Artificially Low Interest Rates Are Problematic

 An anthropologist by the name of David Graeber published a book in 2011 with the title: "Debt: The First 5,000 Years." At no point in this tome is the phenomenon known as negative nominal interest rates referenced. Shortly after the publication of Graeber's book, negative interest rates appeared on the scene. The European Central Bank (ECB) introduced negative deposit rates in June 2014 to combat deflationary risks in the Eurozone. The Bank of Japan adopted negative interest rates in January 2016 as part of its ongoing monetary stimulus. Although we never dropped below zero in the United States, the federal funds rate was lowered to 0.25% twice. The first time was December 2008 during the Great Recession. The second time was March 2020 in response to the economic disruption caused by the COVID-19 pandemic. As a matter of fact, the entire U.S. Treasury yield curve dropped below 1% for the first time ever in March 2020. I said at the time that negative or ultra-low interest rates were unnatural and potentially harmful to the long-term health of the economy. I opine now that negative or ultra-low interest rates are unnatural and without doubt harmful to the long-term health and vibrancy of the economy. Before proceeding, it should be noted that the free market was not responsible for the exceptionally low interest rates between 2008 and 2020. This is all on the shoulders of the "planners" at the various central banks across the globe,  particularly the Keynesian economists at the Federal Reserve Bank. History will show that the imposition of low interest rates was a colossal error that has facilitated multiple problems that we are currently attempting to cure. Imposing artificially low interest rates is not only the ultimate form of interventionism, but depressing the price of risk triggers reckless behavior and excessive debt.

There are many negative implications associated with keeping interest rates at repressed levels. I will only be addressing the half-dozen negative impacts that could be classified as major. They are as follows:

1.) One overlooked "silver lining" of economic recessions is the cleansing attributes of creative destruction. Similar to the avoidance of recessions, keeping rates unnaturally low prevents necessary corrections and halts the natural "creative destruction" process where weak firms make way for innovative ones. In capitalism, the dead weight needs to be removed to make room for new ventures.

2.) When borrowing is abnormally cheap, capital flows into risky, unproductive, or failing businesses that would otherwise go bankrupt. This wastes economic resources and stunts true productivity. The term for this misallocation of economic resources is known as "malinvestment." Malinvestment leads to the creation of zombie companies. A zombie company is one that cannot pay interest on debt with operating profits, has negative return on assets, or negative net investment. It is no accident that zombie companies soared in an environment of falling interest rates. According to a study by the Bank of International Settlements, the percentage of zombie companies rose to all-time highs in the period of ultra-low interest rates. This organization states that on an international basis, the share of zombie firms among publicly traded companies in advanced economies has risen from about 4% in the late 1980s to roughly 13% - 17% today. The Federal Reserve Bank of St. Louis estimates that roughly 10% of U.S. publicly traded firms and about 5% of private firms meet strict zombie status.

3.) In an ultra-low interest rate environment, prudent savers and investors are punished. Bank Time CD's and risk-free bonds fail to even yield the rate of inflation. The most affected parties would be those in most need of additional income - senior citizens of limited means and young families saving for their first house.

4.) It should come as no great surprise that artificially low interest rates lead to excessive debt. Households, corporations, and governments are incentivized to take on massive amounts of debt. When the cost of capital is minimal and distorted, the interest payments due from borrowers are relatively easy to cover with normal cash flow. Borrowers tend to be poor students of history, especially the history of interest rates. Thus, many borrowers struggle to repay when interest rates eventually normalize. The interest rates we experienced between 2008 and 2020 were exceptionally abnormal. Current interest rates, 10-Year Treasury at 5% and 30-Year mortgages at 7%, are more in line with historical averages.

5.) There is a general consensus that we are in the midst of both a residential real estate bubble and a stock market bubble. Cheap credit has flooded into stocks, real estate, and other investments, inflating prices far beyond their true earning potential and setting the stage  for market crashes. Artificially low mortgage rates are the primary reason home values have surged since 2020. It has reached the point where the housing market has frozen due to sellers not lowering their asking prices and affordability issues for large swathes of buyers. Low interest rates have propped up the stock market for several years now. Rates on bank deposits and safe bonds were so abysmal for so long that it left investors with few alternatives besides equities and other risk assets. Basically, the government through questionable monetary policy has encouraged speculation and risk-taking. Bottom line - bubbles always occur after artificially lowering interest rates and the injection of liquidity above the real demand for currency.

6.) Pumping excess liquidity and low-cost money into the economy can cause aggregate demand to outpace the supply of goods and services, driving up consumer prices. In other words, hello inflation. Item #5 above addressed asset inflation. Artificially low interest rates also facilitate inflation in consumer prices. Inflation, also known as the "hidden tax," takes a toll on the majority of the participants in an economy. It also wears and tears at the fabric of a society.

When writing, I am prone to go off on tangents and rant about something I find disturbing. Commonly, I direct my ire at politicians and the policymakers at the Federal Reserve Bank. This case is no exception. Monetary policy, in particular the four rounds of Quantitative Easing between 2008 and 2020, created an absolute monster and set the table for what is unfolding at this time. Fiscal policy has been equally abhorrent. Annual deficits of 6.5% of GDP have been the rule and the not the exception. Starting in 2008, policies designed as something exceptional and temporary were extended for more than a decade leaving a trail of inefficiency, malinvestment and excess debt. Policies designed to buy time and conduct structural reforms have become an excuse to avoid them, take more debt, and increase imbalances. It isn't a flaw in the capitalistic system that has created such wealth imbalances in our society, but the Fed-manipulated, centrally planned rates and its money printing excesses.

I embrace the position that the Federal Reserve Bank should be stripped of its monetary and money supply powers. It should only serve as the lender of last resort. Interest rates should not be hiked or cut by a central planner. Rates need to float freely. Anything else creates more imbalances than the alleged benefits they promote. If rates fluctuated freely, the creation of bubbles and excesses of debt would be almost impossible because the risk would be reflected in the cost of money. Free-market capitalism rests on an uninhibited market for capital and debt. The market can only function properly with market-determined interest rates.