Interest rates have ebbed in Britain for a decade. In Japan the tide has been going out for a quarter of a century. In the United States, the official cost of borrowing inched up at the end of last year, but only to around two-thirds of a single percentage point. Rates sometimes used to move a whole point or even two at a time; these days 1 per cent or 2 per cent sounds more like a ceiling. Across the rich world, low rates have slowly become the new normal.
Yet the low-interest era is anything but normal. Low rates are supposed to boost growth, and very low rates are supposed to be for emergency use—for pulling depressed economies back from the deflationary brink. But in the light of 5,000 years of historical records, we can see that the rates of the last several straight years are by some way the lowest ever seen. Critics worry that we’ve become addicted to the emergency medicine, and that today’s ultra-low rates are no longer working as intended. Populist politicians like Donald Trump and even mainstream leaders such as Theresa May have been pointing the finger at central bankers for the low-rate regime which—some suggest—is exacerbating social divisions and fuelling inequality. The zero interest rate world, then, is playing its part in our politically exceptional times. Things could get ugly.
For low rates to be the focus of populist wrath is a startling development. In the long history of credit, while it is debtors who have stood in the dock—facing enslavement or prison—in the court of public opinion, it has been the lenders charging excessive interest who have been condemned. In The Clouds, produced by Aristophanes in 423 BC, old Strepsiades tells Socrates that “by debts and interest payments and rapacious creditors I’m assailed and assaulted.”
That lament echoes down the ages. Medieval churchmen deplored gain from moneylending and usury laws were imposed. In late-19th-century America, self-styled tribunes of the people such as William Jennings Bryan demanded reforms which aimed at cheaper money, to aid the plight of indebted farmers. Our historical filter, then, is formed by the anguish of debtors. Viewed through it, today’s low-interest world is a paradise gained rather than lost.
Creditors are now the victims feeling assailed and assaulted. If Aristophanes were writing a play today—iClouds?—he might cast Strepsiades as a disgruntled elderly German saver, bemoaning the exiguous interest on his account at the local Sparkasse. For these days Trump roughs up the cheap money Fed in his presidential campaign, and May suggests to the Tory conference that the Bank of England ought not to ignore the “bad side effects” of its monetary medicine. Meanwhile Germany’s finance minister, Wolfgang Schäuble, has publicly blamed Mario Draghi, President of the European Central Bank (ECB), for the rise of Germany’s right-wing insurgent party, Alternative für Deutschland (AfD).
The old tradition of populists channelling the rage of the debtor looks to have been entirely upended. Today, the increasingly toxic political issue is the resentment of savers with cash in the bank. It risks ensnaring central bankers. They have a perfectly defensible account of why they have acted as they have done—if they can persuade people to listen to them. But if they can’t, their independence from politics—which has been a given for a whole generation now—could soon be imperilled.
To grasp how on earth it was that low, rather than high, interest rates are suddenly becoming an explosive issue, you need to take the long view. Today’s ultra-low rates are, quite simply, a historical aberration.
Throughout the first four and a half thousand years of recorded credit, even the cheapest borrowing was always pretty expensive (see chart overleaf for the last 800 years) by recent standards. But the exact rates paid were in part a facet of the health of the evolving financial system—when it was more developed, there would be more faith that debts would be repaid, and lending rates would come down; when things got shakier, borrowing costs would go up.
During the early bronze-age period in Sumer—modern-day southern Iraq—interest rates were 20 per cent for lending silver and 33 per cent for the loan of barley. In ancient Greece interest rates were lower, at between 10 and 12 per cent in the 5th and 4th centuries BC. The lowest rate recorded in the ancient world was 4 per cent, in Rome in the first century of the empire, though actual rates could be far higher. High-minded et tu Brutus earned a rebuke from Cicero for demanding interest of 48 per cent on a loan to the citizens of Salamis in Cyprus.
Similarly high rates were charged in China over most of the past two thousand years, consistent with a credit system that remained rudimentary until modern times. That was also the position in Japan until the Meiji Restoration of 1868 and the subsequent introduction of a modern banking system, though rates remained high by western standards.
