Economic Growth And Interest Rates

For the last several decades, one can observe a worrying trend when it comes to economic growth: All of those countries are experiencing a slowdown of growth. The 'good years' are getting worse and worse for quite a while now.

While most observers point out that this tendency is vastly a result of structureal problems like high regulation, taxes, growing bureaucracy, demographics and debt, the slowdown in economic growth is accompanied by a continuing decrease in interest rates.

Altough some people claim that the fall in interest rates has nothing to do with central bank policy and is due to other factors (recently, some economists put the cart before the horse and claimed that it is because of rising inequality), we cannot let central bank policy makers of the hook on that. 

Nearly all schools of economic thought (at least the neoclassical and Keynesian mainstream) propose that, if the economy falls into recession, interest rates should be lowered (neoclassics) and government spending should be ramped up (Keynesians). The goal of both policies is to push up 'aggregate demand' to support businesses and to prevent them from going out of business. MMTers are even more extreme and say that governments can spend any amount the want, because they are the real creators of money.

The main argument, however, is always the same: lower rates will stimulate growth, economic output will recover and the economy will be fine again. Higher interest rates, they say, will be counterproductive to achieve that goal.

While, there is no parallel world to test this assumption, one cannot deny that lowering interest rates in a crisis may help to dampen an economic slowdown in the short run. But what are the effects in the long run? As Frederic Bastiat once wrote, one should always account both, the effects that are seen, and also those which it is necessary to foresee. This is exactly the point that I want to lay out in this piece: that lowering interest rates may have a 'seeable' positive effect in the short term, but an 'unseen', negative, effect over the long run.

First of all, if the economic assumption that lower interest rates lead to higher growth is correct, there should be a negative correlation between interest rates and economic growth. Lower rates should lead to higher growth and vice versa. 

Undoubtedly, the wrong medicine (monetary policy) against the diesase (economic downturns) have already led to an environment with heavily indebted states, households and corporations and therefore it has become more and more difficult for central banks to reverse course and to do the right thing.

There is an interesting empirical work by German economist Richard Werner and Kang-Soek Lee, who looked at the data of 4 of the 5 large advanced economies. What they find is exactly the opposite from what one would expect. In their paper Reconsidering Monetary Policy: An Empirical Examination of the Relationship Between Interest Rates and Nominal GDP Growth in the US, UK, Germany and Japan, they find that,

'Examining the relationship between 3-month and 10-year bench-mark rates and nominal GDP growth over half a century in four of the five largest economies we find that interest rates follow GDP growth and are consistently positively correlated with growth. If policy-makers really aimed at setting rates consistent with a recovery, they would need to raise them. We conclude that conventional monetary policy as operated by central banks for the past half century is fundamentally flawed'

Is this empirical statement contrary to what one would expect from economic theory? According to Werner et. al., any economic school of thought, be it Keynesianism, monetarism, the Austrian school, the classical or the neoclassical, would assume that lower interest rates would encourage growth.

Recently, I have posted the following chart on twitter, that compares the level of 10y treasury yields with the level of nominal GDP. The result are in line with Professor Werner's findings:

One may reply that there should be a lag in the data and that lowering interest rates today will lead to higher economic growth sometime in the future. However, the findings also support Richard Werner's case if one lags GDP by 1 or 2 years.

While I am sure that Professor Werners analysis is more robust than mine, I just wanted to show that the data agrees with his thesis: Nominal GDP growth correlates positively with interest rates. 

Are central bankers wrong? Maybe higher growth leads to higher rates? Honestly, I think that this is a valid claim. Why? Because lowering rates may helps in the short run to fight the economic contraction, it has hurtful consequences for future GDP growth. 

According to the Austrian business cycle theory, the problem is not the crisis, but the (apparent) economic upswing that preceded it. The lowered level of interest rates means that resources are tied to projects that would not have been profitable in an economic environment with higher interest rates. 

This misallocation of factors of production has consequences on projects that are not realized in such an environment, because factors of production are still scarce. Even if monetary capital can be printed by the central bank, capital goods, that are necessary to produce, remain scarce. 

Thus, because resources are misguided in a low interest rate environment, economic growth is lower, and factors of production are not used where they could be used. As a result, GDP is growing, but at a slower pace.

Lower interest rates have a direct consequence for the banking sector, who are those who lend out money into the real economy. If interest rates are low, the risk spread, the amount that banks are making for handing out a loan is also falling. Therefore banks are hesitate in financing younger, small businesses and prefer to lend out to established ones (This is partly true in a higher interest rate environment too, but a low interest rate environment is execerbating this problem). Those new firms have a harder time to find access to capital.

Additionaly, low interst rates helps established businesses to grow: Let us say, for example, that a trading company wants to expand with a certain number of existing sales branches in order to increase sales. It buys land in order to build a new store and uses already existing land and stores as collateral for the loan. The newly built property or land on which it is being built then could be deposited as collateral for the purchase of the next property, ans so on. 

As long as the interest payments can be earned, the company can continue to expand. The lowering of the interest rate in the event of a crisis plays into the hands of those who were no longer able to make their interest payments in the previous environment. Now that interest rates have been lowered, they can continue to exist, tying up resources that profitable, agile companies lack. This way a process of economic zombiefication is set in motion.

Low interest rates encourage a rise in mergers and acquisitions. As a result, bigger companies usually need more administration staff. The bigger the administration becomes, the harder it is to stay efficient. This is not only valid for governments, but also for all economic entities. However, the increase in inefficiency can be masked by the integration of small competitors.

