Too much debt, too little growth and too low interest rates

Jul 29, 2015

- By Vivek Kaul

Vivek Kaul
The financial crisis that started in September 2008, after the Wall Street investment bank Lehman Brothers, went bust, led to the economic growth stagnating in large parts of the world.

The central banks around the world tackled this by cutting interest rates to very low levels. The hope was that at low interest rates people would borrow and spend. At the same time, corporates would use this opportunity to borrow and expand. And this would lead to economic growth coming back. QED.

But that is not how things panned out. Instead of prospective consumers borrowing and spending money, large institutional speculators borrowed money at low interest rates in large parts of the Western world and invested it in financial markets all over the world. This excessive inflow of "easy money" has led to bubbles in financial markets in large parts of the world.

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This point is made in the latest annual report of the Bank of International Settlements (BIS) based out of Basel in Switzerland. The BIS is often referred to as the central banks of central banks. As the BIS annual report for the financial year ending March 31, 2015 points out: "very low interest rates that have prevailed for so long may not be "equilibrium" ones, which would be conducive to sustainable and balanced global expansion. Rather than just reflecting the current weakness, low rates may in part have contributed to it by fuelling costly financial booms and busts. The result is too much debt, too little growth and excessively low interest rates. In short, low rates beget lower rates."

This is a very interesting point. What BIS is saying is that low interest rates have led to very little economic growth. At the same time the total amount of global debt has gone up (as can be seen from the accompanying chart). In order, to tackle this low economic growth rate, the central banks have either cut interest rates further or maintained them at their low levels. In fact, several central banks in Europe have also taken their interest rates into negative territory i.e. you have to pay money in order to deposit money with them. Hence, lower interest rates have led to further lower interest rates without creating much economic growth.

Interest rates sink as debt soars
Data Source:Sources: IMF, World Economic Outlook; OECD, Economic Outlook; national data; BIS calculations.

As can be seen from the accompanying table, the total global debt has touched around 260% of the global gross domestic product (GDP). In 2008, it was around 230% of the global GDP. It's a weird economic world that we live in. While the low interest rates did not lead to economic growth as was expected, they did lead to financial market booms.

As Gary Dorsch of Global Money Trends newsletter puts it in his latest column: "Cheap money encourages more debt and creates financial booms and busts that leave lasting scars on the economy. They underpin both the potentially harmful high risk-taking in financial markets, while subduing risk-taking in the real economy, where investment is badly needed. And while increases in interest rates could cause stock prices to fall, - the likelihood of turmoil is only increased by waiting."

Long story short-the longer the era of easy money continues, the worse the crash will be, as and when it comes. This is a point that the BIS makes it in its report as well, where it says: "Risk-taking in financial markets has gone on for too long. And the illusion that markets will remain liquid under stress has been too pervasive. But the likelihood of turbulence will increase further if current extraordinary conditions are spun out. The more one stretches an elastic band, the more violently it snaps back."

This basic elastic-band analogy should tell us very clearly how delicately poised the global economy is with all the excessive debt that has been built up over the last few years, in the hope getting economic growth going again.

The BIS feels that the era of easy money and very low interest rates needs to be reversed as soon as possible. "Restoring more normal conditions will also be essential for facing the next recession, which will no doubt materialise at some point. Of what use is a gun with no bullets left? Therefore, while having regard for country-specific conditions, monetary policy normalisation should be pursued with a firm and steady hand," the BIS annual report points out.

The question is will the central banks take the risk of raising interest rates in the days to come. The economic recovery (whatever little of it has happened) continues to remain very fragile. And will any central bank governor (or Chairman) take the risk of killing even that by raising interest rates? As John Maynard Keynes once said: "Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally."

It is also worth asking here if central banks will sacrifice the short-term for the long-term? As the BIS report points out: "Shifting the focus from the short to the longer term is more important than ever. Over the past decades, it is as if the emergence of slow-moving financial booms and busts has slowed down economic time relative to calendar time: the economic developments that reallymatter now take much longer to unfold. Meanwhile, the decision horizons of policymakers and market participants have shortened. Financial markets have compressed reaction times and policymakers have chased financial markets more and more closely in what has become an ever tighter, self-referential, relationship."

The Federal Open Market Committee (FOMC) of the Federal Reserve of the United States is meeting over July 28-29, 2015. Many experts have said time and again that the Federal Reserve will raise interest rates this year. The Fed chairperson Janet Yellen has hinted at the same as well. Let's see if FOMC comes around to doing that.

Vivek Kaul is the Editor of the Diary and The Vivek Kaul Letter. Vivek is a writer who has worked at senior positions with the Daily News and Analysis (DNA) and The Economic Times, in the past. He is the author of the Easy Money trilogy. The latest book in the trilogy Easy Money: The Greatest Ponzi Scheme Ever and How It Is Set to Destroy the Global Financial System was published in March 2015. The books were bestsellers on Amazon. His writing has also appeared in The Times of India, The Hindu, The Hindu Business Line, Business World, Business Today, India Today, Business Standard, Forbes India, Deccan Chronicle, The Asian Age, Mutual Fund Insight, Wealth Insight, Swarajya, Bangalore Mirror among others.

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