There is something of a shadow over borrowing costs in the dark ages, but you can bet it wasn’t cheap. A sophisticated banking and credit system then emerged in medieval Europe especially in the Italian city states, and with it regular data. That helped to bring down short-term rates from 10 per cent in the early-13th century to around 5 per cent between the late-14th and early-17th, after which they dropped sharply, especially in the Netherlands where by the dawn of the 18th century they had fallen to a remarkable 1.75 per cent (see chart on p32.) That aroused English envy since low rates were associated with prosperity; after the last decade, however, such rates sound high.
In the next phase of development, interest rates evolved from being a market outcome to being, in part, a tool of public policy. The creation of central banks—the Bank of England was founded in 1694—put in place the infrastructure which would later enable interest rates to be set with a view to the effect on the currency, the international trade balance, and then later, in the 20th century, the pace of growth and the rate of unemployment.
After the depression of the early-1930s, this new role of rates—as rudders to steer the whole economy—came to the fore. The pound tumbled off the gold standard in 1931, which freed the Bank to cut its main rate—which it soon did—from the crisis rate of 6 per cent right down to 2 per cent, where it more-or-less remained for two decades. That 2 per cent rate was as low as had ever been reached in the then two-and-a-half centuries of the Bank. It enabled the average rates paid to British savers to fall even lower, to the 1.3 per cent in the 1930s, and then further again down to 0.8 per cent in the 1940s.
The 1940s, however, really were an emergency. Nobody could dispute it: life, liberty and treasure were being sacrificed to the war. Any squeeze on savers would pale beside that. Today, however, we are not at war, nor even in recession—and yet entirely new depths have been plumbed. From March 2009 the Bank held the base rate, not at the wartime low of 2 per cent, but instead at 0.5 per cent—a three-century low. And it remained there until August 2016 when, following the Brexit vote, the Bank cut rates again—to 0.25 per cent.
Common sense might suggest that—with zero in sight—this is at least a limit. After all, you would have thought that nobody would keep their cash in the bank if they had to pay for the privilege, when they could simply withdraw their funds and hold the cash. Hence the time-honoured precept that interest rates could never fall below zero. Remarkably, though, several central banks have now indeed introduced negative interest rates. These are in effect a charge on deposits made in a bank and, it turns out, they are feasible in practice, because large depositors would find it costly to store their funds safely in cash. The ECB went negative, to -0.1 per cent in June 2014, and has since cut further, to -0.4. Rates are even more negative in Denmark, Sweden and Switzerland, all three outside the euro area.
There can, then, be no disputing either that the zero world is both new and genuine. But how far should we care? Before we can settle that we need to take account of inflation, or the lack of it. When prices are rising, savers lose unless they are paid enough interest to compensate them for the dwindling purchasing power of their funds. What matters to them—or ought to matter—is the real interest rate they receive, the actual interest paid adjusted for inflation. And indeed, there is very often a close connection between these two things.
The zero world dawned in Japan two decades ago. That was no accident, since this was when Japanese prices also started to fall. Until the financial crisis, this mix of mild deflation and very low interest rates appeared a curiosity. More recently “turning Japanese” has mutated from a hit record in 1980 by the Vapors to shorthand for financiers getting a touch of the vapours about the spread of deflation. “Lowflation”—a term coined by Christine Lagarde, head of the IMF—has gripped the eurozone in particular since autumn 2014, with inflation scarcely ever significantly above zero and several months of outright deflation.
In a lowflation environment, investors no longer have to worry about prices eating up savings, which makes very low rates less disruptive. Yet the trend decline in actual interest rates has surpassed the reduction of inflation since the 1980s. Real rates have thus also fallen steadily for the past three decades or so. They are not breaking records to the same extent as headline interest rates have done, because bouts of rapid inflation have tugged real rates into negative territory before. Even so, today’s real rates are the lowest since the highly inflationary 1970s, and far lower than usually seen in peacetime.
The historical evidence, then, appears incontrovertible: today’s low rates are real and indeed unprecedented.
No doubt that helps explain the newly incendiary politics surrounding them. But why have they become the new normal?
Politicians are taking potshots at central bankers because at first sight, they appear responsible. After all, it is they who have torn up the rulebook since the financial crisis. As well as introducing ultra-low rates, they have set the electronic printing presses whirring through quantitative easing (QE).
