After a couple of weeks of apocalyptic visions of a world heating up, it is perhaps reassuring to turn back to the economy of today emerging from the deep freeze of Covid restrictions and lockdowns.
It is tempting to think of the world as returning to “normality”, albeit with a recovery that is very uneven, characterised by disruption in supplies, especially of energy, and a spurt of inflation. But there are some aspects which are very unsettling. The most notable is what is happening to interest rates.
We have got used to the idea that interest rates are very low – close to zero. After the economic heart attack of the 2008 financial crisis, cheap money – very low interest rates and quantitative easing – were used to keep the patient alive. This life support system remained connected throughout the decade and then proved necessary during the Covid lockdowns. But surely this is only a temporary emergency? When does “normality” return?
There is endless chatter about when and how central banks, through their control of short-term interest rates, and capital markets through their impact on longer-term rates, will return to higher levels of interest, and the pain that this may or may not cause borrowers. What is being overlooked is that, with inflation taken into account, interest rates are becoming strongly negative. In simple terms, those who save are paying for the privilege; credit-worthy borrowers, especially governments, are being paid to invest.
To give examples, those holding index-linked British bonds due to mature in a couple of years are earning a return of minus 4 per cent and long-term bonds a little more – minus 2 per cent. The United States figures are a little higher but still negative. German 30-year government bonds are being sold, offering their buyers a zero return with inflation meaning the investments will suffer negative growth. The same is true of Japanese bonds. Corporate bonds tell a similar story.
China is the only significant country to have high real interest rates reflecting the authorities’ concern to cut back on a wild and often wasteful investment binge. And in leading emerging markets such as Brazil and Turkey, creditors are panicking over future debt problems so these countries do not have the luxury of cheap capital.
Overall and throughout the developed world, however, capital markets are judging that interest rates, in real terms, will be negative for the next generation. The American economist Larry Summers has called this situation “secular stagnation”.
What lies behind this phenomenon is that society’s desire to save (at least in rich countries) is substantially greater than the collective desire of business and governments to invest. In normal circumstances, this would have produced a collapse in demand and slump. But this has been kept at bay by central banks pursuing a “printing money” policy.
Now that the printers are being turned off, we need to look at the underlying problem. Various factors are involved in explaining the imbalance of individuals’ savings against government and private investment. Ageing populations tend to save. The rich save more than those who are poorer and, though we are becoming more unequal, there are a larger number of rich people each year. The pandemic put their instincts on stilts as shops and hospitality venues were shut, forcing people to save.
At the same time, governments, companies and individuals have been reluctant to invest because of uncertainty over the course of the pandemic and worries about accumulated debt. The overall business environment has been damaged by such factors as the trade warfare of the former US president, Donald Trump, Brexit and current geopolitical tensions between China and the US. Money is pouring into high-tech companies, but not enough investment is taking place to absorb all the savings.
These issues may seem abstract, but they have serious consequences for the real world. Because banks and other financial institutions can no longer make a return from holdings of “safe” financial assets, they are tempted to adopt riskier behaviour. In practice this means borrowing more – leverage – to invest in high risk/high return assets, such as complex derivatives or high loan-to-value mortgages.
There are, in turn, mounting pressures to soften the regulations which prevailed after the financial crisis, requiring the institutions to hold more capital on their balance sheets, to guard against the risk of default. Phrases like “we need to boost the competitiveness of banks” are being heard more frequently and concessions are being made. We know where that leads – to financial crises of the kind we had in 2008.
For individuals, and the pension funds and asset managers who look after our money, the frustration over negative or derisory returns on bank deposits and other “safe” personal investments has led to a search for higher returns in riskier activities. Shares are one example and stock markets – with the notable exception of Brexit Britain’s – have boomed, especially in high-tech stocks.
More seriously, money has moved into property where there is a reasonable prospect of profiting from escalating house prices. From London, Melbourne, Berlin, San Francisco and Stockholm to Tokyo, Beijing, Seoul and Mexico City, house prices have surged creating a self-fulfilling spiral of asset inflation. Though there are asset bubbles also to be found in cryptocurrency and exotic financial products, nothing quite beats “bricks and mortar”, perhaps because the owner has something tangible and useful, beyond just a store of value.
The social consequences are profound. A McKinsey study across 10 countries suggests that home prices have tripled on average in the first two decades of the century, severely undermining the aspiration of young people to buy or rent affordable housing; and this, in turn, weakens their capacity to spend. Overall, in these 10 countries, property accounts for two-thirds of the net wealth of households. And since the investment in property is not adding to economic performance and future growth, it is unproductive and acting as a long-term drag on the economy.
It was the nominally communist president of China who had to point out the truism that housing is for living in, not speculation. The lecture sounds especially galling when a large share of property – particularly in London – is owned by speculators from abroad.
One of the lessons of the last few years is that even when interest rates are very low or negative, private investment will not necessarily flow because of political uncertainty or lack of demand. So, governments must step in. Yet governments have often failed to understand the significance of low or negative market interest rates, or take advantage of them. In the UK, the Treasury – by assuming the interest rate phenomenon is just a short-term blip – has assumed rates would rise in its own valuation of long-term projects, causing serious and unnecessary economic damage.
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The result is that unnecessarily high interest rates were applied on everything from student loans to loans for the Green Deal of home insulation, effectively killing off an environmentally valuable programme. Low-risk, environmentally important projects like the South Wales tidal energy project were killed because they wouldn’t make a fast return. Bonkers.
In fact, the use of public investment to “build back better” is a crucial part of the response to the bigger problem of ultra-low, often negative real interest rates and the structural excess of savings relative to investment. Borrowing to finance it is extremely cheap, minimising the risk of longer-term debt servicing issues. Public investment, if sensibly deployed, also produces a return. And it can renew the transport and power infrastructure, something that is badly needed for the transition to a decarbonised economy.
Even the divided and fractious US Congress has grasped this essential point by passing the Infrastructure Bill. The EU has taken the first halting steps to indulge debt-financed investment on a European basis. The UK Treasury, meanwhile, is cutting investment in rail projects in the north of England to the despair of those who see a unique opportunity to exploit the availability of cheap capital.
Negative real interest rates may not be an easy subject for political banter, and are pretty weird in economic terms, but they represent a crucial fact of current economic life, which our ever-conservative Treasury is ignoring at some cost.
Sir Vince Cable is the former leader of the Liberal Democrats and served as secretary of state for business, innovation and skills from 2010 to 2015