Absolute Return Letter: The Real Burden Of Low Interest Rates by Absolute Return Partners
“The situation is desperate but not serious.”
Old Viennese saying
The ceteris paribus enigma
One of the questions I am most often confronted with goes as follows:
In a rare interview with Harvard Business School that was published online earlier this month, (it has since been taken down) value investor Seth Klarman spoke at length about his investment process, philosophy and the changes value investors have had to overcome during the past decade. Klarman’s hedge fund, the Boston-based Baupost has one of Read More
Why is the extraordinarily and persistently low interest rate environment not great news? Why is it not a once-in-a-lifetime opportunity to get all the wheels spinning again? Put another way, why do I think very low interest rates for an extended period of time can actually do quite a lot of damage?
It is a tricky question to which there is no simple answer. Low interest rates, ceteris paribus, obviously boost overall economic activity, and those who are so critical of our central bankers for their relentless pursuit of easy money, should probably think again before they have another go. Imagine what economic activity would have been like, had rates not been kept extraordinarily low. The economy post 2008 is without precedent, and an economy without precedent requires a monetary policy that is also without precedent.
The sharp reader will now argue that I am contradicting myself. One moment I suggest that low interest rates for an extended period of time can do a lot of damage. The next I scold those who criticize our central bankers for keeping interest rates low. How come? The answer lies in the use of the term ‘ceteris paribus’. The point is, other things are not equal.
More often than not, the critics point at the ongoing paltry GDP growth rate to prove their point. My point is different. Low interest rates for an extended period of time don’t damage economic growth directly, but they cause damage in a multiple of other ways – a point almost universally missed by the critics. That is what this month’s Absolute Return Letter is all about.
Credit growth has driven GDP growth over the years
Let’s begin by looking at how the low interest rate environment post 2008 has affected total borrowing. When the Bank for International Settlements (the central bank of central banks) published its 2014-15 annual report a few months ago, they answered that very question (chart 1). As you can see, total debt (public and private) continues to rise almost as if 2008 never happened.
This leads me to the obvious question – is debt creation actually good or bad news as far as economic growth is concerned? Few topics divide the investment community more than this question. When reading other commentators, it appears that the fundamentalists amongst us are of the opinion that any increase in debt from current levels is going to come back and haunt us eventually. Debt is akin to evil, or so they seem to think.
On the other side you will find those who accept that some debt creation is actually good for economic growth but only up to a point. Let’s call those who subscribe to that view the pragmatists. Going back to the question again – does debt creation actually create economic growth? – allow me to revisit a chart I used in last month’s Absolute Return Letter. Produced by Deutsche Bank in 2008, it demonstrates a very clear link between credit growth and C+I, which is a proxy for private sector demand (chart 2).
C+I is part of the well-known formula GDP=G+C+I+(X-M)1. The fact that the growth in credit correlates very tightly with C+I implies that credit growth also correlates quite highly with GDP. Looking at chart 2 again, it is therefore fair to conclude that the pragmatists have the upper hand in the war of words with the fundamentalists – or had, at least until 2008.
Let’s go back to the fundamentalists’ point of view for a moment. How can they possibly argue that debt creation will ultimately prove very damaging? After all, it is hard to argue against the findings of chart 2. The argument put forward by their camp is that ‘when interest rates normalise, we will be proven right’.
Assuming that a ‘normalisation’ of interest rates to levels we experienced before the great recession would imply a return of economic growth and inflation to those same pre-2008 levels, as regular readers of the Absolute Return Letter will know, I don’t think there is a cat in hell’s chance that we will return to those sorts of levels of growth anytime soon. For that very reason, neither will interest rates.
For the record, U.S. interest rates will probably rise more than they will here in Europe, but they will stay comparatively – and surprisingly – low everywhere. Hence the biggest risk is therefore not that interest rates suddenly take off. Rather the biggest risk is that interest rates stay very low. Let me explain.
Issue # 1: Low interest rates lead to lower productivity
My journey begins by digging one level deeper than chart 1 did. Who has actually taken on all the additional debt since 2008? The good news in this context is that private debt, although it is still comparatively high in places, has actually fallen meaningfully since the peak of the financial crisis (chart 3). Public debt, meanwhile, has not, as is obvious when looking at the right hand side of chart 3.
See full PDF below.