Monday 24 October 2016

Zero interest rates may not be a good bargain in the end

Published 06/10/2016 | 02:30

ON account of misreading the timetable, I spent part of my holiday sitting in a small Italian station waiting for a train that was not running.

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That gave me plenty of time to study how decrepit was the station, the track and all the other pieces of equipment.

It also prompted the thought that, even though Italy's borrowing costs are among the highest in the euro area, at 1.3pc for ten-year loans, surely it would make sense to raise some money and fix things up.

That was a couple of months ago, but suddenly the effects of ultra-low interest rates are all over the financial news - and it is mostly the bad news. Until now, the general view has been that central banks did a great job in forcing down rates to levels not seen before, thereby saving more banks and countries from collapse Irish-style.

It has also been an enormous help to those which did collapse. The European Central Bank arrived late on the scene but the fall in the cost of money compared with even historical averages has been worth around 2pc of GDP to Ireland - €4bn a year - and helped avoid the painful dislocations of having to default on debt.

Those were emergency times. Concern is growing at the absence of any sign of a return to normality. The flurry of coverage may owe something to last month's report from the Organisation for Economic Co-operation and Development (OECD) which saw the preponderance of zero interest rates as increasingly part of the problem, rather than part of the solution.

It is a truism that if something has not happened before, its consequences are unforeseeable. They certainly may not all be benign. The worrying conclusion in the report is that the world is in a "low-growth trap", where investment, wages and spending are all constrained by near-zero inflation, thereby choking growth and employment as well.

There has been some recovery in emerging markets, but things are slipping again elsewhere, especially in Europe. The report sees last year's growth of 1.9pc in the euro area declining to 1.4pc next year. Brexit is expected to push Britain's respectable 2.2pc growth below the euro average, falling to 1pc in 2017.

The weakness in the US may be less troubling, owing a lot to oil prices curbing investment in new projects and a rundown in stocks elsewhere.

Yet any setback seems enough to scare a jittery Federal Reserve away from the long-promised (or is it threatened?) rise in rates.

Property prices are raising their ugly head again. Lower rates mean higher asset prices, whether of stock market shares or houses to let. The OECD notes that real house prices have been growing as fast, or faster, than during the run-up to the crash in a number of countries. In Britain, Canada and the US, commercial property prices are already above pre-crisis highs.

It recommends counter-measures of the kind controversially put in place by the Central Bank of Ireland. It is in fact rather difficult to fit Ireland into this global picture.

Interest rates are high for those not fortunate enough to have bubble-priced trackers and, with inflation at zero, real rates are at the kind of levels which would have crippled growth in the past. Yet, as we know, Irish growth is the envy of Europe.

Much of that is semi-automatic recovery from artificially low levels of business and construction activity during the Crash. According to the ESRI, recovery is now complete and, unlike most of the euro area, the economy does not need stimulus.

Irish policymakers find themselves in an odd situation, even if the political situation were not so unstable.

Despite its achievements, the country is not immune from the perceived dangers of credit costing next to nothing. It is heavily indebted, leaving it vulnerable to any sudden increase in rates, whenever that might come.

It is the case that markets often stay irrational longer than participants can stay solvent and one worries about the quite widespread view that this time is so different, that rates will stay low almost for ever.

The solvency in question here is that of the banks, where Ireland is particularly exposed. Reassuring noises from the IMF last week about the progress made on Irish banks (a lot done, more to do) were followed within days by the shock fall in share prices at Deutsche Bank.

All is not well in Europe's banking system, which means all is not well in Ireland's, and at the heart of it is the impossibility now for banks to borrow short-term at one rate and make profits lending longer-term at a higher one.

There was already a view that a few more years of this will see another banking crisis: irony of ironies not because the banks are lending too much but because they are lending too little. And we not even have a few years.

Thoughts are turning rapidly to what has been the deeply unfashionable idea of fiscal stimulus - government borrowing or direct handouts of new money. Fergus McCormick, chief economist at the Canadian ratings agency DBRS, calculates that if Germany and the Netherlands borrowed an extra 1pc of GDP per year for ten years, the resulting growth would see their debt/GDP ratio rise by just 2-3pc, but would leave the Eurozone ratio 2pc better.

It is another but of the argument which has raged since the crisis began but there is agreement that the effects of such actions will depend on how the borrowed money is spent.

That little branch line in Italy perhaps should not be there at all: keeping unnecessary facilities open, but starving them of funds rather than face the political consequences of closure, is a pattern familiar to both Italians and Irish.

Even worthwhile investments that make economies more efficient take time to organise and time may be in short supply.

Italy is squaring up to another political crisis, accompanied this time by a banking one. Something urgent is needed to shake off the pervasive sense of helplessness.

Here, major investment in housing would qualify as both stimulus and increasing the economy's potential growth. No houses for workers means the work will be done somewhere else. But no one seems able to find a way to do it quickly enough, on sufficient scale.

Unlike elsewhere, Ireland may not need stimulus but it does need the infrastructure. The EU rules which would prevent such investment are already largely discredited and financing terms have never been better.

Fixing the pervasive sense of helplessness which affects European governments, including Ireland's, may be the first job.

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