Ideal for investors, not for the economy

 In Articles

Interest rates that are too low lead to a mis-allocation of capital. In the long term, this is not good for the economy or for society. In the short term, the combination of low interest rates, rising inflation, and strong economic growth creates an ideal scenario for equity investors. The stock market agrees, as evidenced by the recent record series. 

The importance of the right interest rate

The interest rate is an important factor on the basis of which savers and investors make choices. It only makes sense to invest if you can earn more with it than what it costs to borrow. The return on the investment must therefore be higher than the interest on the financing. Moreover, an investor prefers to buy relatively certain and short-term existing activities instead of developing uncertain and long-term future activities. For the latter, the return requirement is higher. At present, the return on existing activities is largely dependent on the growth of the economy. When the economy grows by 2 percent and there is also 2 percent inflation, this means that at an interest rate of 4 percent there is effectively zero return. This provides an incentive to invest in (future) growth where, thanks to innovation, a higher return than 4 percent can be achieved. Innovation means more productivity and therefore more economic growth. As soon as the interest rate is much higher than the economic growth rate, no more investments are made, not even in replacing existing capacity. After all, a savings account yields more. When the interest rate is much lower than the economic growth rate, investments are made mainly in existing assets, for example, houses. The risk of creating bubbles increases in such a situation.  

Mis-allocation of capital

When real interest rates are negative, almost any investment is profitable. There is hardly any more capital discipline and therefore a much higher chance of mis-allocation of capital. Then the money goes to projects that under normal circumstances would no longer be profitable. Not good for productivity, also because zombie companies are kept alive. In recent years, in addition to negative real interest rates, central banks have bought up trillions in bonds. This has left even fewer investment opportunities. As a result, there is more speculation with the remaining assets. Take high yield bonds, for example, where the interest rate is now even below inflation in the United States. Even without bankruptcies, something that is theoretically possible with such extremely low interest rates, an American high yield investor is currently not receiving enough to compensate for inflation. What a big difference with December 2008. If you looked at the high yield market back then, you would see a portfolio of companies that were all allowed to go bankrupt the next day, where an investor could easily get his deposit back even with the historically low recovery. Unfortunately, those times are over.  

Consequences for society and investors

The price society has to pay for this monetary madness is less innovation, less productivity, and more social inequality. The low interest rate is a tax on savings, which ultimately means that less is saved and therefore less is invested. The rich get richer due to rising prices of financial assets, but it is mainly the poor who hold savings. Furthermore, this section of the population spends relatively more money on food, energy, and rent. Too much money causes rising commodity prices, higher energy prices, and higher rents. Whatever the purpose of monetary policy, central banks have skimmed off savings and the proceeds have gone towards consumption and government financing. This resembles the macro-economic policy of the Soviet Union. However, a negative interest rate does not only mean borrowing from the future, it also ensures the destruction of capital, with the result that the economy cannot grow as fast in structural terms. For investors, this Keynesian policy means that central banks will stick much longer to the policy of low interest rates, even if inflation is rising. The government is playing a much bigger role and is trying to fuel economic growth with a pressure cooker. This may cause more inflation, but probably also more growth and job creation in the short term. History shows that such an expansive fiscal and monetary policy can be successful for a long time, see for example the period after World War II. It seems that the financial markets, too, are following such an optimistic scenario, as interest rates remain low despite rising inflation and equity markets are picking up record after record. 

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