Central bankers themselves talk with forked tongues. On the one hand they stress their duty to pursue monetary policy à l’outrance when they are under-shooting their inflation targets. But at the same time, they throw their hands up in the air when accused of impoverishing savers, and enriching the wealthy by boosting asset prices through flooding the markets with easy money. At this point their story suddenly switches to one about their own impotence, as they invoke deep forces beyond their control, which are driving real rates down. Central banks here are followers rather than leaders, like ships driven towards the new zero world by winds of change which it would be futile to resist.
The sense that there is something beyond policy at work emerges particularly from conditions in the market for long-term debt. Compared with short-term (up to a year) borrowing, long-term rates always used to be less susceptible to monetary policy, but today’s ultra-low-interest world encompasses borrowing of both sorts. Records here also go back to medieval times, based for example on Venice’s prestiti (bonds first issued in the late 1100s to finance its wars), and—for a long time after 1751—the British government’s perpetual “consol” bonds. The recent downward drift here is, again, very much in evidence.
"The historical evidence appears incontrovertible: today's low rates are indeed unprecedented"Until the crisis, the lowest that long-term yields had fallen was to 2.5 per cent in late-19th-century Britain and 2.3 per cent in the 1940s in the US. That tidemark is now well inland. Yields on ten-year government bonds, the usual benchmark, have fallen to zero and even a bit lower in some countries, such as Switzerland, Germany and Japan. All three were able to issue new bonds at negative rates in 2016. In Britain gilts fell to a record low of 0.5 per cent in August. Although long-term rates have picked up from last summer’s lows they still remain extraordinarily low in many advanced countries, ending the year in Britain at 1.23 per cent, in Japan at just above zero and in Switzerland at -0.26 per cent.
As with short rates, the case of Japan is instructive because it was ahead of the pack. The zero era there dawned as bond yields lurched down from around 3 per cent in the mid-1990s to less than 1 per cent in 2003. Successive waves of investors have retired hurt after betting that yields would rise, a trade that has come to be known as the “widowmaker,” as bond yields gradually sank from the low to zero or below.
Japan’s central bankers have certainly been much more than bystanders here. They were the pioneers of QE, in which newly created money buys government bonds, which keeps down the rate that the government has to pay on its debt. Where Japan led, the world’s other big central banks have—since the crisis—followed. In many countries, the purchases have been earth-moving in scale, making central banks the biggest holder of government debt. And no doubt that is a big part of the reason why those long-term rates are so low.
Not necessarily the only reason, however. One thing nobody imagines central bankers can do is dictate when and how many babies are born—and how long they will live. But demographics also appear to explain a lot about the zero world, including why the journey there began in high-longevity and low-fertility Japan. It has been grappling with an ageing and stagnant population since the mid-1990s. As other countries are discovering—now that their post-war generation of baby-boomers are moving into retirement—ageing produces two troubling effects. First, when a large cohort like the boomers begins to save seriously for retirement, they will push up overall saving. But second, at the same time, if the working-age population stops growing or even shrinks, lower employment discourages investment. These twin effects both push down real rates.
According to this account, ad-vanced economies are suffering from “secular stagnation,” a term first used in the late 1930s but repopularised by the economist and former US Treasury Secretary, Lawrence Summers. If it is the role of interest—the economic reward for patience—to balance the forces of thrift and industry in a society, then strange things might well happen to rates when those two forces get fundamentally out of kilter. Summers sees the desire for saving in our ageing society as structurally over-abundant, and the desire for new investment as structurally insufficient.
It is not just the demographic weight on the workforce that is weakening capital spending. The digital companies reshaping today’s economy pile up cash, whereas the sort of firms that used to be at the technological forefront had to invest heavily in plant and machinery to stay there. That required them to raise funds from the market, which provided an attractive destination for savers.
In five of the G7 economies, non-financial companies have collectively swung from being net borrowers—investing more than they save through undistributed profits—to net lenders, with firms building up stashes of cash. This “corporate saving glut” emerged in the early 2000s in Japan, Canada and Britain, and has since spread to Germany and the US. Analysis by the Fed has suggested that this glut reflects a lack of investment opportunities rather than post-crisis uncertainty. If so, this really is a real economy problem, beyond the control of central banks.
