Interest rate cuts: Quack remedy?
SCMP December 9, 2002

Finally, after long being urged to worry about deflation and not inflation, the European Central Bank has again lowered interest rates. In the wake of the multiple reductions by Alan Greenspan this was only a matter of time. After all, it is now received wisdom that lower interest rates hold the key to a revival of demand in the Organisation for Economic Co-operation and Development world.
But is it not time we looked more closely at this simple assumption? We should look not only at its failure in Japan, but generally at the impact of lower rates on household incomes. That is apparent in Hong Kong as well as Japan and much of Europe.

Cuts are often a zero-sum game. For every over-leveraged corporation, homeowner or borrower from credit card or auto finance company who will benefit, there are those who lose income.

In Japan, low returns on savings have discouraged those with strong personal balance sheets from spending more. Low rates have prompted increased savings, not higher consumption. They end up delaying dealing with structural economic problems. More likely they exacerbate them.

Faced with very low interest income, the response in Japan has been for the thrifty to save even more in compensation for reduced expectations of future, and particularly post-retirement, income.

Meanwhile the very low rates in Japan have enabled those deeply in debt - mostly corporations - to put off the cuts, restructurings and closures that are necessary for a return to economic health. They have also encouraged the belief that the outsized government debt incurred in a vain attempt to stimulate the economy is manageable because the interest cost is, for now, so low.

The government has attempted both Keynesian fiscal stimulation and monetarist expansion of money supply to get out of the hole. But the fiscal stimulus has mostly gone to uneconomic public works projects or to direct lending to unviable businesses. The monetary expansion has failed because the economy is still burdened, not just with bad loans in the banking system but with excess supply in many areas of the economy.

In Japan, and Hong Kong, near-zero interest rates might be justified by the long period of deflation they have endured. Rates have remained positive in real terms while negligible nominal rates have not had the stimulative impact once expected of them.

The US, meanwhile, does not face deflation - at least not yet. Inflation is around 2 per cent while the federal funds rate after the last cut is just 1.25 per cent and money supply is still growing at a smart pace - M2 growth at 7 per cent over 12 months and 8.5 per cent annualised for the past three months.

It is hard to imagine that yet another reduction will do anything for capital spending, given the existing level of over capacity and the high risk premium now placed on much corporate debt. More likely it will just delay the capacity reductions and corporate failures needed to restore pricing power.

The latest US cut may enable the home refinancings and real estate prices surge to continue.

But encouraging baby boom homeowners for whom retirement is not so far off to reduce the equity on their homes will make matters worse in the future. Meanwhile, small savers who have accumulated large net credit positions in bank and savings and loan deposits will see their incomes further squeezed.

Low rates may make it easier to finance a war. They may also help end the dollar's over-valuation. The US currency slipped in the wake of rate cut expectations and a 10 per cent decline from here would certainly help US corporate profits. But on balance, low rates will make those who have been thrifty in the past even more so while delaying the slowdown in household and corporate debt creation needed for longer term economic health.

Internationally, low rates are constraining spending with healthy household savings and strong current account surpluses. At the same time, they are fuelling spending in the US and other economies where consumption is excessive, savings minimal and current account deficits huge. In a vain attempt to avert a necessary recession, they are storing up much bigger problems for the future.

As for Hong Kong, low rates have helped the minority who over-indulged in the pre-1997 speculative bubble. Very low interest rates also suggest that low returns on capital are to be built into our expectations - which, as in Japan, can only create an even bigger gap between reality and what corporate pension funds have assumed and what some life insurance companies have rashly promised.

Pension underfunding in the US and Europe was bad enough, and if very low interest rates mean that more corporate profits have to be diverted to fill the gaps, capital spending will be further curtailed.

Whatever their short term impact, the latest round of rate cuts sends the wrong message. Worse, they will not work.

 

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