Time to admit failed doctrine on low interest rates

The Australian 12:00am April 15, 2017

Alan Kohler

So according to the Reserve Bank, one third of households have no buffer, or a buffer of less than a month’s repayments.

This was mumbled on page 21 of the Financial Stability Review, before moving on quickly to commercial property. No one ran out into Martin Place with hair on fire, no one resigned in sackcloth and ashes, or apologised and, as far as we know, there was no roast from the Prime Minister or Treasurer, declaring their loss of confidence in the central bank.

Interest rates have been cut to the lowest level in history, yet inflation remains bogged below 2 per cent, unemployment is stuck at 5.9 per cent and now a third of borrowers are so far in debt they are bufferless. They are up to pussy’s bow, full stretch, bone on bone: no cartilage.

The real cause of excessive debt and unaffordable house ­prices is not negative gearing or even lack of supply, although those things don’t help.

It’s the failed doctrine that low interest rates promote economic growth and inflation.

You would think that after nine years of obvious failure the economics profession would rethink the hypothesis that negative real interest rates do anything but damage productivity and output, but it’s too deeply embedded.

Actually, it’s probably worse than that: economists tend to be employed by the beneficiaries of low interest rates — banks and the rich — so it would be a career-­limiting move to point out that the emperor has no clothes on.

Negative real interest rates, as the world has had for most of the past decade, allow those who can borrow against existing assets to buy more assets and to pay more for them.

Negative gearing has clearly helped to inflate Australian house prices by allowing less rich people to do it using a taxpayer subsidy, but it’s really about positive gearing: low interest rates allow the rich to own more and more assets by leveraging existing assets. The poor just get a lower return on their savings. Greater inequality is the result.

The big increases in the number of negative gearers in Australia has occurred when interest rates were rising and house prices were not. When interest rates were cut after 2008-09 and then again after 2013, the amount of negative gearing fell and at the same time house prices rose.

That makes sense: when interest rates are rising there are more tax deductible losses. It implies that growth in negative gearing coincides with static or falling house prices rather than the opposite, which goes directly against conventional wisdom.

That’s not to say negative gearing should not be capped or abolished — it should. But if interest rates stay where they are, doing that will have a minimal effect on prices.

The main reason the price of houses — all assets in fact — have gone up is simply that interest rates are being kept artificially low by central banks. And that’s been done because of the worldwide dogma that low interest rates encourage economic growth and higher consumer prices, rather than just higher asset prices.

The world’s central banks have been flogging this dead horse for a decade and the sparks of life we are seeing now are due simply to the passage of time, and to business people forgetting the horrors of 2008-09, as well as an expectation that the political revolution caused by the inequality that low interest rates have contributed to will lead to economic stimulus.

Maybe it will, or maybe the political establishment in the US will prevail. The winners in a world of negative real interest rates are the rich who run the place, and the last thing they want is for rates to be pushed higher by fiscal stimulus.

Donald Trump won the US election by promising to offset the unequal impact of low interest rates (he said globalisation, but that was wrong) by cutting taxes, spending money on infrastructure and creating jobs through protectionism. Bond yields rose in anticipation of a more rapid tightening of monetary policy in response to those policies; lately yields have declined because it looks like Trump won’t get those policies through, so the Fed can relax.

Meanwhile, last week’s March US payrolls report was terrible: 98,000 jobs missed expectations by almost 100,000.

Negative real interest rates for 10 years have not only not worked, if anything they are delaying the resumption of the normal business cycle by suppressing consumption and productivity and promoting speculation and inequality. The problem now is that there is so much debt in the world, consumption and employment are vulnerable to any shock, and in particular to the return of normal interest rates.

As Chris Richardson of ­Deloitte Access Economics pointed out this week, Australia is now uniquely exposed to a downturn in China, which is itself vulnerable because of too much debt. And this with interest rates already super low.

Central banks have been so busy inflating a debt bubble in the fruitless pursuit of higher consumer prices and economic activity that they now have nowhere to go if things get even worse.

Nor do households, or at least a third of them in Australia according to the RBA.

It means that for the first time, the next cycle of rising interest rates will probably cause a genuine property crash because that 33 per cent of borrowers with less than a month’s buffer will have to sell, all at once, for whatever they can get.

Which is what’s called a crash.