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Are ultra-low interest rates dangerous?

The industrialized world is currently moving through a period of ultra-low interest rates. The main benchmark interest rates of central banks in the United States, the United Kingdom, Japan, and the euro-zone are all 0.50% or less. The US rate has been near zero since December 2008; the Japanese rate has been at or below 0.50% since 1995. Then there are the central banks that have gone negative: the benchmark rates in Denmark, Sweden, and Switzerland are all below zero. Other short-term interest rates are similarly at rock-bottom levels, or below (see figures 1 and 2).

Figure 1, by Richard S. Grossman. Image used with permission.
Figure 1, by Richard S. Grossman. Image used with permission.
Figure 2, by Richard S. Grossman. Image used with permission.
Figure 2, by Richard S. Grossman. Image used with permission.

Longer-term interest rates remain higher than short-term rates, as usual, but just barely. Quantitative easing in Japan and the United States have brought long-term interest rates to historic lows—and the planned adoption of quantitative easing in the euro-zone may bring similarly low interest rates to Europe.

How did we get here? And should we worry about the consequences of ultra-low rates?

The main reason for engineering low interest rates is to stimulate spending on houses, factories, and equipment. Since these big-ticket items are often paid for with borrowed money, lower interest rates should make buyers more willing to make these purchases. Of course, if the business climate is so bad that manufacturers have no reason to believe a new factory will be profitable, low interest rates will not induce them to build that factory.

Large-scale borrowers also benefit from low interest rates. According to a study by McKinsey, low rates saved the US, UK, and euro-zone governments about $1.6 trillion during 2007-12 due to reduced interest payments. The same study indicates that non-financial corporations saved about $710 billion.

Exporters benefit from low interest rates too. Low interest rates at home encourage investors to send their money abroad in search of higher returns. To do this they sell domestic currency, which then declines in value, making domestic goods cheaper–and more attractive–to foreign buyers.

Driving interest rates lower in order to stimulate a flagging economy would therefore seem to be sound policy.

But ultra-low interest rates can have negative consequences, too. Lenders—including pension funds, insurance companies, and retirees living off their savings—will suffer because their investments will yield less income. And importers will suffer because the foreign goods they would like to buy become more expensive.

A potentially dangerous side effect of ultra-low interest rates is asset-price bubbles. Low interest rates can lead investors to seek higher returns in ever-riskier investments. The availability of plentiful, cheap credit provides the resources for investors to make large wagers on these high-risk projects. Low interest rates provide the motive, means, and opportunity for investors to drive up the prices of assets, such as real estate or commodities. And when these bubbles burst, the consequences can be dire. Those who have taken on debt to finance asset purchases will find themselves unable to service their loans. And institutions that provided the loans used to finance these purchases will be in serious trouble when their borrowers default.

This boom-bust pattern has been repeated time and time again during the past two centuries. Britain experienced this type of financial crisis in 1825, 1836-39, 1847, 1857, 1866, and 1890; the United States in 1837, 1857, 1873, 1893, and 1907. Boom-bust crises were widespread in Europe during the early post-World War period. And, of course, the Great Depression of the 1930s was the deepest and most severe financial crisis of all time.

The US sub-prime mortgage crisis is the most recent example of the classic boom-bust crisis. President George W. Bush engineered three major tax cuts during his first administration which, combined with additional spending on wars in Iraq and Afghanistan, generated both a substantial fiscal deficit (see figure 3) and an economic boom that would eventually end in crisis. The boom was fuelled by the easy monetary policy adopted by Alan Greenspan and his colleagues at the Federal Reserve (see figure 4). Combined with lax financial regulation, there was very little to prevent the boom-bust cycle from running its destructive course.

Figure 3, by Richard S. Grossman. Image used with permission.
Figure 3, by Richard S. Grossman. Image used with permission.
Figure 4, by Richard S. Grossman. Image used with permission.
Figure 4, by Richard S. Grossman. Image used with permission.

Should we therefore worry that the current round of monetary easing adopted by the industrialized countries will lead to a macroeconomic boom-bust cycle? And should these countries therefore retreat from their current easy monetary policy stance?

In fact, it is possible that low interest rates will lead to bubbles in asset prices. We have seen suspicious increases in a variety of real estate, commodities, and financial markets that should make policy makers sit up and take notice.

Despite these isolated signs, the chances that the current low interest rate policy will lead to a boom-bust crisis in the foreseeable future are slim. Although the US economy is beginning to pick up steam, it has nothing like the momentum it had prior to the sub-prime crisis. If the European economy is exhibiting any momentum at all, it is not clear if that momentum is forward or backward. And Japan has been operating for nearly two decades with ultra-low interest rates with nary a bubble in sight.

Low interest rates may one day contribute to a boom-bust crisis in the industrialized world. However, given the weak state of the economy, particularly in Europe, concerns about low interest rates generating a major financial crisis are unfounded at this time.

Featured image credit: Wall Street, by Alex E. Proimos. CC-BY-NC-2.0 via Flickr.

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  1. […] my latest Oxford University Press blog post on ultra-low rates.  The post is based on a presentation I will make at the SUERF/OeNB/BWG […]

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