the plan for the future
26 October 2019 (latest update: 24 December 2020)
When the average interest rate on capital nears zero, the consequences can be confusing. The situation may be weird and appear unnatural. This is uncharted territory. For instance, interest rates on mortgages may become negative and corporations that are hardly profitable may be able to survive. If the average interest rate on capital nears zero, the interest rate on risk free money would be negative, and many corporations would make little or no profit.
This goes against conventional wisdom. It seems that something is wrong and that it must end badly. Why are people willing to lend money at a negative interest rate? And why can corporations survive that make little or no profit? It doesn't seem to make sense. But if people are willing to lend money at a negative interest rate, corporations with zero profits can survive. Is this what socialism looks like? These are legitimate questions.
It may be good to explore this uncharted territory a bit further. To see why this might happen, you could look at the bigger picture. In the past returns on investments on average have been higher than the rate of economic growth. Most of those returns have been invested again so the amount of capital has grown faster than the economy. A growing share of total income was not for wage earners but for investors. This cannot go on forever. An example can demonstrate that.
The graph above shows how total income and interest income develop with a rate of economic growth of 2% and an interest rate of 5% when interest income starts out as 10% of total income and all interest income is reinvested. After 25 years the economic pie has grown faster than interest income so that wages have risen. At some point interest income starts to rise faster than total income, and wages go down. After 80 years there's nothing left for wages.
That won't happen because the economy would have corrected long before that. With central banks the situation becomes a bit different. They forestall and mitigate systemic crashes so crises that destroy a lot of capital do not materialise. It is also a reason why interest rates have gone down in recent years. In the short run it was possible to prop up business profits by using lower interest rates to let people go further into debt to buy the stuff corporations make.
In the long run the growth rate of capital income can't exceed the rate of economic growth. Now economic growth stalls because of an abundance of capital. Something has to give. There are three ways out, at least so it appears:
The supply-side view is that there is an excess of capital that needs to be cleansed. The reason why the excess emerged, it is often argued, is that governments and central banks eliminated the business cycle that is a natural and healthy part of the economy as recessions eliminate companies that are inefficient or wasteful. It is the requirement to make at least the interest rate in the market that defines which corporations are useful and efficient enough to survive.
Since the late 1980s a rising number of so-called zombie firms is unable to cover debt servicing costs from current profits over an extended period. This increase is linked to reduced financial pressure, which in turn seems to reflect in part the effects of lower interest rates. They can weigh on economic performance because they are less productive and their presence may lower investment in and employment at more productive firms.1
The demand-side view says that these corporations can be useful and might have been profitable if there was more demand. Destroying capital in order to rebuild it doesn't seem a rational course of action. Therefore, governments should go into debt to increase spending or to lower taxes to keep the economy afloat. If corporations do not provide a useful product or service then customers will not come anyway so inefficient and wasteful corporations are still eliminated.
The proliferation of zombie firms may be the result of the abundance of capital rather than a lack of productivity. Disruptive innovations attract more investment capital than ever. Increased competition and economies of scale may erode profits as capital costs go down. Amazon can deliver books cheaper than local bookstores. And because of its size Amazon has lower capital costs as it can tap into the capital markets while a local bookstore must use more expensive bank credit.
It is unlikely that after a major depression Amazon will be gone and that local bookstores will flourish again. The benefits of scale in a globalised economy are rather obvious. To favour smaller scale local businesses, it might be better to improve their access to capital markets, to introduce transaction costs by using illiquid local or regional currencies, or to introduce legislation favouring local and regional production and consumption.
An alternative to a depression or debt fuelled spending could be allowing negative interest rates. Once interest rates are negative, positive interest rates could be banned to prevent a quest for yield and the irresponsible risk taking. A stimulus can come from negative interest rates without more debt. Corporations with low profits may remain in operation. If low profits are the result of intensive competition or an excess of capital then that may not be bad as consumers will benefit.
The requirement of making at least the interest rate in the market can lead to weird and unnatural situations too. A corporation that makes a product people like can go bankrupt when potential customers don't have enough money to spend and the corporation can't make enough profit. In other words, if an investment in this corporation yields less than the interest rate in the market, it must fail. Economists are inclined to think this is healthy and natural.
In this way a coal fired power plant that returns 6% is considered efficient and useful while a windmill that makes 2% is seen as inefficient and wasteful at an interest rate of 4%. This logic can be suicidal because of climate change. People without a background in economics can't believe this stupidity. Something is terribly wrong with economics and this must end badly, they believe. But if investments don't make the interest rate in the market, few people would make them voluntarily.
It might be a good idea to make investing in ending poverty and making the economy sustainable profitable so that people make these investments voluntarily. Perhaps it is better to make a distinction between what should be done, for instance making the economy sustainable and ending poverty, and what can be done, which depends amongst others, on the interest rate. At an interest rate of 0% the windmill could be profitable. That's why lower interest rates can be beneficial.
Indeed, there are other measures for usefulness than profitability. Perhaps the requirement to make a specific interest rate may not seem particularly useful to humankind but it can help to allocate capital more efficiently. Hence, for the benefit of humankind interest rates might need to be as low as they can possibly be. In this way it may be possible to generate the investment capital needed for making the economy sustainable and ending poverty.
Lower interest rates allow for more debt to exist. Debt levels have grown faster than the economy in recent decades. You can service more debt when interest rates are lower. If you can service € 100,000 debt at an interest rate of 4%, you might be able to service € 400,000 debt at an interest rate of 1%, provided you have collateral. In theory your debt could be infinite once interest rates are zero or lower. Only no-one in his or her right mind would lend you so much money.
There is a supply side and there is a demand side to economics. Taking one side might make you choose between two options, letting things correct in a depression or propping up demand by letting people, corporations and governments go deeper into debt while hoping for the best. Choosing between those options might not be needed as supply and demand for money and capital might balance if interest rates are allowed to go negative.
It is argued that low and negative interest rates destroy capital by favouring consumption over investment and that a recession creates new room for growth. Interest rates may be low because there is an abundance of capital or a lack of demand so that the amount of capital is constrained by consumption rather than investment. And if interest rates are lower, corporations that are hardly profitable may continue to exist, so with lower interest rates there could be more capital.
The graph above plots possible courses of economic activity while keeping unprofitable investments versus creating new room for growth by destroying unprofitable capital. New room for growth could mean an economic depression. During the Great Depression it took nearly a decade for the US economy to recover to the old level. Continuing the path of debt fuelled spending can also end badly. At some point trust in money and debts might disappear, leading to higher interest rates and capital destruction. And so what might seem a bad idea could prove to be a rational course of action.
When interest rates are always negative and positive interest rates on money and debts are not allowed then the economy could become inherently stable. Equity investments are favoured to debt investments. The maximum interest rate on debts makes debt investments less attractive. As interest is also a reward for risk, high risk debt could be phased out.
The improved financial stability can make equity investments even more attractive so leverage may reduce even further and financial stability may improve even more. Because of the negative interest rates on money and debts and the lower risks attached to capital, the interest rate on capital may well go to zero. In other words, capital may start to serve humankind without requiring a return.
1. The rise of zombie firms: causes and consequences. Ryan Banerjee (2018). BIS Quarterly Review.