How Ultra-Low Interest Rates Will Cause The Next Global Recession

Ever since the Great Recession, central bankers around the world have been deploying ultra-low interest rates policies to revive global economic growth.

Some central banks have gone too far, pushing official interest rates below zero (e.g., ECB and Bank of Japan).

Initially, these policies had some success, helping the global economy grow out of the Great Recession. But growth hasn’t been sustainable. Japan, the pioneer of ultra-low interest rates, has been floundering in the swamp of stagnation, counting one lost decade after the other. America, the early adopter of this policy, is still growing at subpar rates, while Eurozone, the true believer in these policies, is barely growing. And things may turn worse in the near future for that region. The European Commission has lowered its spring economic forecast for Eurozone growth from 1.7% to 1.6%.

Worse, financial markets, which thus far have served as the link between ultra-low interest rates and the real economy, have begun to lose faith in central bankers.

That’s a worrisome sign for the global economy. Last time financial markets lost faith in central bankers was the late 1920s when bank failures spread like wild fire on both sides of the Atlantic — and aggregate demand collapsed.

We’ll know what happened shortly after: the global depression.

While things may not go that far this time around, there are two good reasons to believe that ultra-low interest rates are leading the global economy into the next Great Recession.

First, ultra-low interest rates undermine the very existence of traditional banking, especially negative interest rates that turn the “interest rate spread,” the core source of traditional banking profitability, negative. Especially in Europe, where banks have a hard time finding qualified borrowers.

Worse, banks may soon have to charge depositors interest, which would certainly prompt massive withdrawals, as depositors will choose to keep money in a safe — or chase after inflated assets — rather than keep them in the bank. This means that banks will be squeezed on both sides of their balance sheet, and some will fail.

In addition, massive withdrawals will be followed by a credit contraction, crashing asset values and consumer spending—the largest driver of economic growth in developed countries–in the process.

Second, ultra-low interest rates for a prolonged period of time fuel what I call “pent-down” demand, which undermines future growth.

To understand what pent-down demand is, a natural place to start is with the more familiar concept of pent-up demand, which boosts future growth. Pent-up demand, which usually arises before a period of consumer euphoria, describes the lack of demand – when consumers choose to postpone their expenditures to a future date, due to lower price expectations, depressed consumer confidence, or lack of access to credit.

In contrast, pent-down demand materializes after a period of consumer euphoria and excess borrowing and describes the lack of current demand — when consumers have moved future purchases forward in previous periods, due to the low cost of financing — which blurs the distinction between present and future.

Simply put, ultra-low interest rates help “steal” sales from the future, creating market saturation that eventually depresses spending on “high ticket” items.

That’s what happened shortly before the Great Recession. The Federal Reserve, by implementing a policy of ultra-low interest rates between 2002 and 2006, created a distorted economic environment where consumers abused cheap credit to boost present aggregate spending at the expense of future spending.

Consumers, for instance, raced to take advantage of “zero percent” financing to buy cars they would normally buy years later. That’s how automobile sales increased from an average of 15 million in the 1980s and the 1990s to 17 million in the first six years of 2000s, before they tumbled during the Great Recession.

We all know what happened shortly after: the Great Recession followed and aggregate spending dropped sharply.

The trouble is that the Federal Reserve and other central bankers around the world didn’t take or didn’t want to take notice of the impact of pend-down demand on future growth. They upped their ultra-low interest rate policies, refueling pent-down demand (automobile sales are above the pre-Great Recession levels).

This time around, pent down demand may be supported and re-enforced by debt, a lot of debt, accumulated in the aftermath of the Great Recession on top of old debt, which fueled the bubble that preceded the Great Recession — as documented by a McKinsey report.

“Seven years after the bursting of a global credit bubble resulted in the worst financial crisis since the Great Depression, debt continues to grow,” according to the report. “In fact, rather than reducing indebtedness, or de-leveraging, all major economies today have higher levels of borrowing relative to GDP than they did in 2007. Global debt in these years has grown by $57 trillion, raising the ratio of debt to GDP by 17 percentage points. That poses new risks to financial stability and may undermine global economic growth.”

While higher debt levels boost economic growth in the short-term, they depress it in the long-term, as debt payments chip away at spending, setting the global economy into a vicious cycle whereby slow growth in one group of countries spreads to the rest of the world through international trade.

That’s why this time around the global economy may be heading to a more serious Great Recession than that of 2008-09.

Source: Forbes 22th May 2016

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How Ultra-Low Interest Rates Will Cause The Next Global Recession

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