To revive America’s economy, raise interest rates

The longer the low-rate environment lasts, the greater the systemic risk

by: Tony James

The US Federal Reserve delayed raising interest rates again last month. Meanwhile, the American economy is underperforming: gross domestic product is sluggish, productivity growth is down and, though wages are ticking up, incomes have hardly budged.

With fiscal policy locked in permanent austerity mode, the Fed’s easy money policy is not working. Worse, today’s artificially low interest rates are likely to be harming the economy.

Sustained zero rates hurt workers’ pay, the incomes of the elderly and businesses’ funding for long-term liabilities. Low rates destabilise the financial system. If you consider these points in turn, it is easy to see why it is time for the Fed to change course.
First, when interest rates are low for a long time, companies substitute capital for labour to an unnatural degree. Without sufficient demand to absorb this newly displaced labour, cheap capital puts downward pressure on wages and people out of work, damaging aggregate demand and undercutting any monetary stimulus.
Furthermore, businesses will have borrowed all they want, sometimes even more than they need. One result is a huge cash stockpile, another the wave of stock buybacks. Since business credit demand is already satiated and businesses already have enough production capacity, more rate reductions will not stimulate more productive investment.
Second, low rates hurt the elderly and others who depend on income-producing investments.

The yields on these investments are tied to government interest rates. As such, incomes and spending are pinched in a sustained low-rate environment.
Third, low rates hurt households, businesses and institutions that are investing today to fund future spending. A 1 per cent decrease in rates of return can increase savings required to make up the gap by 20 per cent. As a result, people must save more to fund future requirements — and spend less now precisely because rates of return are so low. Whether you consider parents saving for their children’s university education or companies funding pensions, ultra-low rates vastly increase the “present-value” cost of future commitments, creating another vicious cycle of reduced near-term demand and lower growth.
Fourth, low rates hurt the financial system and create systemic risks. Near-zero rates encourage investors to buy esoteric assets as they grasp for higher returns. This diverts resources from more productive investments. Investors dive into risky areas such as emerging markets and derivatives instead, inflating asset prices and creating greater market volatility in the process. The longer the low-rate environment lasts, the greater the danger of asset price bubbles and systemic risk.
In addition, with negative interest rates, banks cannot lend profitably. They need either to take more risks or shrink their balance sheets. But the latter has the opposite of the intended effect as it reduces banks’ ability to ex­tend credit and fuel growth. Finally there is the psychological effect. Negative rates communicate the fear of central banks that the economy is struggling.

That message is counterproductive.
For all these reasons, I believe conventional monetary policy has played itself out. While the immediate damage from artificially low rates may not be large, such rates hold back growth.
There are certainly significant challenges facing policymakers. Populations are ageing and demand from abroad is slowing. Incomes are stagnant and productivity is disappointing. The interplay of globalisation and technology creates challenges across the economy. These are the causes of our economic malaise and they call for real, fiscal solutions. We should not add to our challenges by sustaining ultra-low rates. They are doing more harm than good.
The writer is president and chief executive of Blackstone

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