markets, 2000-2020 - Click to enlarge |
| Some of this weakness may be explained by the stagnation of our corporations, which have taken on extraordinary debt levels as a result of the many years of easy money policies since the financial crisis. Capital has been increasingly diverted from productive uses—such as investing in new technology or hiring new workers—to paying off increasingly large debt burdens.
By keeping rates near or below zero for the foreseeable future, the Fed is granting already overly indebted companies access to more capital (at as low a rate as possible) to stay alive during the current recession. This will do the trick in the short run, but in the long run it will leave a substantial number of corporations alive but on life support, zombie companies that are increasingly unable to do anything with their cash flows but pay down the mountains of debt that they owe. Thus, committing to a policy of zero or negative interest rates for an extended period of time—as Powell did last week—will in all likelihood lead us down the same path as Europe and Japan. It will not lead to more spending and a higher growth rate. Instead, it will erode the profitability of the banks; ensure zombie corporations use cash flows to pay off debt rather than to invest, increase wages, and hire additional workers; and ultimately condemn America to a broken economy with little to no endogenous growth potential. |
U.S. Rising share of companies with debt servicing costs that are higher than profits - Click to enlarge |
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