Cheap money, too much of a good thing

First published in the Sunday Times on 13th December 2015.

There is a widely held view that low interest rates help the economy and business. Supposedly they enable government, companies and households to borrow cheaply, and consequently they spend and invest more, so generating economic activity.

But there is an alternative theory that suggests the current record low rates are actually bad for business, many consumers and indeed the country. Allow me to explain.

Interest rates of close to zero have triggered a number of perverse effects and undesirable outcomes. For example, in recent years, due to actuarial assumptions about future returns, substantial deficits have appeared in many defined-benefit pension schemes across industry and the public sector. As a case in point, the Universities Superannuation Scheme has a deficit of £13bn.

The trustees of every pension fund like this must devise a plan to remedy the deficit — typically by increasing contributions. This means ever more funds are diverted from possibly productive uses to plug the shortfalls. I would estimate that if base rates rose to 3%, say, virtually all projected pension deficits would evaporate overnight. These theoretical calculations may appear arcane, but they really do have an impact on issues such as capital spending in lots of companies.

Another adverse consequence of ultra-low rates is the reduction in the earnings of companies that sit on cash. For example, our travel businesses typically receive payment in advance for holidays. But currently they earn negligible profits on these floats. If interest rates rose, interest income would become a serious addition to profits. The same applies to insurance companies, banks, advertising agencies, building contractors and other firms that receive deposits and payments in advance from customers.

A big constituency who would benefit handsomely from higher rates are savers. There are actually fewer people in the UK who have mortgages and borrowings than there are savers. A report in 2013 from the consultancy McKinsey stated that low rates benefited the government by £80bn and cost savers £73bn between 2008 and 2012. Both those numbers will be materially higher by now.

One might postulate that cheap money has fuelled government spending, which boosts the economy in various ways. But I would suggest that household saving is imperative for any society, and by destroying returns for savers, loose monetary policy has discouraged productive investment. Generally, channelling funds away from the private sector towards the public sector — which is what low rates have done — acts as a drag on growth and lowers potential living standards.

Unquestionably, the inexpensive money flooding the system since Bank rate fell to 0.5% in 2009 has boosted certain asset prices disproportionately. It is estimated that house prices are at least 20% higher than they would have been without such low rates. Thus homeowners have become wealthier — but ownership is further out of reach for the young, and the costs of renting have risen. Moreover, the value of houses in Britain is so high that land and buildings are constantly diverted away from productive commercial purposes towards residential use. This inhibits attempts to rebalance our economy. In the long term it damages job creation.

We cannot prosper as a nation of buy-to-let landlords; we must also produce goods and services and export to pay our way in the world.

Cheap money tends to lead to misallocation of capital. I see it across many sectors. Investors desperate for any yield will back marginal and speculative ventures, leading to overcapacity and waste.

I think very low rates favour short-term investment over longer-term plans. Share buybacks and other ruinous strategies have flourished thanks to cheap money. There have been various asset bubbles since 2009, from equities to bonds to property. Many are at or close to all-time highs, in nominal and real terms.

All this ill-judged investment produces fewer jobs and weaker growth than would be the case if capital were scarcer — over- capacity leads to deflation. Look at the secular stagnation suffered by Japan during the past two decades, and see how very low interest rates there have only added to the losses and missed opportunities.

Super-low interest rates have allowed zombie companies to survive without restructuring, because banks are often reluctant to foreclose on impaired loans as long as borrowers meet interest bills. This simply delays the inevitable and prevents the timely “creative destruction” that is a sign of a healthy economy.

So capital and assets are tied up in the wrong hands, and not reorganised into more efficient arrangements.

The unintended consequences of artificially low interest rates are multiple. Over time such policies harm savers, business returns, job creation, economic growth and industrial investment.

The US is about to embark on a series of interest rate rises. Britain must follow eventually — better we do it sooner rather than later. Partly we should move promptly to protect our currency and stop the importing of inflation, and partly to reverse some of the pernicious effects of cheap money on industry and society as whole.