American evidence suggests that rising inequality is also dragging down real rates. Why? Richer households, who command a larger share of resources in an unequal economy will tend to save proportionately more. The inequality effect does not seem as large as the effect of ageing on desired saving, but it is yet another channel which central banks cannot directly control. Yet another such factor is the inflow of savings into the global economy from China and other emerging economies.
So there is a fundamental imbalance between what people want to save and how much businesses want to invest. This would have dragged rates down even if central bankers had been bystanders. But in fact, interest rates fell even further, because central bankers were anything but idle spectators. If structural factors can explain a great deal of the long decline in real interest rates between the marked highs of the mid-1980s and 2007, a great deal of the marked and exceptional further fall since the crisis is without doubt due to the exceptional post-crisis interventions of the central banks.
Sleuths always ask who benefits from the crime. If low interest rates are a crime, governments have the most to gain since they are the biggest debtors of all. Carmen Reinhart, an economist at Harvard University, believes that the low rates set by central banks since the crisis echo previous “financial repressions,” in which they have colluded with governments to lighten debt burdens by imposing negative real rates on savers. The fillip to budgets has been considerable. Even though public debt has soared, the cost of servicing it has fallen thanks to dirt-cheap rates.
Whatever the precise contribution to low rates from central banks and deeper global forces, the longer the zero era lasts the more pervasive its impact will be.
The aim is supposed to be—through a return to healthy growth—to get inflation back on target. Cheaper borrowing for households and businesses ought to help with that, and studies have found that things like QE really did prop up the economy, especially in the immediate aftermath of the crisis. But as low rates persist, there is mounting concern that they may be hindering rather than spurring a return to economic health.
There are four ways in which low rates could become counter-productive. The first is by inhibiting capitalism’s creative destruction. Low rates ease the burden of debt, but that allows zombie companies to keep going. The replacement of poorly performing businesses with new entrants would otherwise bolster efficiency. Stop and think about that for a minute, and the famously dismal performance of British productivity for the best part of the past decade starts to seem like less of a puzzle.
A second problem, which is particularly important for British employers, is the increasing cost of honouring their salary-related pension pledges. The fall in long-term yields has greatly raised the present value of pension liabilities, and by more than the rise in pension-fund assets. This leads to deficits, which firms have to plug by diverting cash that might otherwise have been used to invest.
Thirdly, low rates are undermining the business model of high-street banks. Low rates squeeze their traditional margin—the gap between the interest they receive on loans and the rate they have to pay out on deposits. That differential will never be what it was while banks continue to balk at setting negative rates for retail depositors. The effect of this aspect of the low-rate environment is especially baleful in parts of Europe that are overbanked, such as Italy and Germany. Rationalisation may be necessary, but it will be painful and protracted. In the meantime struggling banks adopt a defensive crouch, concentrating on retrenchment rather than lending to support new projects and businesses.
"The return journey from the zero world could be a long way off. Some underlying forces are pushing us towards more of the same"Fourth, low rates are prompting investors to adopt riskier strategies to get decent yields. That behaviour could result in a further round of financial instability as the Bank for International Settlements, a forum for central banks based in Basel, has repeatedly warned. Even if regulatory changes make an exact rerun of 2008 unlikely in the banks, big asset managers in other parts of the system could again fall prey to dangerous herding behaviour.
If low rates are becoming less effective and even counter-productive that would be reason to say enough is enough. Yet it is the social impact that may matter most of all, by undermining the public’s acceptance of low rates.
The main charge is that they are exacerbating inequality. Once again the zero world turns out to be a place of paradoxes. Central bankers were traditionally charged with siding with the rich when they imposed unduly strict monetary regimes—in The Economic Consequences of Mr Churchill, Keynes deplored the then-chancellor’s decision—fully supported by the Bank of England—to rejoin the gold standard in 1925 at an uncompetitive valuation, which necessitated high interest rates to lure foreign funds to invest in Britain, as promoting the interests of rentiers over those of workers.
