"You can pay me now . . .” counsels the sensible mechanic promoting Fram oil filters in the old-time advert, “ . . . Or pay me later,” interjects his pricier associate, as he tinkers with the broken engine of a customer who has ignored the advice. Central bankers should take heed. Dirty oil and artificially priced financial markets have much in common. Both can destroy engines eventually — and in the case of central banking it is the motor of the real economy that is at risk.
Historically, it has generally been assumed that lower bond returns would eventually lead to higher bond and equity prices, and that the capital gains and lower commercial and consumer interest rates associated with them would stimulate additional investment and consumption — a virtuous circle leading to job growth, mild inflation and higher profits.
The US Federal Reserve began a quantitative easing programme in 2009; interest rates are historically lower across much of the developed world. Meanwhile, gross domestic product is growing in many eurozone nations, even if unemployment is higher than many would like. An unbiased observer ought to admit that the model is working. So why change the oil filter?
But are near-zero interest rates and a global store of about $13tn worth of negative-yielding bonds actually good for the real economy? Recent data suggests they may not be. Productivity growth, perhaps the best indicator of an economy’s vitality, is abysmal in most developed countries. It has been declining in the past half-decade or so, not coincidentally tracking the advent of QE and zero lower bound interest rates.
In the US the year-on-year trend for productivity has turned negative . Most central bankers dismiss this fact as a short-term aberration. But the Japanese economy provides an example of what interest rates at or near zero can do to a large, developed economy. The answer is not much: not much real growth; not much inflation - and, together, not enough nominal GDP growth to repay historic debt should yields on sovereign debt ever return to normal.
In other large economies, a further negative effect of zero lower bound yields and interest rates can be observed. Investment — an important source of productivity growth — has never returned to the norms seen before the global crisis of 2008. Corporations are using an increasing amount of cash flow to buy back shares as opposed to investing for growth. In the US, more than $500bn is spent annually to boost investors’ incomes rather than future profits. Money is diverted from the real economy to financial asset holders — where in many cases it lies fallow, earning little return if invested in government bonds and money markets.
Why would the private sector or governments not borrow at practically no cost to invest in a centuries’ old capitalistic model proven to reward risk-taking in the real economy? Well, for governments and supranational agencies such as the International Monetary Fund, balanced budget orthodoxies and even national laws as in Germany rule the day. We are not “all Keynesians now”.
The private sector may be reluctant to invest because of a host of secular forces that increase risk, including ageing populations that temper consumer spending and an anti-globalisation trend of which the Brexit vote is an example. Savvy corporate chief investment officers who know anything about bond pricing may also recognise that an investment in the real economy — albeit at historically low borrowing costs — will pose its own risks once yields begin to return to normal and borrowing costs increase.
There are other obvious drawbacks to near-zero yields and interest rates. Historic business models with long-term liabilities — such as insurance companies and pension funds — are increasingly at risk because they have assumed higher future returns and will be left holding the short straw if yields and rates fail to return to more normal levels.
The profits of these businesses will be affected as will the real economy. Job cuts, higher insurance premiums, reduced pension benefits and increasing defaults: all have the potential to turn a once virtuous circle into a cycle of stagnation and decay.
Central bankers are late to this logical conclusion. They, like most individuals, would prefer to pay later than now. But, by pursuing a policy of more QE and lower and lower yields, they may find that the global economic engine will sputter instead of speed up. A change of filters and monetary policy logic is urgently required.