Borrowing can improve wealth, in the form of rising asset prices. In this regard, leverage can act as a substitute, taking the place of real productivity increases. This is the financialized world we live in today, one in which the globalization of labor markets, financial markets, and goods markets have all been enabled by leverage and helped to further its use. The result is an improvement in overall wealth and asset prices, but not necessarily an improvement in real income – a world where wealth inequality helps to intensify populism and nationalism.
Less is more
Although financialization has translated into higher asset prices over the past decade, there is evidence that the marginal return from borrowed capital has been shrinking. The more we use it, the less of an impact it generates. To offset this, the cost of capital needs to fall and therefore, interest rates need to fall. As financialization has developed, investors have become more and more uncomfortable with volatility and the slightest market shifts have become magnified. The result seems to be a need to have central banks come to the rescue every six months. In other words, financialization has made the global economy more sensitive to interest rates than it’s ever been before.
Zombies and unicorns
Lower rates may be having a more profound effect on businesses and consumers than we realize. Lower rates are deflationary – they decrease the overall price of goods and services. For one, the low and falling cost of capital enables the persistence of zombie companies, or companies that should probably be out of business but are still kicking around. Zombie firms prevent creative destruction and inhibit innovation. As the lower cost of capital keeps them upright, these companies create excess capacity, which is also deflationary.
Secondly, the low cost of capital enables the creation and development of “unicorns” – privately held companies valued over $1 billion. Cheap funding has helped enable technologically adept start-ups to create new products and services that generate further deflation as they alter the landscape of a given industry, be it retail, transportation, or entertainment.
The global wealth divide has been exacerbated by the technological altering of the ways businesses and consumers operate across the broader economy. Tech has eroded the cost of everything we produce and consume and has also monetized people themselves, or at least their data. Another deflationary consequence of tech-based evolutions in automation and digital communication has been the separation of many employees from their wages.
Easy money, negative implications
Banks are key to the global financial system and the global economy’s use of leverage. They are responsible for credit generation and dissemination. Without credit, financialization grinds to a halt and the system freezes up. Since the Global Financial Crisis, credit generation has been facilitated by accommodative money policy on the part of central banks worldwide in the form of lower interest rates. Logically, this suggests that in a world of low interest rates, it makes sense to go below zero, but the reality is not that simple.
Lower rates are one thing – negative rates are another. Modestly negative interest rates at first saw a bump up in credit growth in countries that employed them, including Sweden and Denmark. But that trend reversed when rates began to move even more negative. This flipping point is referred to as the “reversal rate” – the rate where too low a rate level becomes a headwind rather than a tailwind to investor confidence. In fact, signs of reduced credit generation resulting from negative rates are already beginning to emerge. These include increased savings from households and non-financial corporates, lower rates earned by savers, and lower bank profits. Net interest margins, the difference between a bank’s income and interest payouts, are also on the decline as of early September.
While negative rates have demonstrated some short-term positive results, once the reversal rate is breached, their longer-term benefits begin to erode and the results appear to be doing more harm than good to the system. Negative interest rates are therefore not a long-term viable solution to economic malaise, as the adverse impact to the credit system starts to impede financialization, which ultimately acts as a drag to global growth.
End of an era?
The global economy has been relying on the monetary policy levers of lower rates and quantitative easing1 for years to stimulate growth for years. It looks as though Japan and Europe are now at a crossroads, having maximized their capacity to rely on these strategies. While the US and many emerging market countries may have some room left to run using this approach, the possibility remains that they too will eventually exhaust its benefits.
As they continue to lean on the monetary levers, evidence of diminishing returns is starting to emerge; strong deflation, scarcer growth, lower corporate investment, and more speculation – not to mention the increases in income and wealth inequality. At some point, monetary policy will need to be deemphasized and the baton will need to be passed to fiscal policy – the use of government spending and tax rates in the attempt to spur economic growth.
In a low rate, deflationary environment, bonds are likely to continue to do well. Varying forms of financial speculation are likely to continue over the near term. However, growth opportunities will remain hard to find, increasing the likelihood that quality and growth stocks outperform value stocks. In a system where leverage is essential, significant increases in interest rates remain unlikely, even in a future that sees a renewed focus on fiscal policy. Nonetheless, fiscal spending on infrastructure, for example, would stand to benefit hard assets such as precious metals and real estate.
The return of robust private sector growth will likely bring a meaningful return of confidence among businesses and investors, which will require an easing of political tensions in the US and elsewhere. We are unlikely to see this in the near term, as we live through what may be the final stages of a leveraged era.
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