Since the Second World War the typical cycle has seen rates decline when the economy weakens, and rise when it overheats. This has delivered rough justice. Debtors have gained when rates have been cut whereas creditors have benefited when they have risen. The distributional effects have thus broadly washed out over the cycle. Nonetheless there has usually been rejoicing when rates have been cut thanks to the relief they bring to borrowers, especially those with mortgages.
But the longer that rates stay so low, the more that savers are feeling the pinch. Their plight is particularly prominent in Germany, where many less wealthy families rely heavily on saving through their banks. Addressing the Bundestag in September 2016, Draghi sought to soothe the mood, pointing out that “what a household may lose in terms of little interest on their bank account, it might save in lower mortgage payments for their home.” The trouble is that the household losing savings interest is quite likely to be different from the one paying less on its mortgage.
On the face of it, the immediate losers from low rates are older whereas the winners are younger, and the reverse will be true as and when the policy is eventually unwound. In Britain, for example, the Bank reckons that a rise in interest rates would benefit those aged 55 and above, while hurting younger age-groups. In an ageing society, where the grey vote has growing clout, the stark losses on the savings deposits of the old helps to explain the novel sight of Trumpian populists siding with the savers.
Another group of older people who have reason to feel cross are workers, who have prepared for retirement by building up a personal pension pot—which they then turn into whatever income the market will give them. The zero world affects their investments in different ways, but the overall effect is clear. For even a single 65-year old, with no need to leave behind a pension for a spouse or partner, to achieve an inflation-proof income of just £10,000 a year, in today’s zero world it is necessary to have saved more than £300,000—entirely unobtainable to most people.
But think through the full effects of the zero world and there are winners among the old as well as losers among the young. Low rates have pushed up house prices. That is good for old homeowners, but it hurts youngsters watching the first step of the housing ladder slip out of reach. Even if they can get a foot on the rung, any benefit from historically low mortgage rates is offset by the need to take out historically large mortgage loans. Ultra-low rates have also inflated stocks and shares—again, that works to the benefit of mostly older “haves” at the expense of younger “have nots.”
So the caricature of the old being the great victims of the zero world can be questioned. Even if there is something in it, we need to put that in context. As the Institute for Fiscal Studies has pinpointed, older people have fared far better overall than the young since the financial crisis. Real incomes among the 60-plus group have risen whereas the real wages of twenty-somethings have declined. Without lower rates, we could have seen an even more harrowing recession, which would have exacerbated the divide by consigning many youngsters, in particular, to the dole queue. If the alternative to zero world were rentier world, then we should be grateful for what we’ve got.
There is certainly plenty that’s not to like about the prospect of ultra-low rates without end. But the political backlash against central banks is misplaced. Within their remit they should set the appropriate monetary policies for the economy while it is for politicians to use taxes and benefits to ease the lot of those groups of whom low rates are asking too much. With the pound under pressure following May’s perceived attack on the Bank of England in early October, Chancellor Philip Hammond conceded this point when being quizzed by MPs two weeks later.
Yet the attacks on central bankers in advanced economies are unlikely to abate while the zero era continues. There are tentative signs that it may be drawing to a close. Long-term rates have risen since the summer lows of 2016, and the Fed has signalled three further quarter-point rate rises in 2017. Trump’s plans to rebuild America’s infrastructure entails government borrowing that should push up long-term rates. More generally across advanced economies there is an acknowledgement that monetary easing has been extended as far as possible and that further stimulus must come from fiscal policy.
But there have been false dawns before for those expecting a return journey from the zero world. Central bankers have signalled extreme caution about tightening policy. Before the shock of the Brexit vote prompted yet another cut in the base rate, Mark Carney, Governor of the Bank of England, cautioned that future increases would be “gradual and limited,” such that rates would remain “materially lower than in the past.” And to the extent that broader underlying forces such as population ageing are responsible for low rates, the outlook is also for more of the same, at least until the baby-boomers get so old that they give up on saving, and start running down what they’ve got.
But whether or not the central bankers have in part responded to larger economic forces, there is no doubt they bestride the zero world. The politicians’ rhetoric may be unfair but it reflects genuine social grievances. It would be a bitter irony if the main casualty of the zero era proved to be central bank independence.
