Low interest rates are causing distortions & mis-allocations
- Baupost Letter Points To Concern Over Risk Parity, Systematic Strategies During Crisis
"The rates we’ve had in recent years, including right now, are the lowest in history. The book that I co-authored on the history of interest rates traces back to the code of Hammurabi, Babylonian civilization, Greek and Roman civilization, the Middle Ages, the Renaissance, and early modern history right up to the present. And I can assure our listeners that the rates that they’re experiencing right now are the lowest in human history."
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
So says Richard Sylla, Professor Emeritus of Economics and the Former Henry Kaufman Professor of the History of Financial Institutions and Markets at New York University's Stern School of Business. He is also co-author of the book A History Of Interest Rates.
We invited Professor Sylla onto the podcast after hearing his work favorably referenced by the panel convened at the recent hearing held by the US Congress titled: “The Federal Reserve’s Impact on Main Street, Retirees and Savings.”
Based on his deep study across the scope of millennia of human history, Sylla warns we are at a dangerous moment in time:
What’s really unique about the current period is that these low and negative interest rates have not been some accident, but a policy target of central banks (...)
Large parts of the population haven’t seem to have gotten much benefit at all from these central bank policies or even the 'recovery'. But the rich have done quite well, despite having to compete with one other to pay $100 million for a painting(...)
These low interest rates aren’t just affecting the asset prices though. There’s this search for yield that was going on before the financial crisis and it’s something we probably ought to worry about because money may be being mis-allocated now.
One area in which we see this is, despite low oil prices, the capital markets are feeding a lot of money into oil exploration in the United States. This is not wise allocation of capital because a lot of these shale oil, company oil and gas drillers are not making any money now -- so Wall Street is putting money into a business sector where the returns don’t look to be that great. What if a lot of these junk bonds fail as they tend to do, or the shale oil drillers go bankrupt after Wall Street has put a lot of money in there? That’s one of the key worries about very low interest rates such as we’re having now -- it causes distortions and mis-allocations(...)
I harken back to Hyman Minsky, whom I knew. Minsky said Stability breeds instability. I think we found that out in the financial crisis of 2007-2009 and I see that now they talk about the VIX being very low and the stock exchange people don’t seem to think there’s much danger out there in the world. If Minsky is right, this attitude of Things seem to be very stable now, therefore I can run out and buy stocks at prices that are at historic highs -- that may be setting us up for the next financial problem.
There are a lot of similarities to what’s going on right now and what went on before in the 2007-2009 financial crisis. And people don’t seem to worry about that. It’s like things are really stable now and the Central Banks got us through the crisis without having a Great Depression, so it's smooth sailing from here. There’s probably too much optimism right now about the economic future(...)
Looking at the tremendous growth of financial markets compared to GDP growth: there used to be a relationship between them that seemed to be pretty close. But in for the last 50 years or so, the financial markets have expanded at a much higher compound rate. What it means is that the world has taken on a huge amount of debt and has been compounding that debt at a much higher rate then economic growth. It does seem to me to be an inherently dangerous situation because all this debt has to be serviced, you have to pay the interest on it. Usually, you have to pay it back at some point. And so if it’s growing much faster and then the economic base that is going to generate the income to pay it back, I think we are making ourselves more vulnerable. It’s true in the United States; it may be even more true in some of the places in Europe where the banks seem to be more highly levered. And in China there’s been a tremendous expansion of credit(...)
And of course, if we’re at a slow rate of growth now and we have another crisis, the rate of growth will be even slower. My fellow economist Robert Gordon claims that we can look forward to a much lower rate of growth in the future than we’ve had in the past. And furthermore, the ordinary people, the ones who are an angry populace now, they’re the ones who are not going to experience much growth at all. What growth we will have is going to generally flow to the top of the income distribution -- and in that way of the world is becoming more unequal. It’s a gloomy outlook.
I think history would say it’s more than likely that we'll have another financial crisis. And based on a lot of what we've talked about here today, history says that crisis may not be far off.
Click the play button below to listen to Chris' interview with Professor Richard Sylla (47m:58s).
Article by Peak Prosperity