Why Low Interest Rates Cripple Capital Investment
In January, the Bank of Japan, trying to keep Shinzo Abe’s economy from slipping back into recession, followed the European Central Bank into negative territory by cutting interest rates below zero for the first time in Japan’s history. In doing so, the BOJ joined the central banks of Denmark, Sweden and Switzerland.
Supposedly, according to the common wisdom, low interest rates discourage saving on the part of depositors and encourage them to borrow. Low interest rates are also supposedly a classic trigger to move stock markets and create a wealth effect for individuals.
In a word, it hasn’t worked and if anything it has done just the opposite. And by continuing negative rates, in the words of Bill Gross, writing in the Financial Times earlier this month, central bankers have begun to threaten the engine of the global economy. There are now US$13 trillion worth of bonds yielding negative returns.
Low rates disfigure the market's pricing signals, so many cash-rich dinosaur companies are not investing in the real economy. These rates are making the wrong people rich.
By all rational measures, the private sector and governments should be taking advantage of some of the lowest rates in modern history to load up on debt. The US government, for instance, could be taking advantage of these rates to spend billions updating infrastructure that has suffered from years of conservative legislatures that have blocked spending. Corporations are sitting on huge cash piles that are drawing little interest. They are not investing it.
In fact, there are three secular trends described by Gross that disincentivize companies from spending for what is called PME – plant, machinery and equipment.
First is demographics, Gross notes. The developed societies, enduring falling birth rates, are all getting older, putting the brakes on consumer demand. Second is the growing trend towards anti-globalization. BREXIT is the most recent ugly emanation, along with rising protectionism in the United States that appears likely to block ratification by the US Congres of the Trans Pacific Partnership, the omnibus trade measure that President Barack Obama has already signed. Both of his likely successors, Hillary Rodham Clinton and Donald Trump, have followed populous sentiment in saying they would block its passage. So why invest in plant, machinery and equipment when you are likely to have fewer overseas markets to sell into? Third, as Gross says, "savvy corporate Chief Investment Officers who know anything about bond pricing may also recognize 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."
Beyond those issues outlined by Gross, there are other reasons. Low interest rates penalize savers, meaning older people – consumers – must save more to amass the principal to produce returns to lkive on. Hence, consumption suffers. So manufacturers are disincentivized to invest if consumption is slowing.
Second, pricing power has gone to the wind: supply curves are infinite these days, so that anachronistic myth about "too much money chasing too few goods" is a catchy shibboleth, but not for forward-looking policymakers concerned about creating employment. With pricing power out the window, so are many margins. Look at banking, which has to jack up other rates on consumers in order to make up for the low returns on interest. And finally, particularly Europe's and Japan's politicians refuse to reform, so instead they institute regulatory inflation. Why invest if you cannot fire employees reasonably efficiently?
That leaves investors with little choice. Don’t invest in dinosaurs – those who fight with swords get shot. Forget investing in the capital goods sectors of Japan and Europe that are very domestically oriented. Their politicians have regulated themselves out of growth, and compounded the problem with deflationary budgets on the mistaken theory that cutting deficits in a recessionary cycle is a good idea. Instead, investors should be buying into new-economy tech, and particularly into quoted “fintech” companies – financial technology companies based on using software to provide financial services. They are usually startups that whose mission is to disrupt conventional financial systems and corporations that don’t rely on software.