From independence, freedom and truth


Debt, zero interest rates and other calamities

Fernando del Pino Calvo Sotelo

November 29, 2013

During the years that preceded the thunder-clap of the Great Debt Crisis, western central bankers and other members of the political class were absolutely happy, lost in a fog of ignorance and completely unaware of the impending disaster. Central bankers, holding as usual a very high opinion of themselves, thought that they had killed economic cycles; politicians, hardly understanding anything as ever, congratulated themselves because, thanks to them (but of course!) economies were “growing” (GDP dixit), unemployment was falling and voters kept reelecting them. Both sets of players kept asking: Mirror, mirror on the wall: who is the fairest of them all? Six years later, despite all that has happened, nothing seems to have changed: central bankers, having denied their obvious, axiomatic responsibility in the creation of the bubble, are still so fond of themselves as to believe they have saved the world (from themselves?); politicians, still hardly understanding anything, congratulate themselves yet again because the financial markets are going up like a rocket and they have regained the hope of being reelected. And the browned-off mirror on the wall has reached a point at which it just responds with a weary voice whatever it is they want to hear.

The credit orgy designed by central bankers created bubbles in all sort of asset classes and put the financial system on the brink of insolvency; at the same time, it also created a bubble in public spending, the mirror image of the bubble in public income. Politicians, smiling like Scrooge McDuck as their coffers filled up with unheard- of speed, increased spending to brace a nice reelection (you know, the concealed vote buying scheme typical of our democratic systems). When the bubble burst, the price of all assets fell, but debt stood firm at its maximum level; public revenue also fell, but public spending kept constant (it actually grew, due to what economists like to call automatic stabilizers). This caused steep budget deficits, a field in which Spain is a true champion. Central bankers, the same ones that generated the bubble and were unable to predict its huge collapse, in yet another fine example of their infinite wisdom, decided to reduce interest rates down to zero point something and start buying the devalued assets with newly printed money. The supposed goal was to buy time to allow banks, businesses and households to repair their balance sheets, to allow governments to experience the latest fetish expression called fiscal consolidation (formerly known as breaking even) and to proceed with economic reforms that somehow seemed unnecessary to “grow” the economy (GDP dixit), but that it now seemed indispensable to make it come back to life. Six years later and time has not been well used (please read the excellent latest annual report of the Bank for International Settlements).

The reason why time has been wasted is that central banks’ lax policies have eliminated most incentives for debt reduction and deep reform. With zero interest rates and the massive buying of all sort of assets, politicians and, to a lesser degree, the private sector find little motivation to think long term and do what must be done. In our country, the government has grudgingly undertaken the mini reforms demanded by the European Union only to pretend it is doing something, while our public debt has been rising alarmingly.

But the list of intended consequences of these extraordinary actions performed by central banks is a long one. Let’s put forward a few examples.

In the very first place, this brutal interventionism has killed the source of information that can only be offered by market prices being freely established, bringing with it an enormous uncertainty: nobody knows the value of anything anymore – should the central banks’ artificial support languish. This uncertainty was proved when Chopper Bernanke shyly announced that maybe he would start “tapering” if a series of conditions were met. Addicted to the central banks’ interventionism, the financial markets shivered at the mere thought that maybe, sometime in the future, the dose might be reduced. No problem: Bernanke blinked first, shivered even more than the markets and changed his mind before the cock crew twice.

In the second place, zero interest rates, huge asset buying and infinite verbal guarantees have fed, yet again, the same bubbles which caused so much destruction when they burst. Just to have an idea of this new monster, the B.I.S believes that a three percentage points’ increase in interest rates would cause bondholders to lose circa 8% of GDP in the US and between 15% and 35% of GDP in Europe and Japan. Paradoxically, it seems we should be careful with what we hope for – a return to normalcy.

One of the defining traits of democracy is the continuous sacrifice of the long term on the altar of an immediate pyrrhic victory. As the interest rate curve usually has a positive slope, governments tend to borrow short keeping a constant refinancing risk in play (the UK probably being an exception). With zero interest rates, this time preference has become even greater. For instance, Spanish public debt service (principal + interest) in the next four years amount to more than half of all the country’s outstanding debt and more than half of GDP, which must be wholly refinanced. In other words, we have to find someone willing to lend us 600 billion euros in the next four years. This is what I would call a fragile situation.

Another collateral damage has been the strangling of those depending on fixed income coupons. Retired people, pension funds and insurance companies have been obliged to take on more risk than they would have done otherwise as their historical sources of income have been expropriated by monetary policy. This, too, will have consequences.

Lastly, central banks mistook a solvency crisis for a liquidity crisis and wrongly saved financial institutions that should have gone bankrupt and should have disappeared so as to allow their more prudent and better managed competitors to take their place; losses were socialized and, again, the wrong message was sent out, another wrong incentive created.
The ironical part of the central banks’ interventionism is that, beyond the liquidity support provided for a few weeks back in 2008, has been fruitless for the real economy. It has created huge downsides without any visible upside, precisely the opposite of what a supposedly safety-provider institution should do. Monetary policy effects are asymmetrical and become largely ineffectual when facing a financial crisis, as their transmission mechanism doesn’t work due to the burden of the previous accumulation of debt. The wealth effect, so tender to the economists’ hearts, has proved to be mostly chimerical.

Our goal should be debt reduction, both public and private, but monetary policy is curbing it. Politicians hope that, if they wait, GDP growth (whatever that means) will reduce the huge levels of indebtedness without obliging them to take measures that might put their reelections in jeopardy. The problem is that the larger the debt grows, the more we will have to grow to repay it. But it gets worse: as we already know that, beyond certain hurdles, debt hinders growth, we are creating a vicious cycle, a spiral to default. Spain has already surpassed those hurdles, both in the private and public sectors.

In addition, if we are to grow faster, we should undertake deep reforms to increase the flexibility of our economies, which is precisely what politicians are dodging, spoiled by the central banks’ actions. Therefore, it is rather hard to believe that growth will save us from debt.

Eliminating the incentives for debt reduction and for reform was not a good idea. Neither is it, to artificially support the financial markets. We will suffer yet again the damage caused by the arrogant elite’s interventionism, and the arrogant elite will once more shamelessly blame the free markets.


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