Another point is that low interest lates makes it more attractive for businesses to engage in longer term projects instead of short time projects. As long-term projects create value later in time than a short-term project, economic growth is diminished over the medium term. Further, longer term projects are much more vulnerable to a change in economic conditions and therefore suddenly can turn out to be not as profitable as one would have thought.

But small business pay a lower rate of interest and therefore benefit from low rates is another fallacious argument. 

On the one hand, some factors of production become more expensive in a low interest rate environment: land, buildings, office space, to name a few. Just have a look at the development of property prices since 2008. My argument would be that this is bad for people who think about starting a business because those things usually are their highest expenses (forget about start-ups like Facebook or Google, they are an exception). Therefore I would point out that, as costs are driven up, low interest rates benefit innovation in less capital intensive areas (social media, etc.) while it slows innovation in capital intensive areas. 

As Banks do not lend these companies any money because the risk premium seems too low to themventure capitalists come into play, but they too concentrate here on projects that promise big profits in the future. 

Due to the artificially narrowed risk premium, the bank prefer to give a loan to established companies so that they can continue to grow, instead of financing a young, small company. The low spread also causes a shift in cash flows towards relatively scarce tangible assets, i.e. financial assets (stocks & bonds) and real estate. Low risk premiums increases an incentive for investors to invest more in these areas. In these areas, the hunt for returns leads to investments in riskier areas of the financial market, like companies that can only survive because of the low interest rate environment and not because they generate real economic growth.

Thus, the statement that low interest rates lead to lower GDP growth corresponds, in my opinion, very well with the Austrian business cycle theory. Since scarce resources are used unproductively and offer only a small return, one prefers to rely on risk-free paper profits than on only insignificantly higher profits on real, riskier investments. The tailwind turns into a boomerang...

In addition, banks are also looking for other fields of engagement apart from their traditional business (loans to businesses). They are starting to get more involved into financial markets, especially the government bond market, since these papers are considered 'less risky'.  Thus, banks lend out less in a low-interest environment than they would have done in an higher interest rate environment and prefer to increase investments into financial markets: They buy risk-free government bonds, corporate bonds and stocks. 

Bond purchase programs bycentral banks reinforced this effect, since the banks can be sure that the Fed, the ECB, the BoJ or any other central bank has become the buyer of last resort. Thus, governments have no incentive to cut spending, but rather increase it. The additional debt is mostly spend and used inefficiently and does not contribute very much to economic growth (just think about the Junker Plan or any other EU program).

If central banks are also buying corporate bonds, investors have an incentive to continue to finance them.

That is why i do not see a contradiction by Professor Werners additional findings if we use Austrian Economic Analysis. However, I see that his findings contradict the Keynesian and Monetarist view, that lower interest rates and higher government spending helps to consume out of a crisis. 

The manipulation of interest rates (arguably the most important price within a market economy) does not promote growth, but preserves existing, uneconomical production processes. Although the crisis is dampened at the beginning, the distortion process progresses over time and therefore dampens economic growth medium- and long term.

Proponents of a slash of interest rates in times of crisis may be right that it stops the downturn in the short run, but it hinders the economic recovery and leads to a new level of equilibrium. Economic growth remains subdued, because factors of production continue to be tied to companies that should have disappeared from the market due to the market shakeout.

So, if all my theoretical arguments are valid (it depends on the reader to decide that), then why are central bankers doing the opposite of Professor Werner's empirical findings? Why is it that the dogma that low interest rates stimulate growth is still supported? 

I would say it is because government officials and central bankers are not interested in the long run. They never have been. They fear the severity of the downturn so much that their only interest is to contain the downturn at the expense of future economic growth. Kicking the can down the road is a very comfortable policy tool. Let us deal with the problems later, preferably when the people in charge are out of duty. 

In addition, governments all over the world like the current low interest rate environment. It is extremely attractive in order to realize prestigious projects to serve (their) individual groups of voters. The immediate consequence is ongoing capital consumptionat the expense of the future.

Another winners of current policies are the (big) banks, who have also benefitedsince they are much more active in the financial market and easily earn the bid/ask spread as market makers. Smaller banks were also forced to become more involved into financial markets alongside the traditional lending business. 

Thus, neither central banks, nor governments or big banks have are intersted in a policy shift to a higher interest rate environment because they are the benificiaries. Since those three are very powerful players in influencing public opinion, it will also be difficult to change course. 

In addition, many economists are trapped within their economic models that do not reflect economic reality. I remember Jeff Snider, Head of Global Research at Alhambra Partners, who always stressed that he was not an economist.

Finally, there is an analogy the the - much more controversial - discussion about climate change. Incrementum AG, who yearly publish the In Gold We Trust Report called the 2021 publication Monetary Climate Change, with reference to ESG and Green Central Bank Policy to fight climate change. 

When it comes to the fight against climate change, it is always argued that the older generations have a duty, after all, because they have exploited nature at the expense of the following generations.

Where I would reply that why we do the exact opposite when it comes to economic policy and consume all the stuff that future generations will still have to produce because allegedly we cannot deal with the economic shock that would emerge if we stop to consume like there is no tomorrow. 

Sounds paradox, does it not?

Have a great weekend!
Fabian Wintersberger

(JFYI: No blogpost on 17.9.2021 as I am enjoying the greek sun.)

Disclaimer: This is a personal blog. Any views or opinions represented in this blog are personal and belong solely to the blog owner and do not represent those of people, institutions or organizations that the owner may or may not be associated with in professional or personal capacity.